B.K.

BIRLA COLLEGE OF ARTS, SCIENCE

&COMMERCE
MURBAD ROAD KALYAN (W)

PROJECT REPORT
ON
MORAL HAZARD

M.Sc. (FINANCE 2019-20)

SUBMITTED
BY

Pradnya suresh sukhdeve

ROLL NO - 19

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 ASYMMETRIC INFORMATION
So far in our study of markets we have not examined the problems
raised by difference in information by assumption buyer and seller
were both perfectly informed about the quality of the goods being
sold in the market. This assumption can be defended if it easy to
verify the quality of an item. If it is not costly to tell which goods are
high quality goods and which are low quality goods, then the prices
of the goods will simply adjust to reflect the quality difference but if
information about quality is costly to obtain , then it is no longer that
buyer and seller have the same information about goods involved in
transaction there are certainly many market in the real world in which
it may be very costly or even impossible to gain accurate information
about the quality of the goods being sold. Where one party holds more
information than another. For example, a firm selling sub-prime loans
may know that the people taking out the loan are liable to default.
But, the bank purchasing the mortgage bundle has less information
and assumes that the mortgage will be good. Introduction:
In any transaction, two parties are involved i.e buyer & sellers.
Correct information is necessary for the transaction to take place. But
in reality, information is Imperfect & Asymmetric. Asymmetric
information means one party has more information than the other.
This can effect the decision-making of the other. e.g if buyer is
ignorant, the seller can exploit & cheat. A market which allow frauds,
is a market that has failed. Asymmetric information can leads to
frauds in many areas such as medicine, project such reconstruction of
bridge.
Market for Lemons:
A typical example of market with Asymmetric information in the
category of good is market for lemons. This was discussed by ‘G.A

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Ackelof'. He studied market for used cars. Here “lemons” represent
defective product. i.e. Bradly used cars which requires expensive
repairs. Opposite of lemons are “Orange” Ideally if information is
perfect, market for used cars should consist of two separate segments.
I.e market for “lemons” which has a lesser price. In reality, this
doesn’t happen because good &bad cats are mixed together & the
buyer has no information which helps him to distinguish between the
two.

The process that arises in this situation is as follows:

In the beginning, since buyer do not know to distinguish between low
quality & high quality used cars, and seller is aware of this, the may
succeed in selling “lemons” at a higher price. Once it is known that a
“ lemons” is sold at a higher price, the buyer of used cars will reduce
their demand. At the same time the seller of good cars get lesser price
than they deserve. As a result, the supplies, all high quality cars start
withdrawing. Finally, all higher quality cars get removed from the
market as more and more buyer become aware of low quality cars &
are prepared to pay only a low price. This further lead to withdrawal
of good quality cars. This process is shown in the diagram.
This show market failure due to Asymmetric information. Since all
the high quality cars are removed from the market, this process is
called as Adverse Selection.
Further, a poor quality product gets a better price and a good quality
product gets a lower price. This, process can be controlled by Market
signalling.

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What Is Moral Hazard?
Moral hazard is the risk that a party has not entered into a contract in
good faith or has provided misleading information about its
assets, liabilities, or credit capacity. In addition, moral hazard also
may mean a party has an incentive to take unusual risks in a desperate
attempt to earn a profit before the contract settles. Moral hazards can
be present any time two parties come into agreement with one
another. Each party in a contract may have the opportunity to gain
from acting contrary to the principles laid out by the agreement.

Any time a party in an agreement does not have to suffer the potential
consequences of a risk, the likelihood of a moral hazard increases.

Moral Hazard KEY TAKEAWAYS:

 Moral hazard can exist when a party to a contract can take risks
without having to suffer consequences.
 Moral hazard is common in the lending and insurance industries
but also can exist in employee-employer relationships.
 Leading up to the 2008 financial crisis, the willingness of some
homeowners to walk away from a mortgage was a previously
unforeseen moral hazard.

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An Example of Moral Hazard

Prior to the financial crisis of 2008, when the housing bubble burst,
certain actions on the parts of lenders could qualify as moral hazard.
For example, a mortgage broker working for an originating lender
may have been encouraged through the use of incentives, such as
commissions, to originate as many loans as possible regardless of the
financial means of the borrower. Since the loans were intended to be
sold to investors, shifting the risk away from the lending institution,
the mortgage broker and originating lender experienced financial
gains from the increased risk while the burden of the aforementioned
risk would ultimately fall on the investors.

Borrowers who began struggling to make their mortgage payments

also experienced moral hazards when determining whether to attempt
to meet the financial obligation or walk away from loans that were
becoming more difficult to repay. As property values decreased,
borrowers were ending up deeper underwater on their loans. The
homes were worth less than the amount owed on the associated
mortgages. Some homeowners may have seen this as an incentive to
walk away, as their financial burden would be lessened by
abandoning a property. Moral Hazard & Insurance Market:
Moral Hazard refers to a situation where buyer or seller of a product
or a service is able to cheat the other. This is possible when:
 Good & bad product or buyer are available together. It is not
possible to distinguish between them.
 Information is Asymmetric. i.e either buyer or seller is unable to
distinguish between good & bad quality.

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The other party with more information, also known that information is
Asymmetric. This, it is possible to cheat buyer or seller with lesser
information to a Moral Hazard Measure to reduce problem of Moral
Hazard:

 The insurance company can go for Co-insurance. This means

insuring only some parts of possible loss. This means that only a
fraction of health care cost will have to be paid by the company.
 Insurance company may make annual critical check up of the
person. In case of insurance against fire or health company may
inspect security and safety of the buyer.