Moral hazard and adverse selection arise because of information asymmetry. Information asymmetry signifies a situation in which one party involved in a transaction with another, has more or superior knowledge and information than the other. This is often the case between buyer and seller, where seller has more knowledge than buyer. However, the opposite condition can also happen at times. The situation can potentially be harmful as the party with more information can take advantage of other's lack of knowledge and therefore exploit the other party.
Asymmetric information is the source of two major problems such as the following:
This reflects on the immoral behaviour of a party with asymmetric information subsequent to a transaction. For example, some people commit arson purposely to reap benefits from the fire insurance.
Adverse selection is a term which refers to a market process in which undesirable results occur when buyers and sellers have asymmetric information. Adverse selection is a term used primarily in insurance although it is useful for other industries. It refers to a situation in which the buyer or seller of a product knows something about the product quality or condition that the other party does not know, allowing them to have a better estimate of what the true cost of the product should be. In this case, the party displays immoral behaviour by taking advantage of the knowledge or asymmetric information prior to transaction.
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Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of certain parts of an agreement whereas the other(s) cannot.
Distinction between moral hazard and adverse selection
In adverse selection models, the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement.
An example of adverse selection is when people who are in dangerous jobs or high risk lifestyles have a tendency to get life insurance as the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behaviour or cannot effectively retaliate against it, for example by failing to renew the insurance.
In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. As individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service, which would otherwise not be necessary. In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services.
Sometimes moral hazard is so severe it makes insurance policies impossible. Coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing the out-of-pocket spending of consumers, which decreases their incentive to consume. Thus, the insured have a financial incentive to avoid making a claim.
For instance, if you offer an average interest rate for your loans, the people who are better risk takers will go elsewhere for their money, while the risky people will gladly take your money.
Moral hazard is also described as "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly. Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return.
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Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend using their cards, because without such limits those borrowers may spend borrowed funds recklessly, leading to default.
Sales of second hand car
A good illustration of this principle was presented by George A. Akerlof in his article "The Market for Lemons". As an example, suppose 2 people want to sell their car. The first person is an old lady who rarely drove her car and kept it in good condition. The second person drove his car during his wild teenage years: speeding, drag racing, and getting involved in a few fender benders. On top of that in order to save on money, the second person changed the oil only once in a while.
They both come to a used car lot to sell their car. If the car dealer or the customers could not distinguish between the cars, then the offer would be an average price for both cars. Indeed a customer is not going to pay more than an average price without some guarantee that a higher priced car is better than a lower priced one. The old lady will not accept less than what her car is worth, while on the other hand the young man will acknowledge it as a good price for his car and will gladly takes it. Suppose that the car dealer stocks up on lemons because the lemon sellers gladly accept the average price while the owners of sound cars do not.
The above scenario is not reality because there are ways of distinguishing the quality of cars, such as the mileage and the year it was manufactured and the car can be inspected for dents and other damage. But fund seekers will be harder to distinguish.
Techniques to mitigate adverse selection and moral hazards
The techniques used to mitigate adverse selection and moral hazards are as follows:
There are number of signals that can be sent to clients to convey the credibility of the seller and the reliability of the product being sold. Signalling is an action by a party with good information that is confined to situations of asymmetric information.
Signalling can be interpreted as an idea that one party credibly conveys some information about itself to another party. For example, "potential" employees send a signal about their ability level to the employer by acquiring certain education credentials. The informational value of the credential comes from the fact that the employer assumes it is positively correlated with greater ability.
Examples of Signalling
Guaranty and Warranty
One way a seller can signal the quality of its product is by offering guarantees or warranties. If a firm offers a warranty on a poor product, it will suffer a loss. Therefore, it is in the firm's interests to only offer a warranty on a quality product. The warranty tells potential buyers that the firm will stake money on its belief that it has a good-quality product.
Another way a firm can signal quality is by building a brand name. A brand name is valuable only if consumers associate it with quality, and the firm can build this association only with time and resources. Once a brand name is established, it is in the interests of the firm to protect it by ensuring that its products and or services are of high quality.
When a firm with an established brand name does offer a poor-quality product, it usually puts a different name on the product so as not to endanger the public's perception of its brand name.
Signalling plays an important role in the labour market. The applicant for a job must demonstrate that he/she possesses the required skills and knowledge to perform the requested duties for a job, either through academic pathway whereby the level of education achieved is demonstrated and testimonials from referees to testify the applicant's characters and abilities. For examples, the ACCA (Association of Chartered Accountant) qualification communicates a high level of professional competency in Finance and Accounting. Hence education builds human capital of high value to future employers.
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Screening is an attempt to filter helpful from useless information. It is an action by those with poor information and it occurs even when information is symmetric. For example, when two people go on a blind date, both are unsure if they are compatible, so both are screening, listening and watching to learn if the other person is someone with whom they would want a second date.
