Wednesday 4 December 2013

Moral Hazard and Adverse Selection

A while back, someone asked me how does an individual differentiate between moral hazard and adverse selection. I thought about it for a while before answering not because I didn't know what was the meaning but because I was thinking of the best way to explain to someone who does not have any economics background.

One similarity between them: They are both market failure conditions

As it is a term that is commonly used by economists, I was surprisingly shocked by how could it even be possible that someone does not know the difference when it is so distinct. Anyway, we can't always assume that everyone knows the same amount of information =). Ask me something about literature and I am sure would not know the answer either although it may be common sense to the literature major student. At the end of the day, I managed to clarify those terms to him, I hope.

By the simplest definition of moral hazard, it can be understood as the change of an individual's behaviour solely due to the contractual agreement between the 2 parties. In layman terms, your behaviour towards an issue is affected due to an agreement that you have with another party. This change of behaviour will lead to a deadweight loss (DWL) i.e. a loss in welfare to society.

Let me explain in more details using the example for moral hazard first before showing you graphically why is it a loss in welfare to society. I will be using the example of healthcare since I just finished a module on Health Economics. Assuming, you have to spend $100 bucks on healthcare expenditure every time you visit a doctor due to the prescription drugs. However, due to your budget constraint, you can only afford 5 visits per month. Now if an insurance policy is offered to you for a very low premium and at the same time pays 50% of your healthcare expenditure for every visit to the doctor. Would your behaviour change if you were to take up the policy?

Almost every rational consumer would either increase the number of visits to the clinic if required or even ask for a more expensive version of the prescription drug if available as the out of pocket expenditure by the individual is reduced. This in essence is moral hazard. I'm sure there are many other examples that you can think of once you grasp the concept.

Graphically, it can be shown as such:



 
Note: I took it directly from my lecture notes as it would save me time trying to draw the graph. Nonetheless, the main point is made.
 
Now, with respect to DWL;
 
As seen in the graphical representation using a simple demand and supply diagram, we can see from the first diagram that the original total healthcare expenditure is blue in colour whereas, the additional expenditure due to insurance coverage is pink in colour.
 
From the second diagram, we can see that the additional value gained from the individual is the lighter blue shade under the original demand curve and the yellow triangle refers to the DWL.
 
Lastly, in the third diagram, adding in the supply curve and using the graph to represent the whole economy, we can see the that total yellow region has increased.
 
Why does DWL cause a loss in welfare to society? In layman terms, it is because, these resources could be better utilised elsewhere.
 
Moving on to adverse selection:
 
Again, let us start off with the definition. Adverse selection can be understood as a market process where sellers have information that buyers don't (or vice versa), or asymmetric information (access to different information) about some aspect of product quality or service, resulting in the "bad" products or services to be more likely to be selected i.e. Both parties have different level of knowledge of the product or services and thus one side is always at an advantage.
 
Let me explain this using the insurance market once again. In Bukina Faso, Africa, formal insurance for the farmers in the rural farms seldom exist for a couple of reasons such as high fixed and variable cost of operations. Apart from that, the insurance company may not be able to guard against the issue of moral hazard if they were to provide insurance for the farmer. i.e. How would the insurance company know that farmers will continue to take care of their farm and not slacken off in order to receive the pay out by the insurance company when they do not meet their crop yield requirement?
 
Above that, insurance companies and their agents, normally from the urban cities itself, may not know the conditions of the farms as well as the farmers themselves. What if the farmers were to choose a piece of land that is less fertile or more prone to diseases to insure? It will almost be certain that insurance companies will end up losing money should they insure these land. On the other hand, how can the farmers know that they can trust the insurance companies since they are the ones that know a lot more about the policies as compared to the farmers themselves. This in essence is adverse selection. Often, the presence of asymmetric information would result in adverse selection causing in some markets to fail to exist in the very first place!
 
Hope this post clarifies the differences between moral hazard and adverse selection! =)
 
 
 
 



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