Professional Documents
Culture Documents
Assymetric Information - Adverse Selection and Moral Hazard
Assymetric Information - Adverse Selection and Moral Hazard
MORAL HAZARD
The risk that a party to a transaction has not entered into the
contract in good faith, has provided misleading information about
its assets, liabilities or credit capacity, or has an incentive to take
unusual risks in a desperate attempt to earn a profit before the
contract settles.
Moral Hazard can be present any time two parties come into
agreement with one another . Each party in a contract may have
opportunity to gain from acting contrary to the principles laid out
by the agreement.
Example: When a salesperson is paid a flat salary with no
commissions for his or her sales , there is danger that the
salesperson may not try very hard to sell the business owners
goods because the wage stays the same regardless of how much
or how little the owner benefits from the salespersons work.
Moral hazard can be somewhat reduced by the placing of
responsibilities on both parties of a contract. In the example of
the salesperson, the manager may decide to pay a wage
comprised of both salary and commissions. With such a wage,
the salesperson would have more incentive not only to produce
more profits but also to prevent losses for the company.
Adverse selection is a term used in economics that refers to a process in which undesired results occur
when buyers and sellers have access to different/imperfect information, also known as asymmetric information.
A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by
the party taking the risk.
A lack of equal information causes economic imbalances that result in adverse selection and moral hazards.
All of these economic weaknesses have the potential to lead to market failure.
TERMS
adverse selection
The process by which the price and quantity of goods or services in a given market is altered due to one party
having information that the other party cannot have at reasonable cost.
moral hazard
A situation where there is a tendency to take undue risks because the costs are not borne by the party taking the
risk.
Give us feedback on this content:
Asymmetric Information
Asymmetric information means that one party has more or better information than the other when making decisions
and transactions. The imperfect information causes an imbalance of power. For example, when you are trying to
negotiate your salary, you will not know the maximum your employer is willing to pay and your employer will not
know the minimum you will be willing to accept.
Accurate information is essential for sound economic decisions. When a market experiences an imbalance it can lead
to market failure.
Adverse Selection
Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers
and sellers have access to different/imperfect information. The uneven knowledge causes the price and quantity of
goods or services in a market to shift. This results in "bad" products or services being selected. For example, if a bank
set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance
and high activity customers. The individual price would generate a low profit for the bank.
Moral Hazard
An insured driver getting into a car accident is an example of a moral hazard. The driver will take risks because the cost is not directly felt due
to a transaction. The insurance company pays for the accident and not the driver.
Asymmetric information starts the downward economic spiral for a firm. A lack of equal information causes economic
imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to
lead to market failure. A market failure is any scenario where an individual or firm's pursuit of pure self interest leads
to inefficient results.