Adverse selection and moral hazard describe several different situations between two parties where one of them is at a disadvantage due to a lack of information. That means the second party can be exploited because it does not have access to all relevant information (unlike the first party).
In an economic context, information is one of the most critical aspects when it comes to decision-making. In most cases, an efficient outcome can only be reached if all parties have access to the same information. Therefore, it is crucial to know the characteristics and differences between adverse selection and moral hazard to recognize these situations and react accordingly.
Adverse selection occurs when there is asymmetric information between a buyer and a seller prior to a deal. That means, one of the two parties (usually the seller) has more accurate or different information than the other party (typically the buyer) before they reach an agreement. This puts the less knowledgeable party at a disadvantage because it is more difficult for them to assess the value or risk of the deal. Meanwhile, the more knowledgeable party has access to all the relevant information and can more easily evaluate the quality of the agreement. This ultimately leads to an inefficient outcome and a lower quality of goods and services in the market.
One of the most prominent examples of adverse selection can be found in the market for used cars (i.e., the market for lemons). In this market, the sellers have more knowledge about the quality and the history of their cars than the buyers. For the sake of the example, we’ll assume there are two types of cars in this market, high-quality cars (peaches) and low-quality cars (lemons). The sellers know whether a car is a lemon or not, but the buyers cannot distinguish between the two (since lemons can only be identified as such after they have been bought).
Thus, they are only willing to pay a maximum price between the value of a lemon and a peach, because they know they might end up buying a broken car. This, in turn, makes it less attractive for sellers to sell high-quality cars, which leads them to sell more lemons. Without intervention, this cycle continues until there are only lemons left in the market.
Moral hazard occurs when there is asymmetric information between a buyer and a seller and a change in behavior after a deal. That means, one of the parties (usually the buyer) accepts a deal with the intention to change their behavior after a deal is made. This happens when they believe they won’t have to face the negative consequences of their actions. This puts the less knowledgeable party (usually the seller) at a disadvantage because they are usually the ones who have to face the negative consequences instead. Thus, they might not have agreed to the deal if they had known about the change in behavior in advance.
An excellent example of moral hazard can be found in the market for car insurance. In this market, the buyers can avoid a large share of the negative consequences of their actions once they have insurance for their cars. Many of them will be extra careful with their trucks before getting insurance because they have to pay for damages and repairs themselves. However, once they get insurance, some drivers feel like they don’t have to be as careful anymore because insurance will cover the costs if anything happens to their car. This can lead to more reckless driving or just an overall increase in carelessness on the road. Of course, this kind of behavior is not desired and puts the insurance companies at a disadvantage.
In a Nutshell
Adverse selection and moral hazard describe many different situations between two parties where one of them is at a disadvantage due to a lack of information. Adverse selection occurs when there is asymmetric information between a buyer and a seller before they close a deal. By contrast, moral hazard occurs when there is asymmetric information between a buyer and a seller as well as a change in behavior after a deal.