Problem of Moral Harzard and Adverse Selection in Financial and Insurance Industry

I used to read text book in Microeconomic Intermediate and Microceonomic Analysis of H. Valrian, in chapter dealing with uncertainty and economic of information there emerge the word Moral Harzard and Adverse Selection. He mentioned that these two component is critical in the financial market and insurance industry where information play important role in market mechanism. What is Moral Harzard or Adverse Selection? Why these two elements lead to failure in finacial market such as banking, insurance and pension system?

The term Moral Harzard as it imply is something related to morality but in what way? In fact, the word moral harzard refers to the conduct of individual in a way that he/she is able to do something that firms can not observe due to the lack of information and cuase destructive effect on other. For convinience, I give an example from Text Book of Mankiw, Macroeconomic. He gave an example of company that is trying to promote efficient by raising wage. The problem is firm can not know exactly whether workers work at 1oo percent his ability then it is subject to wrong offer incentive. Further, individual might pretent to work hard in the presence of supervisor. Another easier example is given by most economic text book is in the insurance industry, a driver who buy insurance against accident, after subscribe the insurace might even cause more accident because he thinks he now have insurance and give little care on accidence. You might have heard story about people who burn their house to get firer insurance. These are all example of moral harzard. Becasue of moral harzard most insurance company set new policy to ensure that those who buy insurance bear some part of the risk they sell to the company.

Turn to Adverse Selection, What dose this word mean? This word has long born from one economist named, Goerge Alkolof when he discover problem in used car market. Popularly known as lemon (brandname of car in US) problem. The field is the updated by Joshep Stigliz who won noble prize. The adverse selection always happen in insurance industry and capital market.

Advese selection is a consequence result from firm or individual aim at applying some policy toward one group of people but wrongly benefit other groups. Taking a simple example, in banking industry, bank might wish to raise interest rate for business project that are risky to avoid not being pay back but when the bank raise higher interest rate it is only the most risky borrower who come to as for fund from bank. Why? because they already known that such high interes rate they will be unable to pay. In this example, you see bank increase intrest rate policy is target toward all borrower but in the end it is only risky borrower who come to borrow money from bank. Another example, is the insurance in cancer industry, if insurance company wish to increase the premium for those who want to buy insurance against disease such as cancer or operation, then it is only those who is in helpless situation or those who know that they will die soon will buy insurance from the company. Why? Because they know that they will never recover from the disease, thus no need to worry how high is the premium they will buy insurance from the company.

Therefore, the problem of moral harzard and adverse selection originated from imperfect information between economic agents. Then, the solution is to try to creat more information but since information is public goods (non-rival ) then it is the government who should play this role.