(a) Explain the difference between adverse selection and moral hazard in insuran
ID: 1254395 • Letter: #
Question
(a) Explain the difference between adverse selection and moral hazard in insurance markets. Can one exist without the other?(b) An insurance company is considering issuing three types of fire insurance policies: (i) complete insurance coverage, (ii) complete coverage above and beyond a $10,000 deductible, and (iii) 90 percent coverage of all losses. Which policy is more likely to create moral hazard problems?
(c) Why did MGM bundle Gone with the Wind and Getting Gertie’s Garter? What characteristic of demands is needed for bundling to increase profits?
(d) Why might a seller find it advantageous to signal the quality of a product? How are guarantees and warranties a form of market signalling?
Explanation / Answer
Adverse selection: asymmetry in information prior to the deal.
Adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece.
Moral hazard: asymmetry in information/inability to control behavior after the deal
Moral hazard is seen for services such as insurance and warranties. In these cases, after the deal is done, one of the parties to the deal (in this case, the person purchasing the insurance or warranty) may be more careless because he/she has the insurance, and thus does not need to pay the full cost of a damage. For instance, a person possessing insurance against theft may be less careful about closing the windows when leaving the house. Here, it is not the prior information that either party has, but the inability of the insurance provider to control and monitor increased risk-taking behavior that creates the potential for market failure.
Examples of situations where adverse selection occurs but moral hazard does not:
In most situations that do not involve insurance, warranties, legal liabilities, renting services, or any form of continued contract and obligation, moral hazard is unlikely to occur. On the other hand, adverse selection can occur for any experience good, i.e., any good whose value is determined only after buying it and using it.
Examples of situations where moral hazard occurs involve a somewhat different form of adverse selection:
Any situation involving moral hazard also involves adverse selection to at least some extent. This is because, as in the case of health insurance, the person who could indulge in potentially risk-taking behavior may have prior information about his/her excessive risk-taking tendencies and this prior information may have influenced the decision to purchase insurance. This makes insurance sellers set overly cautious rates, and thus, the buyers who are actually less risk-prone end up not buying insurance.
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