Screening attempts can be found in the following sectors, namely:
There are many examples of screening in employment decisions.
Employers give aptitude tests and check letters of recommendation or testimonials.
The existence of "old-boy" networks is the result of a screening process. If a person wants to hire someone, he will ask those he trusts (the "old boys") for recommendations. As recommending someone who is unqualified will lower his prestige in the eyes of the other "old boys," there is an incentive for a person to only recommend qualified applicants.
Part of the enthusiasm that employers have for graduates of prestigious MBA programs is that the schools are selective about who they let in. They try to select only those students who have the right combinations of intelligence and personality traits to ensure success in the business world.
When there is asymmetric information in the market, screening can involve incentives that encourage the better informed to self-select or self-reveal. For example, a job with a low paying probationary period will discourage those who know they are not well suited for the position from applying.
In the job market, potential employees seek to sell their services to employers for some wage, or price. Generally, employers are willing to pay higher wages to employ better workers. While the individual may know his or her own level of ability, the hiring firm is not (usually) able to observe such an intangible trait - thus there is an asymmetry of information between the two parties. Education credentials can be used as a signal to the firm, indicating a certain level of ability that the individual may possess; thereby narrowing the informational gap. This is beneficial to both parties as long as the signal indicates a desirable attribute - a signal such as a criminal record may not be so desirable.
Collateral taking by banks v/s loans granted
The banks also use screening for their customers for example before granting loans.
If banks give loans without prior screening, they will make adverse selection by granting loans at the same rate of interest to both the high and low risk clients. One way of distinguishing the two types of clients is to ask for collateral as guaranty on loans. Hence, those able to provide a collateral, for example a property, benefits from lower interest rates; while the credit worthiness of the others are further assessed.
Requiring collateral or security can also reduce information asymmetry risks. Collateral reduces adverse selection by requiring a specific value of collateral, such as 20% down payment on a house, for instance. Collateral also lowers moral hazard risk because the borrowers stand to lose their collateral if they do not make the required payments.
Requiring a certain amount of net worth also reduces adverse selection because only those individuals or businesses with sufficient assets over liabilities will be considered for a loan. Moral hazard is reduced because the borrower can be sued if they fail to make timely payments on their loans.
Insurance companies include exclusion clauses in policies
Insurance companies do screening to some extent by having future insured to be examined by a medical practitioner prior to signing the insurance contracts.
Furthermore, they provide potential clients with a questionnaire that needs to be filled with truthful answer, which are later examined before any compensation is paid out. For example, there are exclusions clauses with respect to dangerous sports.
A means used by insurance companies to deal with moral hazards, for example in the car insurance contracts, is to have an 'excess' amount had is disbursed by the clients for repairs, and over and above this value, is covered by the insurance companies.
In the insurance sector, companies may try to reduce exposure to large claims by limiting coverage or raising premiums.
The risks of adverse selection and moral hazard makes direct financing expensive, especially for small firms, since people are unwilling to lend or invest money in unknown entities. With their expertise in gathering reliable information at reduced cost, financial intermediaries can extend financing to many firms or individuals who would otherwise not get it.
The cure for information asymmetry is to obtain more information about potential fund receivers. The best predictor of future creditworthiness is past creditworthiness. Checking the history of the fund applicant reduces both adverse selection and moral hazard. There are many databases on individuals and businesses that can be consulted to check their past history. As such, news sources can be consulted about many businesses.
For lending to individuals, lenders can check the loan applicant's credit files and credit scores, their employment history, and with the permission of the borrowers, lenders can even verify their income by requesting the payment advice of the individual.
For lending to businesses, lenders can check any credit ratings issued by the credit rating agencies for businesses, as well as the Financial Statement of the businesses. More information is available on businesses that seek direct financing through the issuance of stocks and bonds, because they are required by law to report significant financial information before offering their securities for sale, and to update that information periodically.
For individuals applying for insurance, insurers can consult databases and may even request the individuals to submit official documentary evidence such as pay slips. Medical records can be check for health and life insurance applicants.
Another method to reduce moral hazard is through equity finance, which is financing through the issuance of stock. This implies that the managers should own a certain percentage of the company, which is often achieved through the granting of stock options as part of the compensation package.
Debt finance can also mitigate moral hazard through the issuing of bonds. It requires restrictive covenants that prevent the bond issuer from taking too many risks or to restrict the amount of debt that can be added. By law, all bonds are required to have a third party trustee who ensures that the bond issuer comply with the terms of the bond.
Asymmetric information is very difficult to overcome as one party will never fully share his knowledge with another party, and opportunism is a flaw in all human, striving for his best interest. However, through signalling and screening, the potential consequences of asymmetric information can be mitigated as demonstrated above.