Economics 448 – Class Notes – 9/11/09
Adverse selection
: where one party to a transaction knows things that:
a.
are relevant to the transaction
b.
unknown to the 2
nd
party
c.
Difficult to transfer
a.
It’s difficult for seller to transfer information, say about a used car.
i.
If it’s a great car, the seller wants to transfer that information
ii.
If it’s a bad car or someone who does not know about the quality of the
car, it’s hard to transfer that information (especially if you don’t have that
information)
Adverse selection is
Ex ante
pre-existing condition
•
You have a pre-existing condition ( you know something before you go into the
transaction, like with insurance)
Moral Hazard
– Where one party to a transaction may undertake certain actions that:
a.
Affect the other party’s valuation of the transaction
b.
The 2
nd
party cannot monitor perfectly.
Moral hazard is
ex post
after the fact
•
Moral hazrard refers to actions or behavior taken after the transaction
o
I.e
you have insurance so you are more risky
Risk-Preference
1.
Risk-neutral
you don’t care about risk, you just care about the anticipated
payoff or return
a.
You just concern yourself with the size of the expected payoff
b.
Example:
i.
2
investments
1.
15% rate of return, but its REALLY RISKY (you might lose a lot)
2.
6% rate of return – 6% is a sure thing
ii.
The risk neutral doesn’t care about the risk
I am going to go for the
highest expected return on my investment
2.
Risk-averse
Avoiding risky situations
a.
People will tend to avoid risk and risky situations and investments.
They will
prefer the option with the lowest risk.

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- Fall '07
- Nonnenmacher
- Economics, Utility, Car, car buyers, lemons
-
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