Asymmetric Information: Adverse Selection and Moral Hazard - Online Tutor, Practice Problems & Exam Prep

Information plays a crucial role in economic transactions, often leading to issues like information asymmetry, where one party possesses private information unknown to the other. This can result in adverse selection, where unobservable characteristics affect decisions before a transaction, such as in used car sales or health insurance. Conversely, moral hazard occurs after a contract is made, where behavior changes, like an employee slacking off or a driver being less cautious due to insurance. Understanding these concepts is vital for recognizing market failures and the implications of private information in economics.

Asymmetric Information

All right, now let's see the role that information plays in economic transactions as well as the problems that information can pose. So to this point, we've been assuming because we haven't even really talked about it, we've assumed that everyone had complete information, right? Complete information, well that's a state of being fully informed, okay? So right now, we haven't really talked about information, so we just assumed everyone kind of knew everything that was going on. In the real world, obviously, that's a little different, right? We have what's called private information and that's when you know something that others don't know, right? Private information, knowing something others don't know, and this leads to a situation called information asymmetry. And that's the situation where one party, well they know more. One party knows more than the other party in the transaction, okay? So I have some examples here and then we're going to break them into the actual informational problems, leading up. Let's see some examples right here.

First, we have drivers and car insurance. So drivers may be less cautious when they have car insurance, right? So once you get the insurance policy, you might think, hey, I'm covered, you know, maybe I'll run this red light and nothing will happen. If I get in a crash, I'm going to get a big payout. So they're going to drive less cautiously. They're changing their behavior because they have car insurance, right?

How about a used car salesman? Well, a used car salesman knows more about the car that they're selling, right? They know more about the used car than the purchasing it. That's why there's always been a problem in the used car market and there's this reputation of buying a used car and you might get a lemon, right? We call lemons a bad car.

And last one here, a patient might know more. They're also going to know more. Patients know more than the insurance company about their health condition, right? You might have some information about your health that you didn't specifically portray when you got the health insurance, right? But in the back of your head, you had it sitting there as a reason you wanted health insurance. Right? So let's go ahead and pause here and in the next videos we're going to talk about adverse selection and moral hazard. The two informational problems. Let's check it out.

Adverse Selection

All right, so let's start with the first of the two informational problems, and that is Adverse Selection. Adverse Selection is when you enter into agreements where you can use private information to your advantage. You're going to use this private information, you have some private information, and you're going to use it to your advantage. Adverse selection relates to unobservable characteristics, things that you couldn't find out just by looking, right? Unobservable characteristics and it occurs before a transaction, okay? And this is key. This is the key determination between adverse selection here, and moral hazard, the next topic we're going to talk about. So, I'm going to put in this box over here; I want to put 'before' because this is key to remembering which one is adverse selection and which one is moral hazard. I struggled with this for a long time but if you just remember: adverse selection happens before, moral hazard happens after, that's a really good way to remember. Okay? So let's start here with some examples.

Let's go back to that used car sale, right? We had that situation where we have the used car salesman, the salesman knows a secret, right? The salesman is going to know a secret about the used car, and that's the condition of the car. The car's condition, only the salesman knows that. You walk up to the shop and you see the used car, but you don't really know anything about it. So what's going to happen? In this used car market, there's kind of this reputation where you have to buy a used car, and it's going to have all these problems, right, and there's going to be what's called a lemon. This becomes the idea of a lemon problem where you're going to buy a car and then it's not going to work. So what happens is that you end up not buying a car because you don't know enough about the car, and you're not going to want to buy it under these conditions, so there's no sale. Now what makes matters worse is that since you already have a distaste for these used cars because of this lemon problem, well, your willingness to pay for a used car goes down. This almost self-reinforces the issue, right? Because when your willingness to pay for a used car goes down, well, the number of good used cars left is also going to go down. At this lower price point, it's more likely that you're going to get a lemon when you're willing to pay less for the car. So that even makes the adverse selection even worse here. The secret of knowing the condition of the car leads to no sale because you don't know enough about the car as the buyer.

Let's look at this other example with health insurance on the right. We mentioned this above as well, where the patient knows more about their own health than the insurance company. Right? So who knows the secret here? I'm going to say the patient and this is the person buying health insurance. This is before the transaction. And the secret is that they know about their health problems. Let's say they have some health problems; they know about them, and the insurance company does not. So what ends up happening is that since everyone buying insurance might have these health problems that they're not bringing to the table, well, the result is that we have a riskier health pool, a riskier insurance pool. The people who are insured are riskier than they said they were or than we knew them to be because they have these secret health problems, and that's what caused them to go buy the health insurance. So how does this problem make it even worse? Well, when the insurance company sees all these claims being made, and they have to pay out all this money, well, they've got to cover it somehow, and they're going to increase the premiums. And if they increase the premiums, well, that's a bad thing for the healthy people. The healthy people might now look and say, man, these premiums are going up, I don't really use the insurance that much; they might just drop it altogether. So the healthy policyholders are going to go down, and what happens then? Since there are fewer healthy people, there are only the riskier people left now. There are only the people with health problems in the insurance claims, so now you're making the problem even worse here. This is the idea of adverse selection where there are these secrets before the transaction is made, that can't be revealed right away. So, we're going to talk about also how we solve these informational problems, but upfront, these are the problems that we need to deal with. There are these secrets, and they're causing a problem that doesn't allow the economic transaction to happen. Alright? So now let's go on to the next one, Moral hazard. Let's talk about that in the next video.

