Question

concentrates on Asymmetric Information and Moral Hazard. These are two very important basic concepts which affects economics and for that matter our lives. So without providing your own life's confidential information please answer/discuss following: (Please note that this is not meant to ask personal questions or know any confidential information about you. It is just a educational exercise to recognize and know how these concepts are applicable to our lives.

- Did you know about Asymmetric Information and Moral Hazard concepts before? Briefly explain them using example for each one of them.

- Explain why dating can be considered a method to solve adverse selection problem? (This is a question right from chapter questions).

-On a day to day bases do you do any activity that can be considered Moral Hazard? What can you do about it? WIll you do it? Why or why not?

Answer 1

1. Moral hazard occurs when asymmetric information exists between two parties and a change in one party's behavior after an agreement has been reached. Adverse selection occurs if, prior to a deal between a buyer and a seller, there is a lack of symmetric data.
Asymmetric information, also referred to as information failure, occurs when one party has greater knowledge of material than the other party. Generally, the seller is the most experienced party. Symmetric data is when equivalent knowledge is open to both parties.

Consider the implications of purchasing insurance for an example of moral hazard. Suppose a homeowner has no insurance or flood insurance for homeowners and lives in a flood zone. The homeowner is very vigilant and subscribes to a system of home security that helps to prevent burglaries. If storms arise, by clearing drains and moving furniture, he plans for flooding to prevent damage. The homeowner is tired of having to worry about potential burglaries and prepare for floods, however, so he buys insurance for home and floods. He leaves his doors unlocked, cancels the subscription to the home security system and does not prepare for floods after his house is insured, his behavior changes and he is less attentive. In this situation, the insurance company faces the risks and consequences of flooding and burglaries, and the moral hazard issue arises.

Life insurance premiums can be a way to look at an adverse selection example. Suppose there are two groups of people in the population, smoking and not exercising, and not smoking and exercising. It is common knowledge that there are shorter life expectancies for those who smoke and do not exercise than those who do not smoke and exercise. Suppose there are two people who want to buy life insurance, one who cigarettes and doesn't exercise, and one who doesn't smoke and exercise every day. The insurance company, however, can not differentiate between the person who smokes and does not exercise and the other person without further details.

2. To start with, the adverse selection issue applies to the fact that there is an advantage on one side with a large amount of information while the other side is at a disadvantage due to information asymmetry. For example, in the second-hand car market, adverse selection may occur. Sellers have more information advantages in the second-hand car market than sellers because they have a much better car information order than customers. So the only way to solve this problem is to gain more information that can keep the data on both sides symmetrical. Therefore, we need dating to solve that, as dating can help us obtain more data, this allows us to make a better decision.

3. If your motorcycle is not protected, you will be careful not to get stolen. You're going to lock it up carefully. But if it is insured for its full value, you don't really miss out if it gets stolen. Therefore, to defend against fraud, you have less motivation. This becomes an asymmetrical data condition. The insurance company might assume you're going to look after your car, but you might know you're not going to.

In the case of the 2000-2007 sub-prime mortgage market, borrowers faced a moral hazard scenario. They were able to sell to other financial institutions on loan packages. Because there was strong demand from other consumers, and because other banks took all the risks, there was less motivation for mortgage companies to test the mortgages. Therefore, there has been a significant increase in subprime mortgage loans with insufficient audits being carried out.

If there is a guaranteed job for life for managers or civil servants, this may change their motivation for work. We have a greater willingness to make self-serving choices and help friends if they are prevented from making bad decisions. This is more of a concern when it is hard to assess who is responsible for the decision. It is connected to the problem of the principle-agent and can lead to results such as satisfying gain.