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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 'verto .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