Question

Explain the difference between adverse selection and moral hazard using examples for each.

Answer 1

Adverse selection and moral hazard explain several different circumstances between two parties where, due to a lack of knowledge, one of them is in disadvantage. That means the second party can be abused because, unlike the first party, it does not have access to all relevant information. Knowledge is one of the most important factors when it comes to making decisions in an economic context. For most cases an successful result can only be obtained if the same information is accessed by both parties.

Adverse selection occurs when asymmetric information is present between a buyer and a seller before a deal is made. That means, before they reach an agreement one of the two parties (usually the seller) has more reliable or specific details than the other party ( usually the buyer). It places the less experienced group at a disadvantage as they find it easier to determine the worth or risk of the contract. During the meantime, the more informed the group has access to all the relevant information and can determine the consistency of the agreement more easily. In the end, this leads to an inefficient result and poorer consumer price of products and services.

One of the most popular examples of adverse selection is found in the used car industry ( i.e., the lemon industry). The sellers have more information on the price and history of their cars in this market than the buyers. For the sake of the illustration, we'll assume that this market has two types of cars, high-quality cars (peaches) and low-quality cars (lemons). Whether a car is a lemon or not, the sellers know, but buyers can not differentiate between the two (because lemons can only be classified as such after they have been bought).

Therefore they are only able to pay a maximum price between the value of a lemon and a peach, since they know that they may end up buying a damaged car. It, in effect, makes the sale of high-quality cars less desirable for dealers, causing them to sell more lemons. This cycle continues without interference, until only lemons are left on the market.

Moral hazard happens when a buyer and a seller have asymmetric details, and a change in behavior after a sale. Which means, when a contract is made, one of the parties (usually the buyer) signs an arrangement with the intention to change their behaviour. It occurs when they assume that they do not suffer the adverse repercussions of their actions. This places the less experienced group (usually the seller) at a disadvantage, as they are usually the ones who have to suffer the adverse consequences. And they would not have agreed to the agreement if they learned ahead of time about the change in behaviour.

Within the market for auto insurance an outstanding example of moral hazard can be found. Within this industry, if they have insurance for their vehicles, the consumers will escape a significant share of the adverse effects of their actions. Without having compensation, all of them should be extra vigilant with their vehicles because they will have to pay for accidents and repairs. However, if they get insurance, some drivers find like they no longer need to be as vigilant, because insurance would cover the expenses if anything happens to their vehicle. This can lead to more reckless driving, or even a spike in general road carelessness. This kind of action is not expected, of course, and puts the insurance companies at a disadvantage.