1. What is the difference between moral hazard and adverse selection?
Adverse selection and moral hazard both stem from information assymetry, but differ in timing
and focus.
Adverse selection: occurs BEFORE a decision has been made; this is about hidden traits before
a deal, leading to a pool of high-risk individuals
Ex: sick people buying more health insurance
Moral hazard: occurs because of a decision that has already been made; this includes hidden
actions AFTER a deal, as they’re shielded from costs
Ex: insured people take more risks
Adverse selection attracts the “wrong” type, while moral hazard changes the behavior of the
“right” type once protected.
Adverse: who
Moral: what
2. What are examples of moral hazard and adverse selection problems in the health
insurance market?
Adverse selection
Ex: sick people buying more health insurance; they over-select rich plans before getting sick
Moral hazard
Ex: insured people take more risks
This occurs when insured people consume more care than needed because they pay less (ex:
getting extra tests or unnecessary procedures)
Both stem from information assymetry/information gaps:
Adverse selection: people know their health, unsurers don’t.
Moral hazard: people know their usage, insurers don’t fully control it.
3. What are some potential solutions to adverse selection problems?
Since this is an issue where the insurers don’t have enough information, they can often
do the following to collect more or reveal more hidden info:
● Screening: medical exams, questionaires (reveal hidden info)
● Signaling: warranties, quality certs (reveal hidden info)
Market designs:
● Standardization
● Platforms (ex: Carfax increases reliability, risk rating charges higher premiums for higher
risk people attracting healthier people,
● Regulation (lemon laws, mandatory insurance, group insurance, government regulation)
→All force transparency, aligning incentives and ensuring LOWER RISK INDIVIDUALS
participate, as seen in health insurance and used cars.
, If healthy people participate less, then there will be a potential death spiral as more people
leave the market. The same will apply to the used car market; the more plums that leave, the
more lemons are left.
4. What is the difference between the human capital and signaling models of education?
Which model do you think better explains the world?
The human capital model posits that education enhances a worker’s actual skills and
productiving, leading to higher wages. The signaling model, in contrast, argues that education
merely acts as a credential to reveal a worker’s pre-existing ability to employers, without
necessarily increasing productivity.
The sheepskin affect may explain how education acts as a signal for when you graduate, as the
diploma or education may not mean as much as a signal until after you receive a certification or
diploma.
Thus, education does not necessarily, as argued by some, increase productivity; it only helps
employers identify already productive workers.
Evidence for Human Capital: Studies have shown that a reduction in the quality or duration of a
degree program (while keeping the credential the same) leads to a decline in wages, suggesting
that actual learning (human capital) plays a significant role in determining earnings.
Evidence for Signaling: The existence of “sheepskin effect” (a significant wage jump upon
receiving a diploma/credential compared to just one year less of schooling) suggests that the
credential itself, as a signal, holds value beyond the simple accumulation of knowledge from
that final year.
5. Adverse selection makes it (more hard/less hard) for some people to buy the products
they want which leads to _________ !
More hard
Market failure
6. ____ aversion may help undo some of the problems of adverse selection.
Risk
7. To find the expected utility of an investment, why do you have to subtract the value of a
utility by the loss of a utility? Explain why you would also multiply the probability of utility
to the value and the probability of a loss of a utility to the value?
Example:
Let’s say Chococat is buying a new car; the car he tried to fix up on his own is not working
anymore.
He has a 30% chance of getting a car with 20 thousand dollars in utility, and this same car also
has a 70% chance of having a 7 thousand dollar loss.
So, what is his total projected utility from this investment?
1) Find the value of utility and the loss of the utility
Adverse selection and moral hazard both stem from information assymetry, but differ in timing
and focus.
Adverse selection: occurs BEFORE a decision has been made; this is about hidden traits before
a deal, leading to a pool of high-risk individuals
Ex: sick people buying more health insurance
Moral hazard: occurs because of a decision that has already been made; this includes hidden
actions AFTER a deal, as they’re shielded from costs
Ex: insured people take more risks
Adverse selection attracts the “wrong” type, while moral hazard changes the behavior of the
“right” type once protected.
Adverse: who
Moral: what
2. What are examples of moral hazard and adverse selection problems in the health
insurance market?
Adverse selection
Ex: sick people buying more health insurance; they over-select rich plans before getting sick
Moral hazard
Ex: insured people take more risks
This occurs when insured people consume more care than needed because they pay less (ex:
getting extra tests or unnecessary procedures)
Both stem from information assymetry/information gaps:
Adverse selection: people know their health, unsurers don’t.
Moral hazard: people know their usage, insurers don’t fully control it.
3. What are some potential solutions to adverse selection problems?
Since this is an issue where the insurers don’t have enough information, they can often
do the following to collect more or reveal more hidden info:
● Screening: medical exams, questionaires (reveal hidden info)
● Signaling: warranties, quality certs (reveal hidden info)
Market designs:
● Standardization
● Platforms (ex: Carfax increases reliability, risk rating charges higher premiums for higher
risk people attracting healthier people,
● Regulation (lemon laws, mandatory insurance, group insurance, government regulation)
→All force transparency, aligning incentives and ensuring LOWER RISK INDIVIDUALS
participate, as seen in health insurance and used cars.
, If healthy people participate less, then there will be a potential death spiral as more people
leave the market. The same will apply to the used car market; the more plums that leave, the
more lemons are left.
4. What is the difference between the human capital and signaling models of education?
Which model do you think better explains the world?
The human capital model posits that education enhances a worker’s actual skills and
productiving, leading to higher wages. The signaling model, in contrast, argues that education
merely acts as a credential to reveal a worker’s pre-existing ability to employers, without
necessarily increasing productivity.
The sheepskin affect may explain how education acts as a signal for when you graduate, as the
diploma or education may not mean as much as a signal until after you receive a certification or
diploma.
Thus, education does not necessarily, as argued by some, increase productivity; it only helps
employers identify already productive workers.
Evidence for Human Capital: Studies have shown that a reduction in the quality or duration of a
degree program (while keeping the credential the same) leads to a decline in wages, suggesting
that actual learning (human capital) plays a significant role in determining earnings.
Evidence for Signaling: The existence of “sheepskin effect” (a significant wage jump upon
receiving a diploma/credential compared to just one year less of schooling) suggests that the
credential itself, as a signal, holds value beyond the simple accumulation of knowledge from
that final year.
5. Adverse selection makes it (more hard/less hard) for some people to buy the products
they want which leads to _________ !
More hard
Market failure
6. ____ aversion may help undo some of the problems of adverse selection.
Risk
7. To find the expected utility of an investment, why do you have to subtract the value of a
utility by the loss of a utility? Explain why you would also multiply the probability of utility
to the value and the probability of a loss of a utility to the value?
Example:
Let’s say Chococat is buying a new car; the car he tried to fix up on his own is not working
anymore.
He has a 30% chance of getting a car with 20 thousand dollars in utility, and this same car also
has a 70% chance of having a 7 thousand dollar loss.
So, what is his total projected utility from this investment?
1) Find the value of utility and the loss of the utility
