Examples of Adverse Selection and Moral Hazard in Management Scenarios

Understanding Adverse Selection and Moral Hazard

The discussion board question in green is the topic my colleagues are responding to in the 3 responses below.

Discussion Board Question: Identify an example of a management scenario from current events involving adverse selection or moral hazard. Discuss some methods with your classmates for correcting the potential problems of the asymmetric information.  .

Assignment:  Read the 3 short responses below.  Then reply to all 3 responses with a  substantive response with 100 – 150 words no more no less.  Note:  When responding to your peers, praise them for what they are doing well, and lend your information and/or perspective to your peer's discussion response. And please mention the product or sitution your classmate has written about.  (All of your responses within the discussion threads need to be no less than six or seven full sentences in length and pertain to the Discussion Board Question/Topic, to be eligible for participation credit).  See the 3 responses below.  

1. Adverse selection occurs when asymmetric information is exploited. Asymmetric information is known as information failure, in adverse selection, the seller or buyer has more information/knowledge on quality of material of good. Misleading information offered during a transactional agreement is known as a moral hazard situation especially when that party does not think they will face consequences for that action. Situations such as this is immoral because when having more information on a product material than the opposite party (buyer or seller) they are essentially taking advantage of the other and asymmetric information leads to two of the issues listed above, moral hazard or adverse selection.

An example, I once worked for a nice restaurant as a bartender and the bar manager would work as a bartender at times and would even schedule himself shifts to dip into the tip pool. After some time, I eventually left and followed the previous service manager to a new restaurant and she exposed that the bar manager I worked under was a salary manager, this being an adverse selection in which the bar manager exposed of illegal activity by dipping into bartender’s tip pool as a salary manager. However, this bar manager and owner of the restaurant had an agreement thinking that they would not have consequences for their action by introducing themselves to moral hazardous situation. Asymmetric information would involve the misleading information when other workers believed he was an hourly manager (to accept tip pool wages) when in-fact he was not. Eventually after the previous service manager left she reported anonymously and is still an on going investigation.

Examples of Adverse Selection in the Restaurant Industry

2. Top of Form

Adverse Selection is where buyers and sellers have different information regarding the product/service involved in the transaction. The party with the better information can use that to their advantage.

In our textbook, an example they mention regarding risk movement from the producers to the consumers is farmers selling contracts ahead of time to certain companies (i.e, grain companies). They do this to offset some of the uncertainty of future crop prices. This is a reasonable action to take given the state of potential climate change affecting seasonal weather variations and how that may impact crop yields. However, on the other side of this spectrum, the companies buying these contracts from the farmers may do their own research which allows them to gain information. For instance, the National Climate Prediction Center releases seasonal outlooks that give probabilities of temperature and precipitation outputs based on thousands of climate studies and AI computer technology. Now, as a Weather and Environmental Scientist with the military, I will be the first to say our data is high quality, but it is not perfect. However; if there is high probability of a drought to occur in a region where a farmer is intending to grow their crops to sell, that potential buyer may be hesitant to accept that contract and do business with a different farmer in a region that has a low probability of drought/flooding along with low probability of extremely warm/cold temperatures. 

For the farmer to avoid this loss of wealth, they may also utilize seasonal outlooks & climate modeling products to prepare for the upcoming season. If they are informed of unfavorable weather conditions far enough in advance, they could take measures such as seeing if a different crop would survive more easily in those projected conditions. Also, they could invest in protective equipment to better shield the original crop from the adverse weather conditions and inform the buyers of the proactive measures being taken to combat any variability in the normal climate.

3. In a situation with moral hazard, one party will enter into an agreement that provides misleading information or change the behavior after the agreement has been made and they believe they will not face any punishment for their actions.

This can occur in the financial industry in contracts between a borrower and a lender, moral hazard is very common in the insurance industry.

A homeowner does not have homeowner"s insurance or flood insurance but lives in a flood zone, so he decides to purchase house insurance and flood insurance. After his house is insured, his mindset changes and he cancels both the house and flood insurance. So now the insurance company is at risk of having a claim filed against them as the result of damage from flooding or loss of property.

In moral hazard, the change in the behavior of one party occurs after the agreement has been made.