Contracting with Moral Hazard and Adverse Selection
Moral hazard and adverse selection are terms used in economics, risk management, and insurance to mean situations where one party is disadvantaged by the result of another party's behavior. Humans are described as social beings because everything we do affects other people around us. It is our interactions that make the world move. And when it comes to economic growth and development, there is nothing moving forward if we fail to find common ground to work with other people.
Besides, we are always making decisions in life. Sometimes the decisions may be hard, but we still have to make them because they are necessary. This is why the subject of moral hazard and adverse selection comes when handling economic studies.
We all need the information to make decisions, and the more information we get, the better. Moral hazard happens when asymmetric information is present between two parties, and there is a change in the behavior of one party after the two parties have reached an agreement. Asymmetric information can also be referred to as imperfect information. It happens when a participant in the transaction has more material knowledge than the other party. It is a common state that happens in almost every transaction. The term perfect information does not have real meaning in the real world. We never get perfect information because the real economic world is imperfect, and every information that comes out is therefore expected to be asymmetric.
Morality is a virtue that exits with all human beings. We choose to accept or ignore it according to personal relations with other people and how we feel about the world at large. Even though people are different, morality makes us human and is the same that builds good relationships with people around us. When we ignore our moral responsibilities, it hurts other people, and may not sit very well with the whole society.
This is the same state we find in economic studies. Moral hazard is a frequent occurrence in the lending and insurance industry, though it can also exist in an employee-employer relationship. Moral hazards can be present at any time; there is an agreement between two parties. Economic studies have been for long, focusing on these issues to try and explain what happens in business transactions where two people are involved. And since everyone makes decisions, taking on this subject is a critical approach to understanding consumption and decision-making processes.
Another important term used and closely related to moral hazard is adverse selection. This term refers to a state where the seller has more information than the buyer, or the buyer has more information that the seller concerning the aspect of product quality – typically, the seller is the more knowledgeable party. Adverse selection occurs mostly when there is an exploitation of asymmetric information. These conditions and actions can lead to making the wrong decision, but they are common where any transaction needs information.
Studying moral hazard for an economic student does not only help them become better people, but it also makes them influential to society. As stated above, we need the information to make decisions. When you head to the market to buy any item, you will need information such as the product's material quality, the brand, and, most importantly, the price. And in most instances, price is associated with product quality. This is why sellers will put high prices on anything perceived to be more in terms of quality that other similar items.
When a moral hazard occurs, it means one person is entering into the agreement by providing misleading information or changing their behavior after the agreement has been reached. These parties may change their minds because perhaps they believe they will not face any consequences for their actions. In case one has more information about the item they are selling or buying, it becomes tempting for them to offer inaccurate information to other parties that do not or change their stand after some time, especially when they feel they are at a more powerful position. They will not face any consequences from their actions.
When one entity does not bear the full effect of a risk, they may be incentivized to increase their exposure to risky situations. In other words, decision-makers follow what seems to provide them with the highest level of benefit. The decision they will make, which affects the contract with the other person, is based on what seems to give them more leverage or profits. As stated above, human beings are guided by morality, and every decision they make has to be checked to ensure it does affect other people in the same situation, or on a different level. Morality creates goods relationships, and it is an important aspect of an ethical world.
Risk is inevitable when a party enters a bad faith contract, which they may do by providing false information about their assets, liabilities, or credit capacities. It is a very common occurrence in the financial industry when looking at contracts between a borrower and the lender. It is also common in the insurance industry where either party can give false information just to reap more benefits than the other. In decision making, it is very important to understand everything you need to understand about the contract of the product you wish to purchase. This way, you will get in knowing exactly what to expect, and if there are any changes, you will also know how to deal with them. But this may be a hard
the thing to do since decisions often change with changing situations, and sometimes there is nothing much one can do about it.
Consider this example of a moral hazard. Assume a homeowner does not have a homeowner's insurance or flood insurance, yet they live in a flood zone. This person understands the risk of living here, and so they subscribe to a home security system that keeps burglars at bay. When storms come, he also knows what to do, preparing for a flood by clearing the drains and relocating their furniture to ensure they don't get damaged.
