Difference between moral hazard and adverse selection

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    Define moral hazard. Explain clearly the difference between moral hazard and adverse selection.


    Moral hazards: – this arises after the transaction has taken place. The lender runs the risk that the borrower may engage in activities that are undesirable from the lender’s point of view because they make it less likely that the loan will be paid back. For example, once borrowers have obtained a loan they may take big risks as they are playing with someone else’s money. As moral hazards lower the probability that the loan will be repaid lenders may decide that they would rather not make the loan.


    The main difference between the two is that adverse selection occurs when there’s lack of symmetric information prior to a transaction/deal between borrower/buyer and lender/seller. Whereas moral hazard occurs when there is asymmetric information between parties after the transaction has taken place.


    Moral hazard and adverse selection are both important concepts in the fields of economics and insurance. Let’s define each term and then clarify the differences between them:

    1. Moral Hazard: Moral hazard refers to a situation where one party, after entering into a transaction or agreement, is more inclined to take risks or act in a reckless manner because the potential costs or negative consequences of their actions are not fully borne by them. Instead, the consequences are shifted to another party, typically the party providing insurance or some form of protection. In other words, moral hazard arises when a person or entity is insulated from the full impact of their choices or actions, leading them to behave differently than they would if they were fully responsible for the outcomes.

    In the context of insurance, moral hazard occurs when an insured individual or entity alters their behavior in a way that increases the likelihood of a loss or damage, knowing that the insurer will cover the costs. For example, a person with comprehensive car insurance might be less careful while driving since they know that the insurance company will pay for any damages resulting from an accident.

    1. Adverse Selection: Adverse selection refers to a situation where one party has better information about their own characteristics, risks, or intentions compared to the other party involved in a transaction or contract. As a result, the party with superior knowledge is more likely to participate in the transaction, while the other party is left with less favorable or riskier choices. In essence, adverse selection occurs when there is an asymmetry of information between the parties involved, leading to an imbalance in the quality of choices made.

    In the context of insurance, adverse selection occurs when individuals or entities seeking insurance have more accurate knowledge about their risk profiles than the insurer. For instance, if an insurance company offers health insurance without properly assessing the health conditions of potential policyholders, it may attract a higher proportion of people with pre-existing health issues who anticipate needing medical services, leading to increased costs for the insurer.

    Key Differences:

    The primary difference between moral hazard and adverse selection lies in the source of the problem:

    • Moral hazard arises from the behavior of the insured party after the insurance or protection is in place, where the party takes more risks or engages in reckless behavior because they are insulated from the full consequences of their actions.

    • Adverse selection, on the other hand, arises from an information asymmetry between the parties before the insurance or contract is established. The party with better knowledge or information about their risk profile is more likely to engage in the transaction, leading to an imbalance in the pool of participants.

    In summary, moral hazard relates to the behavior of insured parties after they are covered, while adverse selection pertains to the information imbalance between parties before the insurance or contract is formed. Both concepts are crucial for understanding and managing risks in various economic and insurance contexts.

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