Adverse Selection vs. Moral Hazard

Instructor: Brianna Whiting
In this lesson, we will look at the terms adverse selection and moral hazard. We will define each term and look at some examples to help better explain how adverse selection and moral hazard occur. The lesson will be concluded with a quiz.

A Plausible Scenario

At one time in each of our lives, we have made a commitment to another party. It may come in the form of a commitment to buy an item from a seller or from making some sort of deal, financially or otherwise. Now, we would all like to think that when we enter into a commitment we have all of the facts and necessary information to make an informed decision. And, hopefully, that commitment possess little to no risk to us.

But, what if a decision is made based upon risks and poor information? What happens if you only have bits and pieces of the whole situation and enter into a commitment? Would the end result turn out as you had hoped? In this lesson, we will look at what happens when decisions are made in less than ideal situations. In particular, we will be looking at adverse selection and moral hazard.

Adverse Selection Defined

Because there are two parts to this lesson, let's break them up a bit and cover adverse selection first. So, what is meant by the term, adverse selection? Well, adverse selection occurs when someone makes a decision without all of the information, which can result in an undesirable result.

When one party has access to better or more information than the other party during a transaction, it is said that one has asymmetric information. Therefore, when a party has asymmetric information, they may make an adverse selection.

For example, you are interested in buying a new car. While you think you have found the one that fits you best, you are unaware, that the seller has some information about problems with the car that he is not telling you. Because you are unaware of this information, or asymmetric information, you decide to buy the car. What has just happened is you were not aware of the true quality of the car you were buying, so having asymmetric information, the seller was able to sell you a 'bad' product.

Another example can be found in the insurance industry. When an individual goes to purchase health insurance, the insurance company may not be aware of any issues that would cause the purchaser to be at a greater risk of using the insurance and submitting a claim.

For instance, if a 25 year old female purchases insurance, the insurance company may be under the impression that the young lady is healthy and therefore less likely to actually file a claim. But, what the insurance may not know, is that the 25 year old female is pregnant with twins and has a future full of numerous expensive procedures and tests that will be performed, resulting in numerous claims. The insurance company decides to offer her insurance and make what looks to be an adverse selection because of this asymmetric information.

Moral Hazard Defined

The second piece to this lesson is moral hazard. A moral hazard is when an individual takes more risks because he knows that he is protected due to another individual bearing the cost of those risks. Much like adverse selection, moral hazards are the result of asymmetric information. Also, it is important to note, that when a party knows that they are protected in one way or another from risks, they may have the tendency to act differently than if they did not have protection.

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