Moral Hazard and Adverse Selection

Introduction

In the traditional model of the neoclassical school, among the assumptions that would characterize the market is that of complete, or at least symmetric, information. This means that all agents - offerers and demanders - know perfectly well the qualities of the product, or in the second instance, know and do not know the same things about the product and therefore are not subject to deception or opportunism on the part of the other person. However, as you may be thinking, this should not always be the case and in fact it is not. There are market failures that cause the existence of asymmetric information and those failures have a name.

Moral hazard:

We speak of “moral hazard” when in a given market an agent decides to perform actions that a related person cannot control and nevertheless affect it economically. More specifically, it happens that the “risk of harm” that a person faces when taking a certain action is then covered economically by another agent. Seems a bit difficult, doesn't it? Let's go with a closer example and maybe from there it will be easier to understand it. Has it ever happened to you at school that a teacher decided not to take evaluations? If so, do you think you used to pay more or less attention in that subject? When we know that our “bad” actions may not have negative consequences, we have more incentive to do so. Now back to the economic sphere: insurance companies are a typical example. It has been well studied that those who take out comprehensive automobile insurance may then be somewhat less responsible behind the wheel, knowing that the economic damage will ultimately be covered by another agent. From a more macroeconomic viewpoint, we could also cite the example of bank failures. If all commercial banks had the certainty that the Central Bank would bail them out in case of insolvency, it creates incentives to engage in riskier and more irresponsible operations, given that in case of success the profit is higher, and in case of failure the Central Bank saves them.

Adverse selection:

Adverse selection also arises from a case of asymmetric information but here the behavior that is modified is not a posteriori but “a priori”, that is, when one of the agents takes advantage of the misinformation of his counterpart to execute a transaction that for the other could be detrimental. Can you think of any case? The most common example given in economics in this respect - and its author has even won a Nobel Prize - is that of “used cars”. If you've ever had to buy a used car, you'll know that it's almost roulette. Unless the seller is ultra-trustworthy, it is difficult to know in advance if the brakes are working well, if it has had numerous repairs, or if the shock absorbers are worn out.

Returning to the case of auto insurance, here we would not have drivers who start being irresponsible after having taken out an all-risk policy, but it describes the situation that the most irresponsible drivers will be the ones who are likely to take out the insurance, while the more careful ones might consider not taking it out. Or in prepaid medicine, a person who has lived healthy for the last 20 years is less likely to consider paying for a prepaid policy than one who gets sick every year and requires recurrent hospitalization.

What about Pallicies?

As will have become clear, markets where asymmetric information prevails may not lead to an efficient situation in terms of general welfare. The only cars that would be traded in the parallel car market are the most deteriorated ones, and people who take out car insurance may have no problem with drunk driving. While there are some private mechanisms that can help (such as charging different insurance policies according to the insured's historical behavior), the state can play a key role by providing information and regulations to reduce this market failure. Thus, for example, in the drug market it is common for a public agency to regulate that each drug contains exactly what it claims to contain, and that its advertising does not lie about its uses and effects. The same happens when the State forces all drivers to drive with some kind of insurance, so that irresponsible drivers are not the only ones to enter the system, making the activity unaffordable.