Reference no: EM132619554

The classic application of market failures ascribed to adverse selection and moral hazard were found in the health insurance markets.

Adverse selection caused market failure in health insurance because insurers were unaware of the health risks their customers faced. They overcame this market failure by taking detailed medical histories and asking about risky practices such as smoking or extreme sports.

Moral hazard caused market failure because insurers weren't able to monitor customer behaviour (e.g., weight gain, drug use, taking up extreme sports) after customers signed a contract at a fixed price. This risk of market failure was commonly mitigated through co-payment terms where the customer had to pay part, but not all, of the costs of treatment.

How would these two kinds of market failure apply to owners and managers of business firms in absence of any measures to alleviate the risks?

What measures have been taken, or could be taken, to reduce adverse selection and moral hazard between owners and managers of business firms? Hint: consider who has an information advantage in this setting.