Suppose that you have two friends Juan and Juanita. Juan has an idea which will yield a return on his investment of 10%. Juan also likes to play the lottery. In the past Juan has spent his entire weekly paycheck or $1,000 on scratch off lottery tickets at the local convenience store. Recently, the convenience store has been advertising a new scratch off game called Jokers Wild that promises to $500 on a $1 ticket. The chances of winning are 1:100. When Juan comes to you for a loan of $1,000, economists predict that you will not make the loan. Which reason below "best" describes why?
a. Moral Hazard
b. Adverse Selection
c. Earl-Bruce Index of Market Failure
d. Symmetrical information.
My answer is "b". When deciding whether the action is a moral hazard or adverse selection, one must look at the time in which the action occurred. Since you did not make the loan to Juan, the action occurred before the event so the action is adverse selection. If you would have made the loan to Juan and he went to the store to scratch off lottery tickets, then Juan's actions happened after the loan so it would be a moral hazard.
Because it is difficult to know how a person will behave, asymmetrical information about a prospective debtor, a history of reckless behavior would make it highly probable that Juan will not get the loan. Also, the lack of information about Juanita might also cause me not to loan the money to her. The point is, adverse selection causes the flow of credit to slow or clog.
If Juan does get the loan from me, he now has the incentive to go to the store and scratch off tickets. If Juan hits the lucky ticket, his return will be $500 instead of $100. Juan has the incentive to gamble and buy a lot of tickets since any one of the tickets might be a larger return for him. In this case, Juan is a moral hazard since his actions happen after he gets the loan.
The Daily Review is a series of questions intended to feed into my FREE app. Click here for my web page and a link to the Android app.