Question

Resource Allocation and Ownership subprime crisis What are the notions of moral hazard and Adverse selection? How does the subprime crisis demonstrate a real world example of moral hazard and adverse selection.

Answer 1

Moral hazard and adverse selection:

There is asymmetric information in the market. Sometimes buyers know more (insurance buying) and sometimes sellers know more(second hand car selling).

In insurance it is possible that a person may change behavior after buying an insurance policy and thereby risking life/health. This will involve companies paying higher compensations.Eg. Non smoker turning in smoker. This is moral hazard

It should be noted that if there are many cases of moral hazard then insurance company increases premium and only risky people buy it as it becomes costlier and normal people buy it less. This again increases probability of claims . This is called as adverse selection as company ended up selecting risky customers.

Q. How does the subprime crisis demonstrate a real world example of moral hazard and adverse selection.

Ans: It is known that subprime crisis mainly happened due to banks giving home and few other loans even to those people not capable of repaying. The basis considered by banks was that house prices will only go up and hence even if customer does not pay, the mortgaged house ca n be sold and loan be recovered.

However, in this case banks ended up getting those customers who were not fully capable to repay loans. Also customers had incentives showing moral hazard that even if capability was there, expecting house prices to go up and then repay loan at last. This increased supply of houses and demand went down and all of a sudden the loans became non performing assets.

This is a good example of moral hazard and banks getting risky customers through adverse selection.