Adverse selection and moral hazard.

Today I have been learning more about adverse selection and moral hazard. These occur in the market when there is asymmetric information between parties,
when not all of the information is available to everybody,
to use simpler terms.

When there is perfect competition in the market, ie....lots of buyers and sellers.
Price is the most important mechanism to communicate all the necessary information.

If quality is the same, people can only decide how much to buy or to sell.

If price is not a sufficient amount of information then more info is needed. Then we give more information on the content or quality of the product.

You can co-ordinate this information using branding or advertising.
You can also have complete contracts that cover all contingencies that are uncertain at time of purchase. Buying fruit in advance can depend on weather, harvest, economy, extreme factors. Quality is not known at time of purchase but complete contracts cover bad quality in advance.
You can also have information asymmetry. When info is not known to all parties. Some groups have more info than others on the goods. This leads to opportunistic behavior.

This all makes up information economics.

Adverse selection and moral hazard.

Adverse selection comes before entering into a contract and happens where one party has information that is not available to everybody else. They have an advantage from having more information and this causes a bias.

So when the contract is signed, that bias is already there due to the type of person attracted to the contract. This could be health insurance, car insurance, mortgage ect... The bias comes from the asymmetric information that the party signing has.

Moral hazard is what can happen after the contract is signed. Their behaviour can be affected by the asymmetric information after signing the contract. They have a bias from the information contained in the contract.

“Moral hazard describes the temptation for a customer, once he has bought insurance, to takegreater risks than he otherwise might have done. Moral hazard can take different forms. A customer might, for instance, increase the chances that he will incur a loss, so somebody with car insurance may drive more recklessly than he would if he were uninsured. Even though an insured person may try to reduce the odds of a mishap, he may do so in a way that increases the size of the
potential loss. A firm that discovers it has a defective product, for example, may withhold its findings to avoid early lawsuits it has to settle itself, while raising the risk of a huge later payout that falls on its insurance company.”

Source: The Economist, 29 July 1995


For my Economics class we were challenged to identify an example of an existing mechanism to reduce either moral hazard or adverse selection in industry.

Mortgages.

I think that a mortgage is a good example of a contact that could contain asymmetric information. If I walked into the bank looking for a mortgage there would be a lot of unknowns when I sat down to sign those contracts. There was a time when knowing the bank manager was enough to gain approval and it wasn’t that long ago.

It seems to me that the best solutions to asymmetric information are information and transparency.

Every bank offers different deals and mortgages depending on your current situation. They all have different rates and different incentives to sign to their offer. They will attract a certain type of person to each one depending on circumstances at the time.

To reduce adverse selection, they create contracts full of information that outline all necessary details needed for you to sign up and maintain that contract. They provide the information for you to decide and since the last banking crisis have put more restrictions on their lending to reduce the moral hazard of defaulting on that loan. There are now restrictions on LTV and how much you can borrow based on your salary.

They also have a number of requirements to increase their knowledge of your situation and needs,

• Banks statements.
• Proof of salary.
• Identification.
• House insurance.
• Life insurance.

All aimed at gathering more information that you already have and mitigating the risks of signing a contract. The insurance covers their liability if anything happens to you during the term of the loan and the statements show that you can freely enter into and maintain that contract at the time. Combined these mechanisms help to provide a more transparent and more reliable contract between the two parties.

Images used:

Ref 1: Pixabay

Ref 2: Pixabay

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