Chapter 21, Problem 1PS

Summary Introduction

To determine:

Whether a ship owner attempting to insure an old vessel for twice its current market value is an adverse selection or a moral hazard issue

Introduction:

Moral hazard is a phenomenon where a party to a contract has an incentive to alter behaviour in a way which makes the contract less appealing to the other party.

Answer to Problem 1PS

This is a problem related to moral hazard.

Explanation of Solution

Given Information:

Ship owner has attempted to insure an old vessel for twice its current value. Moral hazard is the reason why such act if insuring items for more than its market value or intrinsic value is prohibited as it creates an incentive.

The given problem is a case of moral hazard as the ship owner insures an old vessel for double its current market value. Now the ship owner now has an rational motive to create a loss and to file a claim later on. The issue of adverse selection will crop up only when due to improper information the buyer or the seller will choose a bad product or service. Such improper or undiagnosed information, if known earlier could prevent the transaction from occurring.

Considering this, the major difference between moral hazard and adverse selection is of movement. One party movement is beyond control once the deal occurred. Generally, a moral hazard is seen in case of insurance transactions.