Adverse selection versus moral hazard

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Adverse selection and moral hazard are both examples of market failure situations, caused due to asymmetric information between buyers and sellers in a market. This article discusses the similarities and differences between adverse selection and moral hazard.

Key difference: before versus after the deal

Adverse selection: asymmetry in information prior to the deal

Adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece.

It is this asymmetry of information prior to the transaction that prevents the transaction from occurring. If both the seller and the buyer were uncertain of the quality, they would be willing to trade the good based on expected values. Similarly, if both the seller and the buyer were certain of the quality, they would be willing to trade the good based on its actual value.

Moral hazard: asymmetry in information/inability to control behavior after the deal

Moral hazard is seen for services such as insurance and warranties. In these cases, after the deal is done, one of the parties to the deal (in this case, the person purchasing the insurance or warranty) may be more careless because he/she has the insurance, and thus does not need to pay the full cost of a damage. For instance, a person possessing insurance against theft may be less careful about closing the windows when leaving the house. Here, it is not the prior information that either party has, but the inability of the insurance provider to control and monitor increased risk-taking behavior that creates the potential for market failure.

Also, while in adverse selection, the seller is usually the one possessing more information, moral hazard usually has the buyer (of the insurance service) having too much control.

Examples of situations where adverse selection and moral hazard are related

Health insurance is an example of a service that suffers both from adverse selection and from moral hazard, and often it is difficult to differentiate the two. Here are some examples:

  • The insured person may choose to conceal certain unhealthy habits or genetic traits that make the insurance attractive for the person but unprofitable for the company. This is an example of adverse selection: The person getting insured has more information about the quality of his or her health than the insurance company.
  • After getting insured, the person is more careless about health. For instance, he/she may take fewer dietary precautions, smoke or drink more, or indulge in physical activities dangerous to the health. This is an example of moral hazard.

There is some fuzziness between the problem of concealing a habit prior to getting insured, and becoming more reckless after getting insured.

Examples of situations where adverse selection occurs but moral hazard does not

In most situations that do not involve insurance, warranties, legal liabilities, renting services, or any form of continued contract and obligation, moral hazard is unlikely to occur. On the other hand, adverse selection can occur for any experience good, i.e., any good whose value is determined only after buying it and using it.

For instance, when selling a used car, the seller does not need to worry about how the buyer will treat the car after the deal is done, because the seller has no continued obligation to the buyer to ensure that the car remains in good condition. However, the problem of adverse selection may still occur if buyers have no easy way of evaluating the quality of the car without actually buying it.

Examples of situations where moral hazard occurs involve a somewhat different form of adverse selection

Any situation involving moral hazard also involves adverse selection to at least some extent. This is because, as in the case of health insurance, the person who could indulge in potentially risk-taking behavior may have prior information about his/her excessive risk-taking tendencies and this prior information may have influenced the decision to purchase insurance. This makes insurance sellers set overly cautious rates, and thus, the buyers who are actually less risk-prone end up not buying insurance.

However, this adverse selection differs from the more usual adverse selection seen in used-car markets. In the adverse selection seen in insurance, it is the buyer who has more information, and it is this that makes the buyer unlikely to purchase an insurance that is based on actuarial estimates made by the seller.