Adverse Selection and Moral Hazard

ADVERSE SELECTION AND MORAL HAZARD 5

AdverseSelection and Moral Hazard

AdverseSelection and Moral Hazard

Adverseselection connotes the process which undesirable results occur whensellers and buyers have access to imperfect information which leadsto imbalance of power (Kirabaeva, 2011). On the other hand moralhazard refers to a situation where a given party is ready and willingto take risk because the total weight of the risk would be taken byanother party. It occurs as a result of unequal information. Bothelements have a potential to cause market failure (Tesfatsion,2011).

Inmost circumstances the labor market is not fully transparent. Thismeans that the competition among various firms and job seekers isimperfect due to the fact that information is not distributed evenly(AngelLearning MindClic Process Technology, 2012).It is evident that the opportunity to get skills and educationrequired in the labor market is not evenly distributed and as suchthe markets do not operate efficiently (Tesfatsion,2011).For example, when a particular job seeker is trying to negotiate fora good wage, due to the existence of an agent that has access toinformation that is not explicit to the job seeker, it is notpossible for the job seeker to know the maximum amount of money thatthe employer will be ready and willing to pay and in the same way theemployer will not be able to know the minimum the job seeker is readyto accept. At the end of the day the firms in the labor markets arethe beneficiary of the moral hazard. When organizations can not beable to observe the actions of managers and employees, there ispossibility that selfish and careless decision will occur (Kirabaeva,2011).

Infinancial market moral hazard is the peril that borrowers may not usethe funds for the intended purpose. When the financial institutionscan not differentiate between high and low risk borrowers, high riskborrowers benefit at the expense of quality borrowers (Tesfatsion,2011).Adverse selection means that the quality borrowers will notparticipate in the market due to high interest rate and this leads toa decrease in lending (Kirabaeva, 2011). Small increase in interestrate may cause large deduction in lending and if quality borrower’sdeicide to totally withdraw from the market a financial marketcollapse is eminent.

References

AngelLearning MindClic Process Technology. (2012). TheEconomics of Financial Intermediation.Retrieved from: http://www.oswego.edu/~edunne/340ch11.htm

Kirabaeva,K. (2011). Adverse Selection and Financial Crises. Bankof Canada Review.Retrieved from:http://www.bankofcanada.ca/wp-content/uploads/2011/02/kirabaeva.pdf

Tesfatsion,L. (2011). EconomicAnalysis of Financial Structure.Retrieved from:http://www2.econ.iastate.edu/classes/econ353/tesfatsion/mish8a.htm

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