ECON 215 - Moral Hazard, Adverse Selection, etc.

What is adverse selection?

The problem that arises before a transaction when borrowers who are most likely to produce an adverse outcome are the ones most actively seeking loans.

What is moral hazard?

The problem that arises after a transaction when a borrower engages in risky behavior that makes it less likely the loan will be repaid.

What is asymmetric information?

A situation where one party in a financial transaction has more or better information than the other, leading to problems like adverse selection and moral hazard.

Is fraud the same as adverse selection or moral hazard?

No. Fraud involves deliberate deception, while adverse selection and moral hazard stem from information problems.

A health insurance company charges the same premium to everyone. Who is most likely to buy it, and what problem is this?

People who already have health issues are more likely to buy it — Adverse Selection.

A borrower takes out a business loan but secretly uses it to gamble at a casino. What problem is this?

This is Moral Hazard, because the risky behavior happens after the loan is granted.

A bank can’t tell which loan applicants are high-risk and which are low-risk. What type of problem is this?

Asymmetric Information, because borrowers know more about their riskiness than the bank.

Why do lenders sometimes require collateral when making a loan?

To reduce Moral Hazard, since the borrower has something to lose if they default.

Why do insurance companies require medical exams before issuing life insurance?

To reduce Adverse Selection, by gathering more info about risk before the contract.

A used car dealer knows which cars are lemons but buyers don’t. What’s this called?

Asymmetric Information (also known as the “lemons problem”)