Question

1. Find an example of each of the following: moral hazard problem, asymmetric information problem, and the adverse selection problem. Explain how each leads to an overallocation or underallocation for society. How can each be fixed?

Answer 1

Moral Hazard problem is an ethical issue where the incentive leads to carelessness in a person or we can say it leads to over-allocation/overconfidence to the person towards the utilization of a product. if we purchase a product X with a replacement warranty for a given period of time than the utilization of that product will be overallocated or more careless.  this sort of problem can be fixed with another clause having the point that with good maintenance the period of insurance/security or warranty will automatically be upgraded.

Asymmetric information problem is a popular problem in a competitive world. if a piece of information is useful to all competitors in the market having the same business then the person who has the information tries to hide it to gain some extra profit. purchasing good brand cloth from their own outlet and the normal cloth from the general outlet. There is an assurance in the brand, where non-brand clothes don't have any. This sort of problem is either under-allocated or over-allocated in terms of passing information to the buyer or hiding original information.

Adverse selection is another type of problem which is a part of asymmetric information, in which the counsumer take a decision without knowing all the detail about the product. after closing the deal customer regrate about its selection. for example, if we purchase an automatic washing machine but after dealing wecameto know about a better-featured machine is available at same price then our selection looks like an adverse selection. here the problem is with the under-allocation of information. this type of problem can be solved through a proper comparative analysis of available alternatives.