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Adverse Selection and Moral Hazards
The concepts of adverse selection affect financial markets and the labor markets by creating favorable circumstances for a party with the advantageous information. In the labor market, employers lose because the workers (who are the sellers of labor) have more information about their quality of work (Tirole, 2012). Between employers and employees, there is a situation of information asymmetry created by the extra knowledge by the employees. The employers lose the best workers because they leave due to perceived low compensation. They leave because the average productivity information used by employers to determine wages is lower than the higher productivity of the best workers.
Adverse selection and moral hazards in the financial markets leads to financial loss by honest parties to financial transaction, such as investors due to intentional misinformation by other parties (Gershkov & Perry, 2012). Lenders lose money due to misinformation by borrowers about their business ventures, which leads to intentional loot or collapse of business transactions. At the same time, borrowers end up paying high interest rates because of a risk premium charged by lenders who are skeptical of loss due to misinformation (Gershkov & Perry, 2012). In addition, honest borrowers are affected by stringent procedures by financing organization and banks to ward of risks.
Of all the effects of adverse selection and moral hazards, the impact of moral hazards on the financial markets is the most significant in the economy. This is because the impacts have a multiplier effect on the economy. Due to moral hazards, the financial markets may crash, and bring down production in the economy due to low financing (Tirole, 2012). As a result, the labor markets are affected and the goods markets decline, by destabilizing the forces of demand and supply (Nelson, 2013). This leads to a crash in the market or a recession due to low business and unemployment levels.
References
Gershkov, A. & Perry, M. (2012). Dynamic contracts with moral hazard and adverse selection.The Review of Economic Studies, Vol.79 (No.1). pp. 268-306
Nelson, R. (2013). Demand, supply, and their interaction on markets, as seen from the perspective of evolutionary economic theory. Journal of Evolutionary Economics, January 2013, Volume 23, Issue 1, pp 17-38
Tirole, J. (2012). Overcoming Adverse Selection: How Public Intervention Can Restore Market Functioning. The American Economic Review Vol. 102, No. 1 (FEBRUARY 2012), pp. 29-59