Question

Give an example of adverse selection problem and an example of moral hazard problem. Explain how the financial intermediaries can help in avoiding these kind of problems and reducing the cost of asymmetric information.

Answer 1

(i) Adverse selection: This implies taking the advantage of asymmetric information before transaction. For example, a person may be more eager to purchase life insurance due to health problems than, someone who is healthy.

(ii) Moral hazards: This implies taking the advantage of asymmetric information after transaction. For example, if someone has car insurance he may commit theft by getting his car stolen to reap the benefits of the insurance.

Moral hazard refers to situation where one side of market cannot observe action of the other. For this reason it is sometimes called hidden action problem.

Signaling:

In order to overcome problem of adverse selection signaling is used by which one side of market provide information to the other side of market. For example: Plum owner can offer warranty and by providing warranty they signal to the buyer that they are not purchasing lemon. Similarly, in labor market a person may signal to the employer about higher productivity. For this purpose we provide information about level of education.

In order to indicate better productivity, a person indicates about his education but acquiring education involves cost. So, a person will prefer to get education and incur a cost if by incurring cost he is able to separate himself from others. This type of signaling is called separating equilibrium because it involves each type of worker is making a choice that allow him to separate himself from others.