Markets and Business
Why Markets Fail When Only One Side Knows the Truth: Moral Hazard and Adverse Selection
What It Is and How It Works
In an ideal market, everyone knows what they’re buying and selling. But in the real world, this rarely happens. One side often knows more than the other, creating what economists call asymmetric information. This imbalance can lead to two major issues: moral hazard and adverse selection.
Moral hazard happens when one person takes more risks because someone else will bear the consequences. Imagine a student who stops studying because the teacher announced there would be no exams. Or a driver with full insurance who becomes careless behind the wheel. If banks know the central bank will bail them out in a crisis, they may start taking reckless risks. The danger isn’t just personal—it can spread across the entire economy.
Adverse selection happens before a decision is made. It’s when the person with more information takes advantage of the other side. The classic example is the used car market: buyers might stop trusting the whole market if sellers know more about the car’s problems than buyers. The same applies to health insurance. People who get sick more often are more likely to sign up, while healthy people might not bother. This raises costs for insurers and can eventually make insurance unaffordable.
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The Impact
When these problems take hold, markets don’t work as they should. Quality goods and responsible behavior disappear, and everyone ends up worse off. For instance, a market filled with unreliable used cars punishes buyers and honest sellers. Risky banking behavior can create financial crises.
Governments can step in to fix this. Requiring drivers to carry insurance (not just the risky ones) spreads the risk fairly. Regulatory agencies can ensure medicines contain what they claim and are advertised truthfully. Insurance companies can also try to help by charging higher premiums to risky drivers or offering discounts to those with good records.
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Real World Examples
The 2008 financial crisis is a classic case of moral hazard. Large financial institutions made risky bets, assuming they were "too big to fail” and the Central Bank would bail them out in case of problems. When the crisis hit, governments worldwide had to bail them out to prevent economic collapse.