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Asymmetric Information, Adverse Selection & Moral Hazard | Economics Definitions - YouTube
Channel: INOMICS
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Hello from INOMICS. In this
video we’re going to explain
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what asymmetric information, adverse
selection and moral hazard are,
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how they are related to one another and
why they are important to understand.
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If you want more economics content,
be sure to subscribe to our channel.
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Asymmetric information is when one party has
more information about a good or a service
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than another in an economic exchange.
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In any complex economy, asymmetries
of information are everywhere.
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They allow people and businesses to become more
productive within their chosen specialisation.
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For example, a doctor may have more information
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about a patient’s medical condition than
the patient themselves.
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However, the doctor’s superior
medical knowledge was attained
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through years of intensive medical training.
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It would simply be impractical for the patient
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to also specialise in medicine at the
expense of knowledge in another field.
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Economies thus benefit from an efficient
division of labour and shared knowledge.
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Adverse selection occurs, however, when the
better-informed party uses the asymmetric
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balance of information to take
advantage of another party
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before the exchange or agreement has taken place.
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In other words, when the
party with less information
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is at a disadvantage in a market
to the party with more information.
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The unequal access to information can lead
to a breakdown in the ability of buyers and
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sellers to agree the price or quantity of
a good or service in any given market.
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Market exchanges consequently
become less efficient,
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and in extreme cases, adverse
selection can lead to market failure.
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Adverse selection is often an
issue in insurance markets.
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This is because insurance providers often
know less about their customers’ risk levels
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than the customers themselves.
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Oscar wants to purchase car insurance
as he knows he is an unsafe driver.
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He drives way to fast and it’s only a matter
of time before he gets into an accident.
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Conversely, the insurance provider in this
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example cannot reliably tell how
safe Oscar is behind the wheel.
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The insurer and Oscar therefore
have asymmetric information.
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Oscar has an vested interest in taking out
car insurance
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because he knows he is likely
to make a claim in future.
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Insuring unsafe drivers like Oscar, who cannot
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be reliably identify before offering an insurance
policy, pushes up the cost to the insurer.
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Consequently, the price also
rises for safer drivers too.
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The safe driver knows they are unlikely to
claim
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and therefore no longer deems the purchase
of car insurance as a sensible investment.
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This inflates insurance premiums further as
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the market becomes dominated by unsafe drivers
like Oscar who are more costly to insure.
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This is the problem of adverse selection.
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Moral hazard occurs after a deal has been made
between two parties with asymmetric information
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and one party changes their behaviour as a result.
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Oscar also purchased theft and damage cover
when he got his new auto insurance policy.
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The price of the policy was based on Oscar
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telling the insurance provider that he
always parks his car in a secure garage.
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There is asymmetric information here
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because only Oscar knows for certain whether
he always parks his car in the locked garage.
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The moral hazard arises when Oscar might,
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for the sake of convenience, start parking
his car on the street rather than in the secure
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garage now the insurer, not himself, would
have to pay in the case of damage or theft.
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Oscar has changed his behaviour but will not
suffer the consequences personally of the
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greater risk associated with parking his
car on the street rather than in the garage.
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This is an example of a moral hazard.
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Insurers alongside regulators have developed
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various ways to address the problems
of adverse selection and moral hazard.
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Insurance might be made compulsory for instance.
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Therefore safer drivers can
get insurance at a lower price
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because the average risk of
all those insured is lower now
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than when it was only drivers
like Oscar with insurance.
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Additionally, many insurers offer no claims
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bonuses to incentives people not to
act more recklessly once insured.
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Of course, these problems are a lot
more complicated than presented here.
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For information check out our
extended definitions which you
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can find linked in the description to this video.
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