Chapter 20, Problem 13P

To determine

Whether following situations are of moral hazard or of adverse selection.

Concept Introduction:

Moral Hazard: It is a situation of incomplete information which leads to market failure.

This is the problem when sellers and buyers do not have equal information.

Take an example of accident insurance. The person who is insured drives recklessly thinking that they have got the insurance for covering any damage.

Risk Averse: When a person does not like taking risk, then he is referred to as risk averse. In case of risk averse, the marginal utility is diminishing in nature which means that for every additional unit of good, the marginal utility declines.

Adverse Selection: It is a situation in which sellers and buyers do not have perfect information about the product which leads to market failure.

• Take an example of old car market. Those cars which are in good condition are called plums and those which are not are called lemons. In this case, a buyer does not have enough information about the car whether it is a lemon or a plum.

• In case of insurance market, insurance company does not have enough information about the buyer who is needy and what price should be offered to different people.