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ECONOMICS ASSIGNMENT Name-RITOBRATA GANGULY Roll no.

- MBA/11/051

1. What is Adverse Selection? Adverse selection is a term commonly used in Economics,Insurance, statistics and risk management. It generally refers to a market condition in which really 'bad' outcomes are obtained when a large circle of buyers and sellers have access to different information or asymmetric information. For example a bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its low balance, high activity customers. The term adverse selection is a term mostly used in the field of insurance. It usually describes a situation where an individual's demand for insurance is positively correlated with the individual's risk of loss and the insurer is unable to allow for this correlation in the price of insurance. This may be because of private information known only to the individual, or because of regulations or social norms which prevent the insurer from using certain categories of known information to set prices (e.g the insurer may be prohibited from using information such as gender or ethnic origin or genetic test results). The potentially 'adverse' nature of this phenomenon can be illustrated by the link between smoking status and mortality. Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurers do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers. The average mortality of the combined policyholder group will be higher than the average mortality of the general population. From the insurer's viewpoint, the higher mortality of the group which 'selects' to buy insurance is 'adverse'. The insurer raises the price of insurance accordingly. As a consequence, nonsmokers may be less likely to buy insurance (or may buy smaller amounts) than if they could buy at a lower price to reflect their lower risk. The reduction in insurance purchase by non-smokers is also 'adverse' from the insurer's viewpoint, and perhaps also from a public policy viewpoint. Furthermore, if there is a range of increasing risk categories in the population, the increase in the insurance price due to adverse selection may lead the lowest remaining risks to cancel or not renew their insurance. This leads to a further increase in price, and hence the lowest remaining risks cancel their insurance, leading to a further increase in price, and so on. Eventually this 'adverse selection spiral' might in theory lead to the collapse of the insurance market. To counter the effects of adverse selection, insurers (to the extent that laws permit) ask a range of questions and may request medical or other reports on individuals who apply to buy insurance, so that the price quoted can be varied accordingly, and any unreasonably high or unpredictable risks rejected. This risk selection process is known as underwriting. In many countries, insurance law incorporates an 'utmost good faith' or uberrima fides doctrine which requires potential customers to answer any underwriting questions asked by the insurer fully and honestly; if they fail to do this, the insurer may

later refuse to pay claims. Whilst adverse selection in theory seems an obvious and inevitable consequence of economic incentives, empirical evidence is mixed. Several studies investigating correlations between risk and insurance purchase have failed to show the predicted positive correlation for life insurance, auto insurance and health insurance. On the other hand, "positive" test results for adverse selection have been reported in health insurance, Long-term care insurance and annuity markets. These "positive" results tend to be based on demonstrating more subtle relationships between risk and purchasing behavior (e.g. between mortality and whether the customer chooses a Life annuity which is fixed or inflation-linked), rather than simple correlations of risk and quantity purchased. One reason why adverse selection may be muted in practice may be that insurers underwriting is largely effective. Another possible reason is negative correlation between risk aversion (e.g. insurance purchasers) and risk level (e.g. level of observed claims) in the population: if risk aversion is higher amongst lower risk customers, adverse selection can be reduced or even reversed, leading to 'propitious' or 'advantageous' selection. For example, there is evidence that smokers are more willing to do risky jobs than non-smokers, and this greater willingness to accept risk might reduce insurance purchase by smokers. From a public policy viewpoint, some adverse selection can also be advantageous because it may lead to a higher fraction of total losses for the whole population being covered by insurance than if there were no adverse selection.

