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. David 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 his entrance exam for graduate school.

3. Brenda is buying a life insurance policy. She knows that members of her family tend to die young.

4. Maria, who has a large life insurance policy, spends her vacation pursuing her favourite hobbies: skydiving, bungee jumping, and bull-fighting.

Answer 1

1. Moral Hazard. In this case, since the person has got the money and not utilizing the money effectively, this is the case of moral hazard as it prevents hidden actions. To avoid this problem some amount of money should be given in advance while the rest of the money should be given once the book is complete.

2. Adverse Selection. Since this case represents hidden information from David's side, this is the case of adverse selection.Checking the writing skills of the person beforehand can help in preventing this problem.

3. Adverse Selection. This is the case of hidden information because Brenda knows the tendency in her family to die young which is not known to the person selling the insurance policy.Checking the family history of the person beforehand can help in preventing this problem.

4. Moral Hazard. Since the person is pursuing adventurous activities which can he fatal, this is the case of hidden action and thus represents moral hazard problem.Including the clause in the agreement that company will not be responsible in case of death due to risky sports.