Explain how the agency problems have played a role in different parts of the eco

Question

Explain how the agency problems have played a role in different parts of the economy: moral
hazard (unobserved effort), and adverse selection (unobserved type). Define clearly who are
the economic agents involved (managers, stockholders, borrowers, government, etc.). For
additional points, use a simple model to illustrate the situations: remember that the most
important conditions are the incentive compatibility constraint and the participation con-
straint. Be concise and clear in your explanation and focus on what the theory says. Avoid
making unfounded statements.

Explanation / Answer

This is the case of asymmetric information. Asymmetric information refers to the situation where the information is not equally distributed. One party has relatively more information. Thus, it leads to misallocation of resources.

Moral Hazard: In this case, behavior of consumer changes after taking the insurance policy. Suppose if a car owner takes the insurance for car. then he may not care to save the car from damages. In this way, insurance firm tends to overcharge premium and it derives out the genuine policy takers from the market

Adverse selection: It means the asymmetric information causes the selection of inappropriate items. Lemon car market is example of adverse selection.

In case of firm where sharehoders do not have control over the Manager of firm or in other words, managers have relatively more information. They use such information for their own interest. Sometimes these managers tend to act against the shareholders. This is called the principle agent problem.

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