Adverse Selection and Moral Hazards


AdverseSelection and Moral Hazards

AdverseSelection and Moral Hazards

Theconcepts of adverse selection affect financial markets and the labormarkets by creating favorable circumstances for a party with theadvantageous information. In the labor market, employers lose becausethe workers (who are the sellers of labor) have more informationabout their quality of work (Tirole,2012).Between employers and employees, there is a situation of informationasymmetry created by the extra knowledge by the employees. Theemployers lose the best workers because they leave due to perceivedlow compensation. They leave because the average productivityinformation used by employers to determine wages is lower than thehigher productivity of the best workers.

Adverseselection and moral hazards in the financial markets leads tofinancial loss by honest parties to financial transaction, such asinvestors due to intentional misinformation by other parties(Gershkov&amp Perry, 2012).Lenders lose money due to misinformation by borrowers about theirbusiness ventures, which leads to intentional loot or collapse ofbusiness transactions. At the same time, borrowers end up paying highinterest rates because of a risk premium charged by lenders who areskeptical of loss due to misinformation (Gershkov&amp Perry, 2012).In addition, honest borrowers are affected by stringent procedures byfinancing organization and banks to ward of risks.

Ofall the effects of adverse selection and moral hazards, the impact ofmoral hazards on the financial markets is the most significant in theeconomy. This is because the impacts have a multiplier effect on theeconomy. Due to moral hazards, the financial markets may crash, andbring down production in the economy due to low financing (Tirole,2012).As a result, the labor markets are affected and the goods marketsdecline, by destabilizing the forces of demand and supply (Nelson,2013).This leads to a crash in the market or a recession due to lowbusiness and unemployment levels.


Gershkov,A. &amp Perry, M.(2012).&nbspDynamiccontracts with moral hazard and adverse selection.&nbspTheReview of Economic Studies,Vol.79 (No.1). pp. 268-306

Nelson,R. (2013). Demand, supply, and their interaction on markets, as seenfrom the perspective of evolutionary economic theory. Journalof Evolutionary Economics,January 2013, Volume 23, Issue 1, pp 17-38

Tirole,J. (2012). Overcoming Adverse Selection: How Public Intervention CanRestore Market Functioning. TheAmerican Economic ReviewVol. 102, No. 1 (FEBRUARY 2012), pp. 29-59