In each of the following cases, identify whether the problem is adverse selectio

Question

In each of the following cases, identify whether the problem is adverse selection or moral hazard, and explain your answer. How might the problem be dealt with?

a. Rick has gotten a large advance to write a textbook. With the money in hand, he prefers spending his time sailing rather that sitting in his office working on th book.

b. David is trying to get a large advance to write a textbook. He knows, but publishers don't, that he did poorly on the writing portion of his entrance exam for graduate school.

c. Brenda is buying a life insurance policy. She knows that members of her family tend of die young.

d. Maria, who has a large life insurance policy, spends her vacation pursuing her favourite hobbies: skydriving, bungee jumping, and bull-fighting.

Explanation / Answer

Answer: Adverse selection occurs when there's a lack of symmetric information prior to a deal between a buyer and a seller, whereas moral hazard occurs when there is asymmetric information between two parties and change in behavior of one party after a deal is struck. Moral hazard and adverse selection are two terms used in economics, risk management and insurance to describe situations where one party is at a disadvantage.

a) It is a problem of moral hazard. The problem can be dealt with by incorporating a clause in the agreement to time limit within which book must be submitted and also describing quality standards to be followed.

b) This is a problem of adverse selection as one party has more accurate information than other. This can be solved by employing people on the basis of written tests rather than university degrees.

c) This is a problem fo adverse selection.

d) This is a problem of moral hazard.

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