Login with Facebook

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.

Moral Hazard

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.

Adverse selection

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.

Conclusion

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 resolveMoral Hazard, 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


Comments

Need a custom
essay?

We will write it for you.
Order now

Free Essay Examples

Free essays:

All you need to know about Neuroendocrinology
All you need to know about Big data management
All you need to know about digital special effects
All you need to know Technical Writing?
Basics the Game Theory in Cryptoeconomics
Business innovation ideas for making money
Biosensors for cancer diagnosis
Business Analysis: Pricing strategies and Demand Curve
Conservation Economics
Cybersecurity in business: challenges, risks, and practices
Corporate Behavior
Compare and contrast the political theories
Determinants of Wages
Deontology Vs. Utilitarianism
Development of Advertising
Digital Illiteracy
Economic Analysis of Market Structure
Expected Utility
Everything you need to know about workplace diversity
Efficiency and Market Equilibrium
Factors Affecting Purchasing Behavior
Financial Statement Analysis
Factors Influencing Interest and Exchange Rates
Fiscal and Monetary Policies in Response to 2008/2009
Game theory in microeconomics
Globalization: definition, causes, social impact and risks
Gene expression: what it is and why it is important
Global environmental issues
How women can manage sexual harassment
How to conduct economic research?
How to define the Enterprise Value
How cancer is developed - Cancer biology
Introduction to Labor Markets
Investment in Human Capital
Intellectual Property and Product Liability
Introduction to Social Choice and Incarceration
Journalism: What is News?
Journalism: Broadcast media and Television Presenters
Journalism: Sources of News
Journalism and Law
Key Determinants of National Income
Key Factors That Affect Pricing Decisions
Kinetic models in biology and Related fields
Know about the different forms of traditional African dances
Latest technology trends
Latest dance trends
Modern journalism
Methods of labeling of nucleic acid that enable their detection
Neuromuscular disorders
National Economies, Fluctuation, and Responses to Fluctuations
Neurotransmitters: what they are and different types
Nanomedicines to target tumors
Organizational motivation and its effects
Overcoming Hiring Challenges for Nonprofit Organization
Policy in Corporate Mergers
Political theories of John Locke
Research and Development
Risk Sharing in Insurance and Asset Markets
Risk and the value of information
Reverse discrimination.
Structure of a Corporation
Schizoaffective disorder: how to live better with it
Segregation in the US.
Stages of the Consumer Decision-Making Process
The Role of Internal Audit in Corporate Risk Management
The Use of Law on Economics and Vice Versa
The political theory of Thomas Hobbes
The Game Theory in Social Media
Unemployment
Utilitarianism Vs. Kantianism
Understanding Auctions and Auction Theory: Part 2
Understanding Auctions and Auction Theory: Part 1
Various theoretical perspectives of sociology
Virtual reality, what it is and how it works
What is Neuroplasticity?
What is the 7 layers of OSI model?
4 Facts about Origin of Mathematics!
5 techniques to create an animation
10 emerging technologies according to World Economic Forum
10 strategies to maximize corporate profits
3d Model Of Building
6 Medical Technologies that revolutionized the healthcare in 2020
All you need to know about the ACA Code of ethics
Architecture and Democracy: An Introduction
Architecture and Democracy: Democratic Values
Architecture and Democracy: Democratic Procedures
All You Need to Know About a Synthesis Essay
An essential guide to understanding Film Theory
Application of Artificial Intelligence in Cyber Security
Applications of electrical engineering
Augmented reality: what it is, how it works, examples
Advantages And Disadvantages Of Social Networking
All you need to know about Cryptography
Applications of astrophysical science
All you need to know about architecture engineering
Applications of geological engineering
Artificial intelligence and medicine: an increasingly close relationship
An insight into Computational Biology
ACA code of conduct
A Rose for Emily
Applications of Mathematics in daily life
Architecture mistakes to avoid
All you need to know about Toxicology
All you need to know about Holistic Medicine
All you need to know about linguistics
An introduction to Linguistics and its subfields
All you need to know about Anxiety disorder
All you need to know about Drones
A Brief Insight into Political Science
Assumptions related to feminism
All you need to know about Byzantine emperors
All you need to know about labour economics
An insight into xenobots -the first-ever robots
An ultimate guide about Biomaterials
A Comprehensive Introduction to the Mona Lisa
Analysis methods of Transport through biological membranes
An ultimate guide about biochemical reactions
Analysis of brain signals
Artificial Gene Synthesis
Application to synthetic biology of CAD methods
All you need to know about metabolic pathways
Applications of BIOMEMS
All you need to know about the epidemiology
Asian vs. western leadership styles
All you need to know about Smart prosthesis
