Asymmetric Information- Moral Hazards

Usually, in a competitive market structure is it assumed that the firm and consumer have equal information about the goods. However, in reality, this is not how a market works. Asymmetric Information refers to that situation where buyers and sellers possess unequal information. This usually leads to an underallocation of resources to the production of the particular good or service and the party with less information is vulnerable to exploitation due to their lack of knowledge.

There are abundant examples for situations when the buyer and seller respectively possess more information than the other. One such example that is seen commonly is the excess information possessed by the buyers of insurance- be it health or any other.

Moral Hazard refers to the situation where one party takes risks but does not face the full cost of these risks. It is typically seen when either the consumer or producer changes their behaviour after an agreement is made. For instance, after receiving insurance for one’s car, the car owner might drive it recklessly as compared to if their car was not insured.

The moral hazard problem in relation to purchasing insurance:-

Many individuals who indulge in activities such as smoking and alcoholism, that deteriorate their health, often withhold information from the insurance companies about the degree to which they indulge in these activities so as to prevent having to pay a very high premium due to the high probability of them having health issues in the future. Another issue faced by these companies is the change in behaviour of the consumers once they are aware of the fact that they will receive treatment for their illnesses at a lower cost due to their insurance.

Since it is the producers or providers of insurance who face the problem, it is they who have to deal with it. One method to try and ensure that the buyers bare part of the cost of damages or burden of their risks, are ‘out of pocket payments’. These are aimed to reduce the risky behaviour of the insurance buyers by making them face the consequences for such behaviour.

An issue that often arises with these ‘out of pocket payments’ is that it affects different income earners differently. As a result of this, the low-income earners tend to change their risky behaviour since they get offered less insurance protection. Whereas, the high-income earners have almost no incentive to change their risky behaviour.

In financial areas, as in the case of the buying and selling of loans, moral hazard is dealt with through government regulations for the financial institutions in order to reduce the risky behaviour. However, this leads to various discussions regarding the degree of the regulations that are required in order for them to be effective.  

Citations

Tragakes, Ellie. "Chapter 5: Market Failure/ Section 1: Microeconomics."Economics for the IB Diploma. 2nd ed. N.p.: Cambridge UP, n.d. 132-34. Print.

"Moral Hazard." YouTube. MR University, 23 Sept. 2015. Web. 8 Jan. 2016.