Question

1- Discuss adverse selection and moral hazard? Give examples

2- Define externality and give examples of positive and negative externalities? Give examples

Answer 1

1. Moral hazard occurs when insured customers are likely to take higher risks, believing that their cover will pay for a claim The customer knows more about his / her expected conduct than the provider (insurer) Because, for example, more people have access to health insurance, behavioral changes resulting from moral hazard may result in a significant increase in health insurance payouts. Moral hazard has also been related to the contentious topic of bank bailouts, because if a bank assumes that there is a reasonable chance that it will get emergency financial aid when it faces difficulties, bank workers can be inclined to take increased risks.  In the market for auto insurance an outstanding example of moral hazard can be found. In this segment, if they have insurance for their vehicles, the buyers will escape a significant share of the negative effects of their actions. Before having compensation, many of them should be extra vigilant with their vehicles because they will have to pay for accidents and repairs. However, if they get insurance, some drivers find like they no longer need to be as vigilant, because insurance would cover the expenses if anything happens to their vehicle. This can lead to more reckless driving, or even a increase in overall road carelessness. This kind of conduct is definitely not desired

Adverse selection happens when asymmetric information — information known to one party but not to the other — makes it difficult for prospective trading partners to differentiate between high-risk transactions and low-risk ones. This problem is particularly endemic to insurance markets. One of the most popular examples of adverse selection is found in the used car industry (i.e., the lemon industry). The sellers have more information on the quality and history of their cars in this market than the buyers. For the sake of the illustration, we'll assume that this market has two types of cars, high-quality cars (peaches) and low-quality cars (lemons). If a car is a lemon or not, the sellers know, but buyers can not differentiate between the two (because lemons can only be classified as such after they have been bought).

Therefore they are only able to pay a maximum price between the value of a lemon and a peach, since they know that they may end up buying a damaged car. This, in effect, makes the sale of high-quality cars less enticing for dealers, leading them to sell more lemons. This cycle continues without interference, until only lemons are left on the market.

2. Externalities are a form of market failure, i.e. the inability of the economy to sufficiently reward all the effects of economic behavior. This happens because the calculation of the externality price is difficult or unfeasible and/or there is no method to obtain it. Externalities are positive or negative impacts on outsiders spillovering from an individual's or a company's economic activities and not being adequately priced by the market process.

The externalities are two types: positive and negative. Positive externalities refer to the advantages that people outside the marketplace receive as a result of the actions of a company but for which they do not pay any cost. On the other hand, negative externalities are the adverse effects faced by outsiders owing to the actions of a business for which the consumer charges nothing.

Following a few examples of positive externalities: improvement of property prices resulting from constructing new highways, public transit systems, etc., and reductions in travel time due to higher accessibility.
Upon compulsory expiry of the patent, the creation of new inventions by corporations is freely available to everyone.
A few examples of negative externalities are as follows: the passive smoking that non- face when people smoke in public areas.
The noise and vibration that trains create for people who reside nearby mass transit systems.
Owing to unsustainable commercial fishing the decline in stock of marine life.