Moral Hazard and Adverse Selection - Essay Example

Moral Hazard and Adverse Selection Name Date Business and organisation are exposed to different levels of complexities. Organisations are required to devise means and strategies that will ensure that business succeeds and are protected against external complexities. In economics, there are different risks that an organisation is supposed to factor into consideration before determining the final approach that will be used. Example of such complications is the moral hazard and adverse selection. Adverse selection and moral hazard occurs in economics, insurance and statistics and it usually involves two parties. Thus, the aim of this paper is to analyse moral hazard and adverse selection bringing into consideration factors brings its occurrences, consequences of these factors and means or strategies that can be used to mitigate the moral hazard and adverse selection complications. Moral hazard may be defined as the fact that a given party is protected or insulated from risk, the party may behave differently is such a way that the party will fully be exposed to the risk. Moral hazard is associated with information asymmetry; information asymmetry is a situation in which one party in a transaction has more information concerning a given situation than another (Palacios and Lieras, 2004). Usually, the party that is insulated from risk has more information especially concerning its intentions and actions that the other party that is supposed to meet the negative consequences that results from the risk. Generally, moral hazard takes place in a situation that one party with more information concerning their intentions or actions has incentive or tend to behave in the wrong way from the original perspective of party that has less information (Wessels, 2006). Moral hazard to some extent brings the same principles as those of adverse selection. Adverse selection is when inappropriate information is available to one party and the other party cannot access this information. It is usually used to define a market process that sellers and buyers have asymmetric information and thus the customers may purchase products that are ‘bad’. Such a scenario may occur in the second hand car industry, in which the seller, for example, saloon cars possesses information that the stakeholders within the industry lack (Black, 2005). Thus, the seller operates at a comparative advantage because the information is not authenticated and the car being sold maybe of poor quality (Ricketts, 2003). The buyers seeing the lower price may purchase the car factoring the risks associated with such process and on the other hand, sellers who sell quality cars may not wish to sell at the low price. Therefore, within this example, there are three components of adverse selection that occurs. The first is the random information about product quality, secondly, asymmetry information regarding the quality and there is greater chance for the trader dealing with the poor quality car to sell the product at any given prince compared to high quality cars. In this case, the credit and insurance markets have to be aware of adverse selection (Wessels, 2006). Generally, adverse selection and moral hazard to some extent are the same because it results due to insufficiency in terms of information. The contributing factor is the lack of appropriate information and thus the two difficulties can be prevented through ensuring that there is enough information before reaching a contractual agreement (Palacios and Lieras, 2004). In most instances, moral hazard results because of individual within a party refrain from fulfilling their obligations. It arises because an institution or individual does not factor into consideration the full responsibility and consequence of a given action, and thus, the party may act less cautious or less careful than how the party was supposed to act, leaving the responsibility of their consequences to another party (Black, 2005). For example, the responsibility of a salesperson is to ensure that he sell the business products and may be the salesperson is paid a flat salary with no commission for his sales, thus there is a likely danger in that the salesperson may not sell the business products because he knows that regardless of his contributions, he will still earn the same amount and thus may be reluctant to fulfil the aim and goals of the business. Thus, the salesperson has transferred the responsibility of his consequences to the owner of the business (Ricketts, 2003). Moreover, moral hazard may arise because of principle-agent problem/ relationship. In this case, the principle is the owner of the resource while the agent is a person that is hired by the principle and given responsibility over the owner’s resources (Folmer and Tietenberg, 2005). Usually, such contracts are based on a contract that is imperfectly constituted describing future contingencies. In addition, the post-contractual behaviour of the agent is usually observed and factors such as motivation and monitoring are included (Wessels, 2006). Therefore, moral hazard arises when the agent function in behalf of the principal and the agent is supposed to fulfil the goals of the principle. However, sometimes the principal and agent have differing aims, and at the same time, the principal cannot determine whether the actions of the agent are actually self-interested misbehaviour and thus in such scenario moral hazard occurs (Palacios and Lieras, 2004). Moral hazard and adverse selection have contagious consequences that may influence negatively the economy. The main consequence of moral hazard or adverse selection is the ethical or moral component of the entire process. For example, a person may feel morally wrong after purchasing a car insurance and goes up in the mountains and do not care about risks that may occur (Wessels, 2006). Even if the car is scratched, behind his mind is thinking that the insurance company will meet the expenses but internal principles tells the person that it is morally inappropriate for such actions. Secondly, the society will fare less because of the consequences of these factors. An example in which the society is affected is the current economic crisis that has resulted in a disastrous chain. The mortgage brokers within the housing and bank industry earned commissions on the value of mortgages that were offered without considering the chances of default. This was then