Distinguish who joins from what people do afterwards.
Asymmetric information means parties to a transaction have unequal relevant information. Adverse selection can occur when hidden characteristics influence who enters a market, weakening the mix of transactions. Moral hazard can occur when an action after an agreement is hard to observe and its costs are partly borne by someone else. Explain the incentive and inefficient outcome; unequal knowledge alone does not prove a market collapses.
- Unequal information
- Asymmetric information means one party to a transaction knows more relevant information than the other. The consequences depend on what is hidden and how it affects choices.
- Before agreement
- Adverse selection occurs when hidden characteristics influence who buys or sells. An insurer unable to distinguish risks may attract a riskier group than expected.
- After agreement
- Moral hazard concerns hard-to-observe actions after an agreement. When someone else bears part of a loss, a person may have less incentive to prevent it.
Match the remedy to the problem
Adverse selection
Credible certification or verified information can help distinguish hidden quality or risk before purchase. In a used-good market, low offers based on average quality may drive higher-quality goods out.
Moral hazard
Monitoring, deductibles or performance terms can improve incentives after agreement. Avoid assuming all claims or high usage are inappropriate; some usage is the intended benefit of cover.
Limits
Verification can be expensive or imperfect. Cost-sharing can reduce valuable use as well as waste. The mechanism and evidence determine the assessment.
Required depth
Explain the causal chain verbally. A diagram of adverse selection or moral hazard is not required by this syllabus.
| Problem | Relevant hidden element | Possible response |
|---|---|---|
| Adverse selection | Characteristics influencing entry/purchase | Verified information or certification |
| Moral hazard | Actions after agreement and shifted incentives | Monitoring or contract incentives |
Worked example: Insurance selection and behaviour
Applicants know more about their risk than an insurer, which cannot distinguish them perfectly. The premium is the price paid for insurance; a pooled premium charges a group a common price based on its combined risk. After cover begins, the insurer also cannot observe every precaution.
- Before agreement, a common premium may look too expensive to lower-risk buyers but attractive to higher-risk buyers. If lower-risk buyers leave, the remaining pool is riskier, raising expected claims and potentially premiums further. This is adverse selection.
- After agreement, coverage may weaken the incentive to take a costly precaution if part of any resulting loss is borne by the insurer: moral hazard.
- Verified risk information can address selection. Monitoring or a deductible, the part of a claim the insured person must pay themselves, may strengthen the incentive to take precautions.
- These remedies have costs. A deductible can also weaken protection or deter valuable use; assess the actual contract and response.
Watch out for this
Adverse selection and moral hazard both mean a buyer is dishonest.
The distinction is hidden characteristics affecting selection versus hard-to-observe actions affecting incentives after agreement. Neither requires a moral judgement about the person.
Check your understanding
A buyer chooses more comprehensive cover because they privately know they face a high risk. Which issue is most directly illustrated?
- Moral hazard from a changed action after cover begins.
- An externality because insurance always harms third parties.
- Adverse selection based on hidden characteristics.