Analysis of Economy: Output of Goods and Services (GNP), and GDP on Economic success
A Guide to Pricing Strategies
An Overview Of Economic Studies
Analysis of Fiscal and Monetary Policies
Analysis of Business Cycles
Analysis of Consumption and Investment
A Look into Regression Analysis
Analysis of Household's Consumption and Savings Behavior
All you need to know about Capital Budgeting
All you need to know about risk management
Art looted in wartime.
Appropriate use of Data in Economics
All you need to know about reaction kinetics?
A historical overview of Financial Crises
All you need to know about management discipline?
An insight into the error-correction models
All you need to know about Data visualization
All you need to know about Work-family balance
All you need to know Technical Writing?
All you need to know about digital special effects
All you need to know about Big data management
All you need to know about Neuroendocrinology
How to Write a Personal Essay
Housing Needs in America
How to Write a Description Essay
How to Create an Excellent Scholarship Essay?
How to write a cause and effect essay
How to Hire the Best Essay Writing Service Provider?
How to Write a College Application Essay?
How to get the most out of your English lectures
How to write Expository Essay
How to succeed in your psychology class?
How to Write an Academic Essay in the Shortest Time?
History of Journalism
How Different Sectors are Using Artificial intelligence (AI)
How to write an informative essay
How to deliver persuasive essays?
How to Give a Convincing Presentation
How to write an essay on leadership?
Historical Art Still Around Today
Humanoid robot: what it is, how it works and price
History of Chemistry
Healthcare Advanced Computer Power: Robotics, Medical Imaging, and More
Healthcare AI: Game Changers for Medical Decision-Making and Remote Patient Monitoring
How to understand different types of English
How to Cope with Chronic Pain
How African American choreographers and dancers have influenced American dance
How mobile robot can do in logistics or in production
How To Become a Successful Entrepreneur
History of the Philosophy of Feminism
How is the climate changing?
How to Track Your Content Marketing ROI
How to Gun control In the USA?
Historical and contemporary role of labour in the modern world
How breast cancers are classified?
How the cells of our body communicate?
How the Lymphatic System Works?
How Digestive System Works
How to complete your capstone projects effectively?
How to write a research project
Healthcare technologies that help patients with better self-management
How to choose the topic of the senior capstone project
How to make your business survive at economic crisis
How can immigrants blend in the American society?
How does the economics of war affect society?
Hate speech on social media.
How to Build an Economic Model
How to start a healthcare startup?
How can financial illiteracy harm you?
How cancer is developed - Cancer biology
How to define the Enterprise Value
How to conduct economic research?
How women can manage sexual harassment
Introduction to Urban Studies
Importance of dance in education
InMoov: how to build an open source humanoid robot
Importance of KYC verification to making the Blockchain secure
Importance of Rhythm
Importance of dance student evaluation
I/O control methods -types and explanations
Identity theft: what to do?
Introduction to Utilitarianism
Importance of 3d Modelling in Architecture
Importance of online journalism
Image processing in medical diagnosis
Introduction to USA Politics
Introduction to Comparative Politics
International Relations as a Major in Political Science
Importance of modern trade policy
Introduction to Journalism
Introduction to Writing a TV Script
Introduction of Microfabrication techniques
Introduction to Microeconomics
Interaction of Consumer and Firm Choices in Markets
Importance of corporate sustainability
Issues in International Monetary Macroeconomics
Introduction to Statistics and Data for Economics
Introduction to Data and Probability for Economics
Introduction to the Game Theory
Introduction to Econometrics
Introduction to Economic Information
Introduction to Market Equilibrium
Introduction to Economic Models and Application
Introduction to Empirical Research
Introduction to Econometric Data
Importance of Critical Thinking, Principles, and Goals
Introduction to Identification and Causal inferences
Introduction to Econometric Application
Intermediaries and Government in Financial Crisis
Importance and seven principles of quality management
Illiteracy in the USA
Introduction to Economics of Law
Introduction to Coase Theorem
Introduction to Social Choice and Incarceration
Intellectual Property and Product Liability
Investment in Human Capital
Introduction to Labor Markets
The Looming Energy Crisis in America
Top benefits of performance-based engineering
The More Languages You Know, The More Times You Are a Man
Things to consider while writing an Argumentative Essay
Top Ways to Improve Your Academic Writing Skills
Tips to Excel in Creative Writing
The origins of films in the early 19th century
Top career options in Architecture
The Elevator Pitch
Top finance trends 2020
The basic Structure and functionality of robots
The Way to Success
The election system of the President in the United States of America
Two-party System in United States of America
Top trends in urban design
