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ASYMMETRIC INFORMATION: ADVERSE
SELECTION AND MORAL HAZARD
Presented by •
Farida Ahmed 46-1511
Jailan Mohamed 46-4195
Tony Melad 46-4067
Hana Ayman 46-8555

Audio Recording Apr 21, 2021 at 10:09:07 PM

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DISCUSSION POINTS
AN INTRODUCTION
Definitions of some terms
Lemon Market
Moral Hazard & principal agent problem
Remedies to adverse selection and moral
hazard
Should the Government intervene

Audio Recording Apr 21, 2021 at 10:11:43 PM

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ECONOMICS
OF
INFORMATION
Economics of Inforamtion is a field of
microeconomics that helps explain how the
allocation of information affects the
economy and economic decisions.
It has two assumptions, one is perfect
information. Here we assume that everyone
has full information and access to it about
the goods or services in the economy.
• Yet, economies are more complex than that
and not everyone has complete information.

Audio Recording Apr 17, 2021 at 4:35:23 PM

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ASYMMETRIC INFORMATION
• Also known as imperfect information or information failure, is a
situation in which one party possess more information than the
other party during an economic transaction.
• This phenomenon usually takes place between a buyer and a
seller during the sale of the item. Here, the seller knows more
about the item being sold than the buyer and which this
information will be revealed to the buyer only after the
purchase.
• However, it can be viewed positively as specialization.

Audio Recording Apr 17, 2021 at 4:40:45 PM

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ADVERSE SELECTION
• Adverse selection results due to the prevalence of asymmetric information or
imbalances of information between parties.
• It is the situation were one party has more knowledge than the other party;
however, it takes place before a transaction is under taken.
• The term adverse selection was initially used for the insurance sector
to explain this problem.
Meyer & Parks Realty 2020

Audio Recording Apr 17, 2021 at 4:44:35 PM

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• Akerlof explained this problem through his paper "The Market for
Lemons". Here the seller who has a bad car "Lemon" has more
information about the car than the buyer and they are willing to sell at
any price.
• Thus, those with bad cars will sell at low prices, while anyone with a
good car "peach" will not be willing to sell at low prices. Consequently,
all the cars that are sold are lemons.
• Furthermore, Akerlof explained that adverse selection can destrroy the
market, ecnouraging lower prices and low quality goods.

Audio Recording Apr 17, 2021 at 4:59:01 PM

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66
One way to overcome adverse
selection is through compulsory
purchase or participation,

Audio Recording Apr 17, 2021 at 5:00:48 PM

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MORAL HAZARD
• It is the situation in which a person has limited liability to the risks
he/she takes and the costs associated with these risks. Thus, creating
an incentive to engage in more risks.
• The term was originated in the insurance sector. When a person has insurance
he will have no incentive to take care of the item being insured.
• Consequently, we can observe a situation of a tradeoff: if there is no
insurance one will face high risks, and if there is insurance one won't be
motivated to take care.
Meyer & Parks Realty 2020

Audio Recording Apr 19, 2021 at 9:57:21 PM

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• Also, insurance companies will be faced with this tradeoff, they will not be
willing to provide full insurance.
• This occurs because insurance companies cannot fully ensure that people
would take care of there things after the insurance.
• Instead they will let the person bear some of the risks.
Meyer & Parks Realty 2020

Audio Recording Apr 19, 2021 at 11:16:05 PM

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Principal - Agent Problem
• Arises due to conflict of interest between the principal and the
agent. This relationship is based on the agent acting and making
decisions on the behalf of the principal.
• It typically takes place when the agent decideds to act on his own
interests and benefits.
This problem arises due to:
• Separation of ownership and
control
• Conflict of interest
• Asymmetric Information
Principal
Delegates
Authority
Conflict of
Interests
Acts and Makes
Decisions
Agent

Audio Recording Apr 19, 2021 at 11:34:59 PM

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One famous example is the principal - agent problem
in equity contracts.
• The principal is the shareholder
• The agent is the manager
• The pricipal wants to maximize profits while agent
has no incentive to do so

Audio Recording Apr 19, 2021 at 11:39:49 PM

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Hidden Action Problem
• Moral hazard is when one bears the minimum costs of the risks
he/she takes.
• Thus, in any transaction you cannot fully know the actions of the
other party.
• The Hidden Action refers to the inability to predict the actions of
other people which can affects the results of the transaction.
• In fact Moral hazard is refered to hidden action.
Meyer & Parks Realty 2020

Audio Recording Apr 19, 2021 at 11:48:52 PM

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WHAT IS LEMON MARKET
• The Lemon Market problem occurs regarding a value of a product or
investment due to asymmetric information
Asymmetric information also known as "information failure" happens when
one party has more information that the other party like seller & buyers
• So usually adverse selection occurs when the sellers
have/ hides important information from the buyers,
and negatively harming them in the dark.
• For example, a man came to an insurance company
to make a life insurance for $50 and he didn't
disclose that he is a sky diver which would cost the
company a lot of money if something happens to
him.

