Question

Define and explain the importance of all of the following concepts.

Adverse Selection

Moral Hazard

Too Big To Fail Problem

Answer 1

Adverse selection occurs when there is asymmetric (unequal) information between buyers and sellers. This unequal information distorts the market and leads to market failure.For example, buyers of insurance may have better information than sellers. Those who want to buy insurance are those most likely to make a claim. Therefore firms are reluctant to sell insurance.Sellers of second-hand goods may have better information about the true quality of the good than buyers. Therefore, buyers are reluctant to pay a decent price because they fear getting a ‘dud’.Adverse selection occurs because of information asymmetries and the difficulties in selecting customers.

Consequences of adverse selection:-

Due to poor information and difficulty selecting customers, there will be a higher overall price as firms have to take into account relatively higher payouts to high-risk customers taking out insurance.Low-risk customers may not want to buy because it istoo expensive for their needs – leading to a missing market.Firms may invest considerable time in identifying which groups of consumers are higher risk.

Adverse selection in health insurance:-

Suppose an insurance firm offered health insurance to the general public. It is likely to have the highest take-up rate amongst unhealthy people – people who don’t exercise, people who smoke. They are the group most likely to need health care; therefore, it makes sense for them to take out insurance. Healthy people are less likely to take out health insurance – if the price of health insurance is determined by the average unhealthy person.

Adverse selection for buyers:-

It is also possible that the seller will have better information than buyers, and sellers only sell the product when it is favourable to them.For example, managers of a company may be more willing to issue shares, when they know the share price is overvalued compared to real value. Therefore, buyers can end up buying over-valued shares.

Solutions to adverse selection:-

To avoid adverse selection, firms need to try and identify different groups of people. This is why there are health insurance premiums for people who smoke and obese people.

Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.

In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan.

It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.You have not insured your house from any future damages. It implies that a loss will be completely borne by you at the time of a mishappening like fire or burglary. Hence you will show extra care and attentiveness. You will install high tech burglar alarms and hire watchmen to avoid any unforeseen event.But if your house is insured for its full value, then if anything happens you do not really lose anything. Therefore, you have less incentive to protect against any mishappening. In this case, the insurance firm bears the losses and the problem of moral hazard arises.

Too big to fail" describes a business or business sector deemed to be so deeply ingrained in a financial system or economy that its failure would be disastrous to the economy. Therefore, the government will consider bailing out the business or even an entire sector—such as Wall Street banks or U.S. carmakers—to prevent economic disaster.Perhaps the most vivid recent example of "too big to fail" is the bailout of Wall Street banks and other financial institutions during the global financial crisis. Following the collapse of Lehman Brothers, Congress passed the Emergency Economic Stabilization Act (EESA) in October 2008. It included the $700 billion Troubled Asset Relief Program (TARP), which authorized the government to purchase distressed assets to stabilize the financial system.This ultimately meant the government was bailing out big banks and insurance companies because they were "too big to fail," meaning their failure could lead to a collapse of the financial system and the economy. They later faced additional regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.