The history and theory of African American filmmaking
Top benefits of creative writing
Tinnitus Guide: Common Symptoms and Treatment Options
The language of dance
The digital image processing management
Top famous politicians of the World
Top methods of political science!
The history of the feminist movement
The blood flow in cardiovascular system - Biofluid Mechanics
The best of Leonardo Da Vinci
The Structure and Function of Macromolecules
The structure of cell: a research on the bricks of the human body!
Tissue and organ construction: Adhesion and recognition between cells
The kinetics of the transformation processes
The Modeling of Biological Systems
Tips for writing a great thesis statement
The Defense mechanisms against infections
The impact of the technological innovations in medicine
Top journalism trends to know about
The relation between mass media & politics
Theranostics: Diagnosis and Care through Nanoparticles
The practical Applications of X-rays
The applications of Ultrasound in medicine
Transfer mechanisms of genetic information in Bacteria
The regulation of cellular metabolism in the diagnosis
The Principles of MRI Contrast agents
The technical basis of optical coherence imaging
The New Media: Emerging Trends
The Structure of Interest Rates and the Yield Curve
Technological perspectives and reflections of neural engineering
Types of bioreactors and their applications
The Role of Government Policy in Improving Economic Outcomes
Types of corporate responsibility
The Role of IMF in International Monetary Macroeconomics
Tools for investment decision making
The concept of Organizational Culture and its applications
The Conduct of Monetary and Fiscal Policy
The Basics of Financial Accelerator Models
Tips for labeling medical devices- Medical Entrepreneurship
The different medical imaging techniques
The Economics of Uncertainty – Introduction
Theories of Public Policy
The Game Theory in Social Media
The political theory of Thomas Hobbes
The Use of Law on Economics and Vice Versa
The Role of Internal Audit in Corporate Risk Management
What is a Definition Essay?
What are diagnostic essays?
What is the relation between art structural engineering?
What is a Narrative Essay
What are robotics and intelligence systems?
What are the benefits of studying health sciences?
What is artificial intelligence and why it matters?
What is comparative Literature?
Why study neuroscience
What is Wi-Fi and how does it works
What is French history famous for?
What are Humanistic Studies?
What is covered in Biophysics?
What is modern journalism?
What is Virtualization? Benefits & Applications
What are modern public relations?
What is plasma physics?
What is teacher preparation?
What is rapid prototyping for 3D printing?
What is contemporary European Politics?
Why should you learn American Ballet?
What is engineering physics?
What is the purpose of African American Literature?
Ways to learn the Rhythm
What is digital art used for?
What are Enzymes and how do they work
Who is the father of political science?
Why Study Political Science - Job?
What is the Philosophy of Feminism?
What is a quantum computer?
Ways B2B Startups Streamline Their Conversion Strategies
Why do biomedical signals need processing?
What are the long term effects of climate change?
Why study labour relations
What is Holoprosencephaly?
What is antisocial disorder?
What are the important principles of evolution?
What is the cytoplasm and its function?
What is biopolymers?
What Makes a Good Leader
Women empowerment in modern generation
What is the history of political thought?
What is Gene recombination
What is synthetic biology
What is business cost analysis?
What is Inflation
What are the consequences of unemployment?
What is lithotripsy and its types?
What is transition elastography?
What is the purpose of deep brain stimulation?
What is a Brain-Computer Interface (BCI)
What is neuroethics?
What is Market and Supply and Demand
What is optogenetics?
What are the techniques to record brain activity?
What happens if the interest rate increases?
What is immunotherapy?
What is the economic role of the financial market?
What are the factors behind illegal immigration?
What is the lymphocyte activation?
What is financial market and its types?
What is the structure of financial markets?
What are the methods of measuring business performance?
What is the Credit market?
What is business ethics and code of ethics
What are the Causes of financial instability?
What is MBA with Concentrations
What is regenerative medicine?
What is Population ecology?
What is Microfinance: evolution, and practices?
What is biotechnology and its applications?
What are Workplace diversity and its benefits?
What is the difference between a leader and a manager?
What Is Branding and best branding Business strategies?
Why are microelectronics important?
What are biologic drugs.
What is the Foreign Exchange market?
What is the role of scientific research in times of crisis?
What are the risks of international trade?
What is financial management?
What is gene therapy?
What is education economics?
What is regression analysis, and why should you use it?
What Is Technology Marketing And How Should It Work?
What is Management Accounting
What are the methods of valuation of companies?
What is Immune System and Immunotherapy?
What is big data analytics?
What is the 7 layers of OSI model?
What is Neuroplasticity?