Define moral hazard and explain how it is caused by asymmetric
information
Asymmetric information arises when one party has insufficient information about the other party, which is involved in the transaction, making it impossible for the party with insufficient information to make an accurate decision during the transaction. Asymmetric information occurs during the transaction and leads to the problem of adverse selection and moral hazard.
In the problem of moral hazard, the lender runs the risk that the borrower may engage in undesirable activities from the lender’s point of view. Therefore, moral hazard lowers the probability that the loan will be repaid, so the lender decides not to grant the loans at all. Moral hazard occurs after the transaction, and thus, it creates the problem of asymmetric information.
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