Moral Hazard

Alright. So let's continue here with moral hazard. So remember, adverse selection is before the transaction, right? So moral hazard, well this is a party to a contract altering his behavior after a contract is made. So now we've made a contract together and we're going to change our actions after the contract, right? So when we talk about moral hazard, we're going to talk about a principal and an agent. This is a relationship between 2 people where the principal is the person who entrusts someone being the agent, the principal entrusts the agent with a task, okay? So the principal is going to entrust the agent with the task usually by paying them something, the principal is going to pay the agent and the agent will do something on their behalf. But that's not all cases but that's generally the way to think about it. The principal entrusts the agent with a task. Well and the agent is the person who carries out the task on someone's behalf. Right? Being the principal. So they're kind of interrelated here, right? The principal and the agent, they go hand in hand. So let's see a couple of examples. Oh, before we do that, let's fill in this box here. This is the important box right here. So, adverse selection was before, moral hazard happens after the transaction, okay? So let's check it out. Let's see a couple of examples. So the employer-employee relationship, right? So you can think about when someone gets a job and he's making pizzas, right? Well, the principal is going to be the employer, right? The employer is the principal and the agent is the employee, right? The employer is having the agent do this task on their behalf, make the pizzas on their behalf. So what's the moral hazard here? The moral hazard is that the employer can't really watch the employee all the time, right? There's not going to be perfect monitoring where they're just over his shoulder making sure he's making pizzas every second of every day. Well, the moral hazard is that the employee can start slacking off. Right? If he's not being properly motivated or properly monitored, he could be slacking off, right, when the employer is not looking and that is him changing his behavior after the contract, right? Now we've signed the contract, he got hired, he said he was going to be this great employee, he was going to do all these make all these awesome pizzas, but now when you're not looking he's over there texting on his phone or something, right? So he'll be slacking off, that is the moral hazard there. Let's look at this insurer-insured relationship. So in this case, it's a little more abstract to think about principal and agent, but let's think about the principal here being the insurance company. So the insurer is the principal and the task that they are putting onto the agent is just to be the same person they were before. So let's think about car insurance. Well in the case of car insurance, the insurer expects the insured person to drive just as they would whether they had no car insurance. If you think about it, if you had no car insurance, you'd probably be pretty cautious, you don't want to get into a wreck, you're going to stop at every yellow light, right? Make sure that your car is safe. But once you get insurance, right? Well, you might drive a little less cautiously, right? You're going to say, well maybe I can take this yellow or if someone hits me I'm going to get a big payout, so you don't take all the precautions that you might take when you didn't have insurance, right? So you're going to be a little less wary and you're going to have low effort to prevent losses, right? Because you're insured, the car the car insurance than you did before. Alright? So that's the moral hazard there is that in both these cases, the employee and the insured their behavior after the transaction is made. Okay? So that's the moral hazard, adverse selection was before the transaction. Cool? Let's go on and move on to the next video now.

Here’s what students ask on this topic:

What is the difference between adverse selection and moral hazard?

Adverse selection and moral hazard are both problems arising from information asymmetry in economic transactions. Adverse selection occurs before a transaction and involves unobservable characteristics. For example, a used car salesman knows more about the car's condition than the buyer, leading to potential issues like buying a 'lemon.' Moral hazard, on the other hand, occurs after a transaction. It involves changes in behavior due to the contract. For instance, a driver with car insurance might drive less cautiously, knowing they are covered. Understanding these differences helps in identifying and mitigating market failures.

How does adverse selection affect the health insurance market?

Adverse selection in the health insurance market occurs when individuals with private information about their health conditions purchase insurance. These individuals are often riskier than the insurer anticipates, leading to a riskier insurance pool. As a result, insurance companies may raise premiums to cover the higher-than-expected claims. This increase in premiums can drive healthier individuals out of the market, leaving an even riskier pool behind. This cycle exacerbates the problem, making it difficult for insurers to maintain a balanced and sustainable insurance pool.

What are some examples of moral hazard in everyday life?

Moral hazard occurs when a party changes their behavior after a contract is made. Common examples include: 1) An employee slacking off after being hired because they know their employer cannot monitor them constantly. 2) A driver being less cautious after obtaining car insurance, assuming they are financially protected in case of an accident. 3) A borrower taking on riskier investments after receiving a loan, knowing that the lender bears some of the risk. These examples illustrate how moral hazard can lead to inefficiencies and increased costs in various economic transactions.

How can adverse selection be mitigated in the used car market?

Adverse selection in the used car market can be mitigated through several strategies: 1) Warranties: Offering warranties can assure buyers about the car's condition. 2) Certification: Certified pre-owned programs provide thorough inspections and certifications, reducing information asymmetry. 3) Transparency: Providing detailed vehicle history reports (e.g., Carfax) can help buyers make informed decisions. 4) Reputation: Building a trustworthy reputation as a seller can attract more buyers. These measures help align the information between buyers and sellers, reducing the adverse selection problem.

What role does information asymmetry play in economic transactions?

Information asymmetry occurs when one party in an economic transaction has more or better information than the other. This imbalance can lead to market failures such as adverse selection and moral hazard. In adverse selection, the party with more information can exploit their advantage before the transaction, leading to suboptimal outcomes, like buying a 'lemon' car. In moral hazard, the party changes their behavior after the transaction, knowing they are protected, such as driving recklessly after getting car insurance. Addressing information asymmetry is crucial for efficient and fair market transactions.