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adverse selectionPlease explain moral hazard and adverse selection with reference to market failure.
An insurance company faces an asymmetric information problem of its own:
the people buying insurance know more than the company about the risks
they face.
Consider car insurance. Who needs it more: good drivers who hardly ever get
into accidents, or bad drivers who get into lots of accidents? Now, clearly,
even good drivers want insurance because they’re sometimes involved in accidents
for which they’re not to blame. But bad drivers want insurance even
more to help pay for all the accidents they know they’re going to cause
because of their poor driving. Economists call this problem adverse selection.
An asymmetric information problem faces the insurance companies because
although individual drivers know whether they’re good or bad, the insurance
companies can’t easily tell them apart. If they were able to tell them apart,
insurance companies would simply charge the good drivers a low rate for
insurance and the bad drivers a high rate.
But because they can’t tell the good and bad drivers apart, the insurance
companies run a serious risk of going bankrupt. To see why, imagine that
insurance companies offered the same low rate to everyone, as though they
were all good drivers. This strategy soon leads to bankruptcy because the
insurance companies aren’t collecting enough in premiums to pay off all the
damage caused by the bad drivers.
To avoid bankruptcy, the insurance companies may go to the other extreme,
charging everyone as though they were bad drivers. But then the good drivers
stop buying insurance because for them it’s overpriced. The result is that
only bad drivers sign up for insurance.
This result is very poor for society because you want everyone to be able
to buy insurance at a rate that fairly reflects his or her driving ability. Good
drivers should be able to get insurance at a fair rate. And because good drivers
make up most of the drivers in the real world, insurance companies lose
out on lots of potential profits, unless they can figure out a way to separate
the good drivers from the bad drivers.
moral hazard.
The other big problem facing insurance companies is called moral hazard.
Moral hazard arises because buying insurance tends to change people’s
behaviour. For example, if you don’t have car insurance, you’re likely to drive
much more slowly, knowing that you have to use your own money to pay for
any damage you cause. But because you do have insurance, you may drive
faster and more recklessly knowing that if something goes wrong, the insurance
company is going to be stuck with the bill. Similarly, because you have
contents insurance, you may be more prone to leaving your door unlocked.
hope this helps, it made my concept clear, but i still dont know how to link it to market failure, i mean there is no solution to this, with government intervention, it cant still be avoided unlike with externalities and merit goods and public goods