Question

Give an example of asymmetric information problems from your daily life. Clearly explain the problem. Is it an adverse selection or a moral hazard problem? Who is hurt by the asymmetric information? Is/Was there a way to solve/prevent this problem? (I prefer you giving an example from your own life that you or your family/friends experienced but you can also use examples from movies/popular culture or recent news.)

Answer 1

Asymmetric Information

It is a concept that refers to the situation where one party has more effective information than the other party while making a decision or doing a transaction.

Types of Asymmetric Information

• Adverse Selection

It refers to those circumstances where a seller or a buyer has more information regarding the good than the other party. It usually takes place prior to the transaction completion. This is also known as a Market failure or Information failure.

• Moral Hazard

As for Moral Hazard, here the party is willing to take risks after fully knowing that the costs that will arise will not be borne by them. This occurs after the transaction takes place.

Example

1) Mr. A is a buyer who wants to buy health insurance but he wants to hide the fact that he participates in the underground fights. Company B gave him insurance without knowing the full information so they treat him as an ordinary policyholder. Now with the status of ordinary policyholders, Mr. A does not have to pay a high premium.

This will lead to asymmetric information and will be quite disadvantageous for the insurance company B.

This is the adverse selection which can lead to market failure as one party has more accurate information than the other.

The one who will be hurt by this situation will be the insurance company.

To offset this risk, the insurance company may decide to raise the premium for all according to their age, occupation, health, and other factors which helps the company to know more about their client.

As we know, its fact that usually only the high-risk individuals or the ones who are unhealthy buy health insurance.

2) If we take the present situation into question here, the coronavirus has been rapidly spreading and now the insurance companies do not want to take a risk by giving out the policies when there is no certainty whether an individual has a virus or might contract it in near future. So this is also an example of adverse selection.

They are now carefully taking their time to examine the applicant's health or travel information. This has resulted in insurance companies delaying the approval of applications.

For this, the companies can now start with the underwriting procedures which may include a medical exam of the applicant to know whether they have symptoms of the virus or not. This will help to mitigate the risk for the insurance companies.