Question

Explain the difference between moral hazard and adverse selection. Discuss three examples of features of the labor market that can be explained as features that ameliorate moral hazard in the employer – employee relationship

Answer 1

Both problems arise because of Asymmetric Information prevailing in the market. Both the involved parties have different information before or after the deal or an agreement.

Below are some key differences:

- Adverse Selection problem occurs when the information is hidden. The problem of Moral Hazard occurs when the action is hidden.

- Adverse Selection problem occurs before the agreement or deal takes place. Moral Hazard occurs after the agreement.

- Adverse Selection is also known as Pre-Contractual Asymmetry. Moral Hazard also is known as Post-Contractual Asymmetry.

Examples that can create Moral Hazard in the labor market:

- Suppose an employer A assigns a task to Employee B. B signs the contract and start doing the assigned work. After some time, due to no supervision by A, agent B will start shirking on his job and start indulging in other activities that are of his own personal interests. This hidden action of B leads to Moral Hazard.

- If the employee is involved in risky activities (smuggling of goods produced ) that can harm the company or the firm, then this would create moral hazard problem.

- Principal-Agent Model wherein the Principal cannot supervise the actions of the agent and agent can easily shirk on the job.