Question

Describe either an adverse selection or moral hazard problem a company is facing. Describe the qualities that make it either adverse selection or moral hazard. What is the source of the asymmetric information? Who is the less-informed party? Are there any wealth-creating transactions not consummated as a result of the asymmetric information? If so, could you consummate them? What advice/recommendations would you give the company? Incorporate concepts from the readings and lectures.

Answer 1

*Answer:

* Adverse selection refers to a situation where sellers have more information than buyers have, or vice versa, about some aspect of product quality, although typically the more knowledgeable party is the seller. Adverse selection occurs when asymmetric information is exploited.

* In a moral hazard situation, one party entering into the agreement provides misleading information or changes their behavior after the agreement has been made because they believe that they won't face any consequences for their actions.

* Asymmetric information, also known as "information failure," occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good or service possesses greater knowledge than the buyer.

* If one party in a transaction has more or superior information compared to another. Generally this kind of situation happens in transaction where the seller knows more than the buyer, although the reverse can happen as well. And this could be a harmful circumstance because one party can take advantage of the other party's lack of knowledge. This asymmetric information can lead to two main problems: irst one is the immoral behavior that takes advantage of asymmetric information before a transaction. This is called adverse selection. And the second one is moral hazard. Immoral behavior that takes advantage of asymmetric information after a transaction. Information enters a firm from the bottom so that subordinates who are further down in the management hierarchy are better informed than their bosses.

* An insurance provider agrees to pay benefits to a customer in the event of an accident, or other event based on expectations of the customers behavior. However, moral hazard results if the customer then changes behavior after the agreement has been finalized. For example, a driver might take more risks by speeding and ignoring traffic signals with insurance than without. This change in behavior is not known by the insurance provider.

* The problem of moral hazard is closely related to the problem of adverse selection, and it has similar causes and solutions. Both problems are caused by asymmetric information. Moral hazard caused by hidden action insurance companies con not observe you driving behavior whereas adverse selection is caused by hidden information.

* The moral hazard problem of can represent an opportunity to make money. Moral hazard represents an unconsummated wealth creating transaction. If the insurance company could figure out how to get insured consumers to take care, then it could make money. For example, if the insurance company could observe whether the customer was exercising care, then it could lower the price of insurance to those taking care.

* The market participants often hold this information asymmetrically. In many instances of asymmetric information, the less-informed side knows that the other side has more information. The asymmetric information results in adverse selection problem which is the phenomenon where there is a hidden information problem and people on the informed side of the market self-select in a way that is harmful to the uninformed side of the market. The moral hazard problem majorly occurs after the transaction. In Moral hazard problem one side of the economic activity engages in activities that are undesirable for the other side in terms of their agreement.

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