BEE1023 (Adverse Selection and Moral Hazard)

What is adverse selection?

• Adverse selection is where market participants who have more information trade selectively to the detriment of others

• illustrated for the market of insurance

• The demand for insurance comes from consumers who do not like risk. We model risk as a lottery: a random variable with a payment attached to each outcome. 

  • A risk-neutral consumer values a lottery at its expected value. 

  • A risk-averse consumer values a lottery at less than its expected value. 

What does insurance do?

• Insurance moves “risk” from a risk-averse consumer (lower value) to a risk neutral insurance company (higher value). 

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