Question

In developing countries, the practice of microfinance (banks and NGOs offering small loans to entrepreneurs) has become a popular poverty alleviation strategy. As in all credit markets, there are two issues with the market for microfinance- moral hazard and adverse selection.

i. Briefly explain how moral hazard and adverse selection are similar.

ii. Explain specifically how adverse selection and moral hazard might affect the market for microfinance. Do they have the potential to cause deadweight loss and make this market inefficient?

iii. Microfinance organizations have found that putting borrowers in groups so that each member of the group is responsible for the repayment of the others often helps increase the repayment rate of these loans. Is this practice closest to signaling, screening, reputation, statistical discrimination, or regulation? Explain. Brainstorm two additional solutions that might help solve the adverse selection or moral hazard issues in this market and link these solutions back to either signaling, screening, reputation, statistical discrimination, or regulation.

Answer 1

i).Moral hazard and adverse selection have following similarities:

1. In both the cases one party is at disadvanatge. In case of moral hazard, insurers are at disadvantage and in case of adverse selection consumers are at disadvantage.

2.They both are consequences of information assymetry issue in markets. In case of moral hazard, Consumers have more information than the seller and in case of adverse selection insurer have more knowledge than buyer.

3.Both leads to market faliure. Moral hazard and adverse selction reduces the market size which leads to market faliure.

ii).Adverse selection and moral hazard lead to market faliure for microfinance due to lack of information.

Adverse selection is a term used in economics to refer to a situation when sellers have more knowledge than buyers. The information gap causes the price and quantity of goods or services in a market to shift. This results in “good” products or services not being selected. For example, if a bank set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance and high activity customers. The individual price would generate a low profit for the bank.

A moral hazard is a situation which refers to the situation where buyers have more knowledge than the sellers. A moral hazard can occurs when the behaviour of buyer changes after a financial transaction.  In Malawi, for example, In loan schemes given by government to poor, loan takers often do not repay the loan.

Yes, moral hazard and adverse selction have the potential tocause deadweight loss and make the market inefficient.

iii). Additional solution for these two issues are -

1. Formation of various institutuions: The issue can be solved by intoducing financial intermediaries which helps in building trust by providing a form of guarantee. These instituions can signal the investment performance to the buyers of securities, and a fair price to the sellers of securities.  

2.Equity finance: Equity finance is financing through the issuance of stock, this requires the managers to own a certain percentage of the company, this gives them incentive to not to cheat.