Question

For each scenario, indicate whether it is an example of moral hazard or adverse selection.

a. You decide to buy a new car instead of a used car because you are worried about the quality of the used car.

• moral hazard

• adverse selection

b. You sell your condominium because you fear there will be a large special assessment next year. There has been no official notice of an upcoming assessment.

• moral hazard

• adverse selection

c. The owner of a company has just secured a new line of credit from the bank. He decides to change his business plan and open a second office in a foreign country.

• moral hazard

• adverse selection

d. A firm that has purchased a large insurance policy becomes careless about setting the security alarm.

• moral hazard

• adverse selection

e. A number of households find themselves owing more on their mortgages than their houses are currently worth. Some of them decide to abandon the house and walk away.

• moral hazard

• adverse selection

f. The owners of a company suspect there will be more competition from foreign producers in upcoming years. They have just issued new shares of stock in their company.

• moral hazard

• adverse selection

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Answer 1

a) adverse selection ( occurs before transaction , uncertainty about quality of a used car )

b) adverse selection ( fear of assesment before transaction )

c) moral hazard ( occurs after transaction , new line of credit achieved from bank and then utilized for own self interest )

d) moral hazard ( after buying policy firm becomes careless because insurance company will cover the cost )

e) moral hazard ( mortgage loan not paid off after taking the loan and just walking away )

f) adverse selection ( uncertainty regarding competition while taking a decision )