Adverse Selection and Moral Hazard in Economic Transactions

Navigating the intricacies of economic transactions often involves grappling with the concepts of adverse selection and moral hazard.

Adverse Selection

Adverse selection, or adverse choice, occurs when information is asymmetric, rendering the market unable to mete out fair consequences. Instead of selecting the best agents and prices, it ends up favoring the worst. For instance, a lawyer faced with an uninformed client might persuade them that their case is intricate, justifying substantial fees.

Economically, this transaction is inequitable and inefficient as the lawyer is not compensated fairly. In the banking scenario, borrowers with strong guarantees reject the bank’s interest rates, deeming them too high. Conversely, risky debtors eagerly embrace these favorable rates.

Essentially, bad borrowers drive away the good. The Social Security system may encounter instances of “adverse selection”: patients choosing between two doctors may opt for the one who is more harmful to Social Security, displaying laxity in prescribing generous sick leaves or antibiotics.

Moral Hazard

Moral hazard comes into play when information asymmetry leads to irresponsible behavior. Someone who is insured might, precisely because they are insured, act recklessly. A bank employee aware that their bank cannot go bankrupt may imprudently grant credits. The theory of information asymmetry has led to various practical consequences:

  • The creation of the bonus/malus system for insurance.
  • Implementation of vehicle inspections for automobiles.
  • Establishment of protocols by Social Security limiting the “generosity” of doctors.
  • Introduction of the stock-options system for company managers.

Information asymmetry might not be the exception but the rule in economics. The costs associated with acquiring information can render the market inoperative.

Economic agents with informational advantages enjoy a positional rent, distorting the market dynamics. To address these issues, economists emphasize that individual interest is often incompatible with the common good, and the “invisible hand” requires substantial intervention.

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