And when the homeowner gets tired of constantly worrying about burglaries and floods preparations, he chooses to buy a home and flood insurance. Now that the house is fully insured, the homeowner's behavior takes a different turn. He goes ahead to cancel his home security system subscription and reduces the actions he takes in preparation for floods. In this case, the insurance company faces a greater risk of having a claim filed against them when floods destroy the person's property. This kind of scenario is very common in this industry, and it can happen when least expected.
When one does not have a moral obligation and wants to exploit the other party, they may take some actions that favor the most. This affects the other party, and sometimes the effects can be really great. Understanding moral hazards is one way to ensure proper contracting. For instance, lenders will be able to check borrowers' ability to repay their loans to there will be no defaults. This is one good way of ensuring business flows without too many interruptions.
Moral Hazard – History
Economist Allard E. Dembe, or The Ohio State University, and Leslie I. Boden at Boston University conducted a research to determine the origin of the term moral hazard. According to their report, the term was common with insurance agents in England. Early usage meant if fraudulent and immoral behavior in a transaction. The word 'moral' has also been widely used to mean subjective behavior in the field of mathematics simply; hence, its ethical implication is not quite clear. Moral hazard entered the real of study subjects in the 1960s among many economists. It was not just a
description of the moral of involved parties in a contract, but economists used it to imply inefficiencies created when we don't fully understand risks. When people make decisions without a proper understanding of the risks they face, it becomes easy to face bad consequences. And today, moral hazard continues to be an important subject of study in economics. Because modern economics seems to rely more on morality and safe contracts within the markets, this subject is critical to the economic analysis of starting a business, and more so, serving certain customers. It is all about making the right decisions under proper information or influence.
Not far from moral hazard, there is the term adverse selection, which is a description of a situation in which one party has more accurate and different information about the product than the other party. As such, the less informed party faces a bigger disadvantage and potentially losing more from the contract. It is always good to have full information when entering a contract and to know the risks you may be facing when things change. There is a lack of efficiency in the prices and number of goods and services in adverse selection. This means that adverse selection tends to come from ineffective price signals.
In an example of adverse selection, we can use a situation where we assume there are two sets of people within a population; one carries those who smoke and don't exercise. The other group is for those who do not smoke they exercise. It is obvious that those who smoke and have no exercise schedules have a shorter life expectancy than the other group. Now let's say there are two individuals, one from each group looking to buy life insurance. If the insurance company does not have the proper information, they will not be able to differentiate between the two individuals. They will not know who smokes and does not exercise, or who does not smoke, and exercises.
What the company does is only to ask the two parties to fill out a questionnaire that identifies them. The individual who smokes and does not exercise understands that they will incur higher insurance premiums of the answer truthfully. Hence, they decide to lie and say they don't smoke, and they do exercise. This is where adverse selection comes in since the life insurance company will charge both the same premiums. However, insurance has more value to the smoker who does not exercise than the other person. The smoker and non-exercising will require more health coverage, which means they benefit more from the lower premiums.
Insurance companies need to reduce risks and exposure to huge claims. This is why they limit their coverage or raise premiums. The companies attempt to mitigate adverse selection potentiality by identifying groups of riskier people than in the general population and raising their premiums. They use insurance underwriters, whose role is to assess the applicant for life insurance and to determine whether or not to give them premiums, or how much they should be charged in terms of premiums. Underwriters evaluate any issue that may threaten the applicant's health, including their height, weight, medical history, family history, lifestyle, smoking habits, and many others.
Consider a market place for used cars as another good example of adverse selection. The seller knows about the defects on their vehicle, and they may charge the buyer more than what the car is worth. In an auto insurance application, the applicant may choose to falsify their address information and use areas with a low crime rate in their application to get lower premiums.
Economic study is a wide subject that requires a lot of effort and focuses on gaining the right knowledge. But once you do, you can make the best investment or economic analysis decisions because you have the proper information. Moral hazard and adverse selection are two topics that seem simple, yet carry a lot of weight. In both situations, the issue of information asymmetry is clear. The only difference is when this happens. In moral hazard, the behavior of one party changes after the agreement has been reached. In adverse selection, there is a lack of symmetric information before the contract or deal is made. Contracting under these circumstances is an issue that many parties, especially those who stand to lose more, seek to resolve, yet one they cannot. The only best way about it is to understand that these situations pose real investment risk and use different methods to reduce them – or neutralize the risk.
Author: James Hamilton