Moral Hazard and Adverse Selection

|Microeconomics Assignment |

|Question 1 |

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|Moral Hazard & Adverse Selection, Equivalent Variation, Compensating Variation & |

|Consumer Surplus and Negative Production Externality. |

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|29th April 2011 |

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a) Moral Hazard and Adverse Selection

In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service—which would otherwise not be necessary. In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services.

Two types of behavior can change. One type is the risky behavior itself, resulting in what is called ex ante moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms)

A second type of behavior that...