Question

A researcher may have difficulty separating moral hazard from adverse selection. Use an example to show why this may be the case.

Answer 1

In business, insurance and risk management, unfavorable options are market situations where buyers and sellers have different information, so participants engage in transactions that benefit them the most at the expense of other traders. An example of a textbook is the Akerlof lemon market.

Undocumented countries are concerned about unfair trade, which happens when all information countries use it to their advantage. Fear of counterfeiting may prompt anxiety parties to abandon interactions reducing the size of the business in the market. This can lead to a hammer and solder effect. Another significance of this potential for market failure is that it can act as a barrier leading to higher margins without further access.

Sometimes buyers have good information on how they can benefit from a service. For example, a buffet restaurant you can eat that sets a price for all customers, the risk is chosen unfavorably against high appetite, and consequently, the customer is least profitable. Restaurants have no way of knowing if customers have a high or low appetite. Customers are the only ones who know if they have a high or low appetite. In this case, consumers with high appetite are more likely to use the information they have and go to restaurants.

In this case, the seller, who suffers from unfavorable choices, can protect himself by controlling the customer or by setting a reliable appetite signal. A few examples of this phenomenon are found in sign games and projectors.

An example where buyers are not selected is in financial markets. The company is likely to offer the stock when the manager realizes that the current share price exceeds the firm's base price. Investors who do not have sufficient information require a fee to participate in the stock offering. While this may serve as an example of a buyer’s goodwill being chosen not to be true, the market may know that the manager is selling the stock (probably in a mandatory corporate account). The market value of the stock will reflect the information that the manager is selling the stock.