Question

In each of the following cases, identify whether the problem is adverse selection or moral hazard and explain your answer. How might the problem be dealt with?

1. Rick has gotten a large advance to write a textbook. With the money in hand, he prefers spending his time sailing rather than sitting in his office working on the book.
2. Justin is trying to get a large advance to write a textbook. He knows, but publishers don’t, that he did poorly on the writing portion of the SAT.
3. Mai is buying a life insurance policy. She knows that members of her family tend to die young.
4. Erich, who has a large life insurance policy, spends his vacation pursuing his favorite hobbies: skydiving, bungee jumping, and bullfighting

Answer 1

The problem of adverse selection occurs when there is lack of symmetric information between two sides of the market before the deal has been struck between the parties. The problem of moral hazard mainly occurs after the deal has been struck when insured consumers are likely to take greater risks knowing the claim will be paid by their cover.

1. Moral Hazard. Since the person has received the claim for the book, thus this refers to the problem of moral hazard.

2. Adverse Selection . Since the deal has not been signed yet and there exists lack of information between two sides, thus it refers to the problem of adverse selection.

3. Adverse Selection - There exists lack of information between two sides of the market.

4. Moral Hazard- Since more risk is being taken after the insurance policy has been purchased, this refers to the problem of moral hazard.

The problem of adverse selection can be solved by conducting prior test of the buyers and taking into consideration the medical report before the insurance policy is sold. The problem of moral hazard can be solved through co-insurance. Here the buyer of the insurance policy also has to contribute in case of any health problem.