Question

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

Answer -

The moral hazard problem in economic is a risk that the client or party had not good faith in entering business or contract or it provided manipulating or misleading information about the credit cpacities or liabilities etc.For example Before the 2008 financial crisis , when there is burst bubble in housing , the lenders action can be understood as moral hazard .Like through the use of incentive such as commision to originate as many loans irrespective of the financial means of borrower .As the intention is to sell this loan to investor and shifting the lending institution away from risk , the lender and the mortage broker gains the financial profit from the risk increment but the burden of risk resulted fall on the investors.Borrowers who started to make payment of mortage also had experienced the moral hazard.

Asymmetric information problem is the information failure which happens when one of the party possesses large material knowledge then other parties.OR when the seller posseses greater knowledge than the consumer who is buying goods and services.All the economic related transaction involve the information asymmetric problem.FOR EXAMPLE , there is a tockbroker having knowledge and it is more valuable than the professional who is non investing like say for example farmer who is only interested in trading stocks confidentially to prepare for retirement.Only alternative to this problem is for the worker to have the study of all the fields aprt from specializing in only one field .

The Adverse selection problem generally incur when one of the party who is negotiating has relative information which the other party is lacking.It leads to doing more business with high risk and less profit . For example a manager of company is willingy issue the share when overhauling of price of share happen in comparison to real value .In this the buyer will end up buying it and will lose all money .Also example the seller charge the buyer more despite of disclosing the defect in the car .Avoiding adverse selection requires recognization of group of people who are more at risk thanthe general people

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