Week 9- Adverse Selection and Moral Hazard Flashcards
what does it mean when information is asymetric?
some agents have more information than others about a situation
Why does the problem of adverse selection arise?
the quality of a person or good cannot be perfectly observed
why does the problem of moral hazard arise?
the risks people take cannot be perfectly observed
Is this moral hazard or adverse selection: Where market participants who have more information trade selectively to the detriment of others
adverse selection
what is a risk-neutral customer?
someone who values an item in line with the expected value of the item
what is a risk-averse customer?
someone who values an item less than the expected value of the item
how can unconsummated wealth-creating transactions arise in insurance?
same as price discrimination. If the low-value group can afford the profit maximising price and price is above MC then unconsummated wealth-creating transactions occur
what tools allow insurance firms to tackle adverse selection and identify which customers are low value ones so they can price discriminate
Screening and signalling
what is screening?
a tool used by a less informed party to induce consumers to reveal their type. Eg employers often screen the market by requiring candidates to have a degree
what is signalling?
describes the effort of the more informed party (consumers) to reveal information about themselves to the less informed party(insurance company) eg. good employees could offer to work on commission because they know that they are good at the job.
Firms can also brand and advertise products to signal quality to consumers
While both adverse selection and moral hazard are caused by information asymmetry which one is caused by hidden information and which one is caused by hidden actions?
Adverse selection- hidden info
moral hazard- hidden actions
give an example of moral hazard?
Insurance causes people to take risker decisions which mean insurance companies lose money
give an example of how insurance firms try to prevent moral hazard?
Black boxes on cars and no claims bonus encourage consumers of insurance not to take risky decisions because there is an incentive to take care while driving
Which one (adverse selection or moral hazard) is a problem before a transaction and which one is a problem after a transaction?
Adverse selection- before a transaction
moral hazard- after a transaction
what is expected return?
what you will come out (money) with on average over the long term
