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Adverse selection and moral hazard are two distinct problems arising from asymmetric information. Adverse selection is a pre-contractual issue caused by 'hidden attributes,' where one party has private information about their characteristics before a deal is made. In contrast, moral hazard is a post-contractual issue caused by 'hidden actions,' where one party's unobservable behavior changes after the deal is made.

Adverse Selection vs. Moral Hazard

A key problem in economics occurs when one party in an interaction has more or better information than the other. This can lead to two distinct issues based on whether the information is hidden before or after an agreement is made. Match each scenario below to the specific problem it best illustrates.

Consider the following two scenarios:

1. A company offering health insurance finds that the individuals most eager to buy its policies are those who are already facing significant health challenges, while many healthy individuals choose not to buy a policy at the offered price.
2. An employee who is paid a fixed salary, regardless of output, chooses to exert less effort on their tasks than they would if their pay were directly tied to their performance, knowing their manager cannot perfectly monitor their moment-to-moment work.

For each scenario, identify the specific problem that arises from the information imbalance and explain why, focusing on whether the unobserved element is a characteristic of the individual/good or an action taken after an agreement.

Distinguishing Market Problems from Information Gaps

Match each scenario with the specific problem caused by asymmetric information that it best illustrates.

A person who obtains a comprehensive car insurance policy may subsequently be less cautious about where they park their car or how they drive, knowing that the financial costs of theft or an accident are largely covered. This scenario is a primary example of adverse selection.

After purchasing comprehensive car insurance, a driver begins to drive more recklessly, such as speeding or not paying attention, because they know the insurance will cover the costs of any potential accident. The change in behavior occurs *after* the insurance contract is signed. This is a problem of moral hazard, not adverse selection, as the information asymmetry arises from hidden actions post-contract, not hidden attributes pre-contract.

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