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Study notes

Information Economics - Moral Hazard and Adverse Selection

  • Levels: AS, A Level
  • Exam boards: AQA, Edexcel, OCR, IB

Moral hazard and adverse selection are important concepts related to the problem of information gaps in many markets

Financial Economics Moral Hazard - revision video

Moral hazard

Moral hazard occurs when insured consumers are likely to take greater risks, knowing that a claim will be paid for by their cover

The consumer knows more about his/her intended actions than the producer (insurer)

If more people have access to health insurance for example, behavioural changes arising from moral hazard might lead to a substantial rise in health insurance payouts.

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.

Adverse selection occurs whenever asymmetrical information — information known to one party but not the other — makes it difficult for potential trading partners to distinguish between high-risk and low-risk transactions. This problem is particularly endemic to insurance markets

Richmond Fed

Adverse selection

A good example of adverse selection is in the health insurance insurance market. People most likely to purchase health insurance are those who are most likely to use it, i.e. smokers/drinkers/those with underlying health issues

The insurance company knows this and so raises the average price of insurance cover

This risks pricing healthy consumers out of the market, meaning that only high risk individuals gain insurance – this is clearly a market failure

One interpretation of adverse selection is that "we tend to trust the people we shouldn't!"

Difference between Asymmetric Information and Moral Hazard - revision video

Difference between Asymmetric Information and Moral Hazard - revision video

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