Answer to Question #292206 in Microeconomics for Nibret

Question

1)    Give an example of adverse selection and moral hazard challenges in your home town and suggest policy intervention to address the problem?

Answer 1

Moral hazard occurs when one party engages in hazardous activity or fails to operate in good faith because they are aware that the other party will pay the financial repercussions of their actions.

Example:

In our home town, when a business owner offers a salesman a fixed pay, the salesperson may be tempted to put in less work, take longer breaks, and be less motivated to boost sales generally.

Policy intervention:

Paying salesman based on commission of their sales helps motivate him to increase their sales which in turn will increase their income.

Adverse selection

When one buyer or seller has more information about a product or service than the other, this is known as adverse selection. To put it another way, the buyer or seller is aware that the product's value is less than its worth.

Example:

In our home town, a heavy smoker is more likely to purchase life insurance since they are aware that they are a higher risk. Apart from a visual examination, the insurance company would have no means of knowing about this.

Policy intervention:

In order to avoid adverse selection, the insurance company should put in their policy by ensuring each consumer pays an extra cost to gather for the misinformation from some of their clients.