followed by the investments dealers who earned large sums of profits through slicing and dicing the mortgage loans into packages that are commonly referred to as mortgage-backed securities, for sale to those purchases on interested entities who were unsuspecting and mostly relied on appallingly flawed analyses that were provided by independent but less competent credit-rating agencies (Brownell, 2008). This resulted in many institutions collapsing resulting in moral hazard and since this chain could affect the entire industries the government bailed these industries that had caused the problems but also who had greatly benefited from the entire process. At the end of the entire process the society (tax payers) had to meet expenses (bailouts) that were not supposed to have occurred if the institutions had behaved effectively (Brownell, 2008). Adverse selection and moral hazard negates the principles of fair trade. For example the second hand car industry, the cars that may be sold are of poor quality. In this case, the buyer will frequent garages; the insurance companies will meet extraneous costs, while the car itself will likely not be environment friendly (Ricketts, 2003). Pollution affects the environment and because of the climate change and climate warming, such cars will not conserve the environment and degradation of the environment will translate in impacting the society and will extrapolate to other selectors. Generally, adverse selection and moral hazard is a single process but it contributes to a chain of complications to individual, community, national and globally (Wessels, 2006). Moral hazard and adverse selection occurs because of asymmetrical information between two parties. Generally, there are two approaches that can be used to mitigate or correct the problems and consequences that are associated with these two factors. These approaches resulting in ensuring that the risks are controlled or are within limits that will not cause extensive damage. These two approaches may be defined as “hard” and “soft” side. The most expensive and requires a lot of resources is the “hard” side that bring into consideration many components. Some of these components may include risk oversight committees, policies and procedures, audit process, risk limits, risk assessments, and effective systems (Palacios and Lieras, 2004). This approach requires predefined conditions for parties to enter contractual obligations. It is important to determine in advance the position and capability of a party before providing the required surface through ensuring that there is symmetrical information (Black, 2005). Thus, putting in place the right amount of resources with competent individuals will result in mitigation of the entire moral hazard and adverse selection. In this scenario, the responsibilities can be placed on the two parties involved. For example, in the case of a sale person, the owner may decide to pay a wage that is inclusive of salary and commissions. In this approach the salesperson will have incentive to ensure that he fulfils the laid goals and at the same time, the business will be profitable (Wessels, 2006). The “soft” side is subjective and usually difficult to measure. These involve ensuring that the parties involved understand the benefits of providing information that is appropriate for the given process. Some components that are involved include skills, people, incentives, culture and values, trust and communication, and integrity (Ricketts, 2003). This approach is usually had to factor into consideration of the risk management fundamentals that are rooted in measure, monitor and manage. However, cultivating trust, integrity and values will result in a situation that the parties provide information that will ensure contract is development within known and premises. For example, requiring a customer for health insurance purpose to fill an extensive form that includes independent medical analysis may result in impacting values and integrity to the customer and will result in providing appropriate information. Such information and strategy will ensure that the customer receive value for the money while at the same time the institutions (insurances) can operate effectively (Brownell, 2008). Generally, moral hazard and adverse selection occurs because of asymmetrical information. Two parties that are involved in certain contractual requirement may provide information that is insufficient and such approach may affect the final requirement of the contract. This means that the two parties are supposed to provide information that is appropriate before reaching legal decision. However, in most instances, most contractual obligations utilise minimal information that at the end of the day one party may suffer. Some consequences that are associated with moral hazard and adverse selection are moral obligations, may affect the parties involved and sometimes may extrapolate to entire society. Moral hazard and adverse selection is a contagious issue that may spread and affect many institutions or individuals. However, measures are in place that can be used to mitigate complexities associated with the two components: moral hazard and adverse selection. These measures are “hard” and “soft” side. The “hard” side are measurable but 4requires large investment of resources but the “soft” side requires minimal resources but it cannot be measured. “Soft” side usually involves been frank and cultivating the culture of transparency. Thus, appropriate measures should be in place to ensure that moral hazard and adverse selection is avoided or minimised into a position that is suitable to both parties leading to the satisfaction of the community involved. References Black, W. 2005. The Best Way to Rob a Bank is to Own One: How Corporate Executives Operate. California: University of Texas. Brownell, C. 2008. Subprime Meltdown from US Liquidity Crisis to Global Recession. London: Solving Difficult Sudoku. Folmer, H. And Tietenberg, T. 2005. The International Yearbook of Environmental and Resources Economics 2003/2004. London: Edward Elgar Publishing. Palacios, M. and Lieras, M. 2004. Investing in Human Capital: A Capital Markets Approach to Student Funding. London: Cambridge University Press. Ricketts, M. 2003. The Economics of Business Enterprise: An Introduction to Economics, 3rd Ed. London: Edward Elgar Publishing. Wessels, W. 2006. Economics, 4th Ed. London: Barron’s Educational Series. Read More