Describe whether each of the following is an example of adv

. Describe whether each of the following is an example of adverse selection or moral hazard, and why.

a. When I drive a rental car, I drive much more recklessly than when I drive my own car.

b. The sickest people are the ones most likely to sign up for health insurance.

c. Weasel Wannabe took out a business loan from Firstbank to start a hot dog stand, but instead spent the money on a trip to Aruba.

d. Neighborhoods with high levels of student housing and low levels of owner-occupied housing tend to deteriorate more quickly than other neighborhoods.

e. The safest borrowers are unlikely to need bank loans.

Solution

a. When I drive a rental car, I drive much more recklessly than when I drive my own car.

Asnwer: Moral Hazard

Explanation: Since the behaviour of the individual changes when he drives a rental car as compared to when he is driving his own car and he becomes reckless while driving a rental car, it is an example of Moral Hazard. Moral hazard occurs when there is asymmetric information between two parties and change in behavior of one party after a deal is struck.

b. The sickest people are the ones most likely to sign up for health insurance.

Answer: Adverse Selection

I feel that the answer to this is adverse selection as there is lack of symetric information prior to the deal. The insurance company relies on the information provided by the individual and hence there is a chance of the sick people providing information that does not reflect the correct magnitude of the current situation. The asymmetry causes a lack of efficiency in the price and quantity of goods and services. Both sick people and normal people who have insurance will end up paying the same premium amount however the sick people will beneift more and the insurance company will be at a disadvantage.

c. Weasel Wannabe took out a business loan from Firstbank to start a hot dog stand, but instead spent the money on a trip to Aruba.

Answer: Moral Hazard
Moral hazard occurs when there is asymmetric information between two parties and change in behavior of one party after a deal is struck. The loan was taken for a different purpose. The Bank would have sanctioned the loan amount for starting a hot dog stand. However there was a change in behaviour os Weasel Wannabe after the deal was struck.

d. Neighborhoods with high levels of student housing and low levels of owner-occupied housing tend to deteriorate more quickly than other neighborhoods.

Answer: Adverse Selection:

Adverse selection describes an undesired result due to the situation where one party of a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information. The asymmetry causes a lack of efficiency in the price and quantity of goods and services.

Since the owner can provide accomodation to students on rent and invest in property for investment and not residential reasons, this information can never be made available before hand. Hence due to lack of symetric information this qualifies as an adverse selection.

e. The safest borrowers are unlikely to need bank loans.

Answer: Adverse Selection:

The information about who would qualify as a safe borrower or an unsafe borrower and targeting loans towards safe borrowers is not available before hand and hence it is an example of adverse selection. - Lack of symetric information.