Question

Stiller 4. Explain moral damage and adverse selection problems. BONUS: A person who avoids risk will divide 100 TL between one risky and the other without risk. The rate of return of the risk-free investment is 0.05, the return rate of the risky investment is 20% probability 0.20, 80% probability 0.03. What should be the amount of A which is given as benefit function and can be allocated to riskless investment in order to maximize the return?

explain the moral damage and adverse selection problems by using samples

Answer 1

Adverse selection:

The problem of adverse selection occurs when a person makes a decision without the required information which can result in an outcome that is not desirable.

When there are two parties & if one party has more information than the other one, it is known as asymmetric information & hence a party having asymmetric information may make an adverse selection.

For example if a person wants to buy a car from a seller. You would have selected a car as per your tastes & preferences. The seller may have some unpleasant information about the car which he may not disclose it to the buyer & which the buyer may be unaware of. Because the buyer is unaware of this asymmetric information he would proceed further in buying the car. Hence the problem here is the buyer is not aware of the true quality of the car, so having asymmetric information the seller was able to sell a poor quality product.

Moral damage:

This is another concept where an individual may take more risks believing that he is being protected by another individual bearing the costs of the risks. Like adverse selection, this is also a result of asymmetric information. If a party knows that he is being protected from risks he may act differently than if they are not being protected.

For example, Moral hazard has also been applied to the controversial issue of bank bailouts for if a bank knows that there is a good chance it will get emergency financial support when it encounters problems, employees of the bank might be tempted to take increased risks.

Similarly, this can be seen more in case of insurances where consumers would take more risks believing that a claim will be paid for their cover. But at times it can happen that the insurers may make an in-depth analysis where they may find that the claim is not worth settling which can be a loss for the insured.

Student,

I have not answered the bonus question as you have mentioned only about the first question in the bottom. Please comment. Thanks.