18.11.19 Economics
Adverse selection, Moral Hazard
Introduction
o Information is ‘asymmetric’, meaning some agents have more information about a
situation than others
o Problems include the facts that people usually know more about themselves and the
goods they produce than others
o The problem of ‘adverse selection’ arises because the quality of a good or person
cannot be perfectly observed
o The problem of ‘moral hazard’ arises because the risks people take cannot be
perfectly observed.
Insurance and risk
o Adverse selection: where market participants who have more information trade
selectively to the detriment of others
o Can be illustrated in the market for insurance
o The demand for insurance comes from consumers who do not like risk.
o We model risk as a lottery: a random variable with a payment attached to each
outcome
o A risk-neutral consumer values a lottery at its expected value.
o A risk-averse consumer values a lottery at less than its expected value.
o Likely to purchase insurance if risk averse
o Insurance moves risk from a risk averse consumer (lower value) to a risk neutral
insurance company (higher value)
o A main function of the financial industry is the allocation of risk, moving risk from lower
to higher valued uses
o Insurance companies spread the risk across all the contracts
Adverse selection – First lesson
o To explain adverse selection, modify the bike example. Now assume two equally sized
risk-averse consumer groups:
- Group 1 with a probability of theft of 0.2
- Group 2 with a probability of theft of 0.4
o Issue with increasing the price is that the first group may not purchase the insurance as
they aren’t that risk adverse.
o But it is hard to tell the two groups apart. They know the proportions, but not which
category individuals fall into.
o If only high-risk consumers would be willing to pay the higher price, the company
would make a negative expected return.
Adverse selection, Moral Hazard
Introduction
o Information is ‘asymmetric’, meaning some agents have more information about a
situation than others
o Problems include the facts that people usually know more about themselves and the
goods they produce than others
o The problem of ‘adverse selection’ arises because the quality of a good or person
cannot be perfectly observed
o The problem of ‘moral hazard’ arises because the risks people take cannot be
perfectly observed.
Insurance and risk
o Adverse selection: where market participants who have more information trade
selectively to the detriment of others
o Can be illustrated in the market for insurance
o The demand for insurance comes from consumers who do not like risk.
o We model risk as a lottery: a random variable with a payment attached to each
outcome
o A risk-neutral consumer values a lottery at its expected value.
o A risk-averse consumer values a lottery at less than its expected value.
o Likely to purchase insurance if risk averse
o Insurance moves risk from a risk averse consumer (lower value) to a risk neutral
insurance company (higher value)
o A main function of the financial industry is the allocation of risk, moving risk from lower
to higher valued uses
o Insurance companies spread the risk across all the contracts
Adverse selection – First lesson
o To explain adverse selection, modify the bike example. Now assume two equally sized
risk-averse consumer groups:
- Group 1 with a probability of theft of 0.2
- Group 2 with a probability of theft of 0.4
o Issue with increasing the price is that the first group may not purchase the insurance as
they aren’t that risk adverse.
o But it is hard to tell the two groups apart. They know the proportions, but not which
category individuals fall into.
o If only high-risk consumers would be willing to pay the higher price, the company
would make a negative expected return.
