Question

adverse selection and moral hazard are both examples of asymmetric information. True of False

Answer 1

The answer is True

Adverse selection and moral hazard are both examples of market failure situations, caused due to asymmetric information between buyers and sellers in a market

Adverse selection: asymmetry in information prior to the deal

Adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece.

It is this asymmetry of information prior to the transaction that prevents the transaction from occurring. If both the seller and the buyer were uncertain of the quality, they would be willing to trade the good based on expected values. Similarly, if both the seller and the buyer were certain of the quality, they would be willing to trade the good based on its actual value.

Moral hazard: asymmetry in information/inability to control behavior after the deal

Moral hazard is seen for services such as insurance and warranties. In these cases, after the deal is done, one of the parties to the deal (in this case, the person purchasing the insurance or warranty) may be more careless because he/she has the insurance, and thus does not need to pay the full cost of a damage. For instance, a person possessing insurance against theft may be less careful about closing the windows when leaving the house. Here, it is not the prior information that either party has, but the inability of the insurance provider to control and monitor increased risk-taking behavior that creates the potential for market failure.

Also, while in adverse selection, the seller is usually the one possessing more information, moral hazard usually has the buyer (of the insurance service) having too much control.