Question

23) Discuss how well-functioning financial intermediaries solve adverse selection and moral hazard problems. (5 points)

Answer 1

Adverse selection refers to the situation in which the buyers have less information than the sellers of the good and end up making a poor purchase decision.

For e.g. in case of second-hand cars, the buyer has less information on the performance of the car than the seller

Moral Hazard refers to the situation in which the buyer starts indulging in risky behavior after the purchase transaction is done, if it knows that the cost of risk will be borne by the other party

In order to eliminate these two problems, it is important to have well defined intermediaries in place.

This is because the presence intermediaries will facilitate not only complete exchange of information between the parties in order to let buyers make a good purchase, but also regulate buyer behavior post the transaction in order to reduce the problem of moral hazard.

This will keep both the buyers and sellers from deviating from their rational behavior and lead to an efficient decision making.