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Origin of Lemon Market
1
2
The economist George A. Akerlof
made a research paper theory in
1970 titled "The Market for 'Lemons
Quality Uncertainty and the Market
Mechanism"
He explained his
asymmetric theory on the
car market
• How sellers exploit buyers because
they have more information
3
• Which could lead to a market failure
• Due to market making unprofitable
exchange leaving lemons or poor
products
• Which the buyer paid a lot of money
due to lack of information
• However nowadays the internet
helped reduce this problem due to
the free information available

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Lemons in financial, Stocks & Bonds
market
• Buyers of the stock or bond don't have the information to differentiate
between good firms who have high expected profits with low risk and bad
firms who have low expected profits and high risk
• Because the owners and managers have more information
• Good managers put high prices because of the value of their company which
makes it unaffordable for many people so they buy risky ,low priced ,low
profit bonds creating lemons due to buying something bad which occurs due
to lacking the right information to know if its good or bad
• In financial markets people pay a lot of money in risky projects in order to
gain higher profits who took huge loan and are unlikely to pay it. So
adverse selection increases the chance for the loan to be lent to a bad
creditor.

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WHAT IS MORAL HAZARD?
"MORAL HAZARD REFERS TO SITUATIONS WHERE ONE SIDE
OF THE MARKET CAN'T OBSERVE THE ACTIONS OF THE
OTHER"
THE PRINCIPAL-AGENT PROBLEM IS A GOOD WAY TO EXPLAIN MORAL
HAZARD...
A CONFLICT IN PRIORITIES BETWEEN A PERSON OR GROUP AND THE
REPRESENTATIVE AUTHORIZED TO ACT ON THEIR BEHALF.

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LETS APPLY!
HOW IS THE MORAL HAZARD APPLIED TO THE
INSURANCE INDUSTRY...
PROTECTION AGAINST LOSSES
ENCOURAGING RECKLESS BEHAVIOUR
TAKING ADVANTAGE OF THE CONCEPT OF MORAL
HAZARD

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REMEDIES OF MORAL HAZARD
AND ADVERSE SELECTION
1
3
SIGNALLING
SCREENING
2
4
REPUTATION
EXPERTISE
ALSO, COLLATERAL AND PROFIT SHARING

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Should the Government
Intervene?
Meyer & Parks Realty 2020

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Moral hazard occurs because one side of the competition is
unable to see the behavior of the other. As a result, it's often
referred to as a hidden action problem.
Adverse selection occurs when one side of the market is unable
to observe the "form" or quantity of products on the other side
of the market. As a result, it's often referred to as a "hidden
information problem."

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In the case of hidden action considered above, the answer is
usually "no." If the government can't observe the care taken by
the consumers, then it can do no better than the insurance
companies. Of course, the government COUId have other options
at its disposal that are not available to the insurance, it could
compel a certain level of care and impose criminal penalties on
those who did not take due care. However, if the government
can only set prices and amounts, it would be unable to
outperform the private market.

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In the case of hidden information, similar problems emerge. We've also
seen that if the government can compel people in all risk groups to buy
insurance, it is possible for everybody to be made better off. On the
surface, there seems to be a good case for intervention.
Government intervention, on the other hand, has costs; economic
decisions taken by government decree will not be as cost-effective as
those made by private companies. Furthermore, there may be purely
private solutions to the issues of adverse selection. We've also seen how
having health insurance as a fringe benefit will serve to eliminate the
issue of adverse selection.

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øuNZY7Z>S
.s•o/o
REFERENCES
• HTTP://UWECONSOC.COM/WHAT-IS-ECONOMICS-OF-
INFORMATION/
• HTTPS://WWW.INVESTOPEDIA.COM/TERMS/A/ASYMMETRICINFO
RMATION.ASP
• HTTPS://WWW.ECONOMICSHELP.ORG/BLOG/GLOSSARY/ADVERS
E-SELECTION/
• HTTPS://WWW.THEBALANCE.COM/MORAL-HAZARD-WHAT-IT-IS-
AND-HOW-IT-WORKS-315515
• HTTPS://CORPORATEFINANCEINSTITUTE.COM/RESOURCES/KNOW
LEDGE/OTHER/PRINCIPAL-AGENT-PROBLEM/
• HTTPS://WWW.lNVESTOPEDlA.COM/ASK/ANSWERS/042415/WH
AT-DIFFERENCE-BETWEEN-MORAL-HAZARD-AND-ADVERSE-
SELECTION.ASP#
• HTTPS://WWW.INVESTOPEDIA.COM/TERMS/A/ASYMMETRICINFO
RMATION.ASP
' • HTTPS://WWW.INVESTOPEDIA.COM/TERMS/L/LEMONS-
PROBLEM.ASP

Audio Recording Apr 21, 2021 at 9:52:32 PM

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Audio Recording Apr 21, 2021 at 9:51:41 PM

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