2. What is Moral Hazard? According to the Economic theory, moral hazard is a situation in which a party insulated from risk behaves in a way different if he or she was fully exposed to risk. Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company. Economists explain moral hazard as a special case of information assymmetry a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave

inappropriately from the perspective of the party with less information. Moral hazard also arises in a principal agent problem where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned. The name 'moral hazard' comes originally from the insurance industry. Insurance companies worried that protecting their clients from risks (like fire, or car accidents) might encourage those clients to behave in riskier ways (like smoking in bed, or not wearing seat belts). This problem may inefficiently discourage those companies from protecting their clients as much as they would like to be protected. Economists argue that this inefficiency results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions (like smoking in bed, or not wearing seat belts), allowing them to provide thorough protection against risk (fire, accidents) without encouraging risky behavior. But since insurance companies cannot perfectly observe their clients' actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information. Moral hazard problems also occur in employment relationships. When a firm is unable perfectly to observe the actions taken by its employees, it may be impossible to achieve efficient behavior in the workplacefor example, workers' effort may be inefficiently low. This is called the principal-agent problem, which is one possible explanation for the existence of involuntary unemployment. Similar problems may also occur at the managerial level, because owners of firms (shareholders) may be unable to observe the actions of a firm's managers, opening the door to careless or self-serving decision-making. In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical servicewhich would otherwise not be necessary. In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services. Moral hazard can occur when upper management is shielded from the consequences of poor decision making. This situation can occur in a variety of situations, such as the following:

When a manager has a secure position from which he or she cannot be readily removed.

When a manager is protected by someone higher in the corporate structure, such as in cases of nepotism or pet projects. When funding and/or managerial status for a project is independent of the project's success. When the failure of the project is of minimal overall consequence to the firm, regardless of the local impact on the managed division. When a manager may readily lay blame on an innocent subordinate. When there is no clear means of determining who is accountable for a given project.

3. What is Asymmetric information? Asymmetric information signifies a situation in which one party involved in transaction with another, has more or superior knowledge and information than the another. This is often the case between buyer and seller, where seller has more knowledge than buyer. However, the opposite condition can also happen at times. The situation can potentially be harmful as the party with more information can take advantage of others lack of knowledge and thereby exploit the other party. The Asymmetric information is the source of two major problems as follows:(a) Moral Hazard>>> This reflects on the immoral behavior or party with asymmetric information subsequent to a transaction. For example, some people commit arson purposely to reap benefits from the fire insurance. (b) Adverse Selection>>> In this case, the party displays immoral behavior by taking advantages of the knowledge or asymmetric information prior to transaction. For example, some people secure life insurance although aware of the bad health conditions.

4. What do you mean by Principle Agent problem?

Principle agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent, such as the problem of potential moral hazard and conflict of interest in as much as the principal is presumably -hiring the agent to pursue the principal's interest. The principalagent problem is found in most employer/employee relationships, for example, when shareholders hire top executives of corporations. Political science has noted the problems inherent in the delegation of legislative authority to bureaucratic agencies. As another example, the implementation of legislation (such as laws and executive directives) is open to bureaucratic interpretation, which creates opportunities and incentives for the bureaucrat-as-agent to deviate from the intentions or preferences of the legislators. Variance in the intensity of legislative oversight also serves to increase principalagent problems in implementing legislative preferences. Overview of Principal Agent problem: In political science and economics, the problem of motivating a party to act on behalf of another is known as the principalagent problem. The terms 'principal' and 'agent' originate in law; see Law of agency. The principalagent problem arises when a principal compensates an agent for performing certain acts that are useful to the principal and costly to the agent, and where there are elements of the performance that are costly to observe. This is the case to some extent for all contracts that are written in a world of information asymmetry, uncertainty and risk. Here, principals do not know enough about whether (or to what extent) a contract has been satisfied. The solution to this information problem closely related to the moral hazard problem is to ensure the provision of appropriate incentives so agents act in the way principals wish. In terms of game theory, it involves changing the rules of the game so that the self-interested rational

choices of the agent coincide with what the principal desires. Even in the limited arena of employment contracts, the difficulty of doing this in practice is reflected in a multitude of compensation mechanisms (the carrot) and supervisory schemes (the stick), as well as in critique of such mechanisms as e.g., (1986) expresses in his Seven Deadly diseases of management.

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