The presence of ________ in financial markets leads to adverse selection and moral hazard problems.

Question

BlackTom AI · Accepted Answer

Asymmetric information occurs when one party in a transaction has more or better information than the other, so...

1) Relevant knowledge points and concepts
- Asymmetric information: unequal information between buyers and sellers, lenders and borrowers, or insurers and insured.
- Adverse selection: a pre-contract problem where the party with hidden information (e.g., high-risk applicants) self-selects into transactions that the uninformed party would want to avoid.
- Moral hazard: a post-contract problem where an agent takes hidden actions that shift risk or reduce effort because the consequences are partially borne by another party.

2) Step-by-step reasoning
- Start from asymmetric information: suppose lenders cannot perfectly observe borrower risk types.  
- Before contracting, borrowers who know they are high-risk are more likely to seek loans; lenders cannot fully distinguish them → adverse selection.  
- After contracting, if borrowers can take risky actions that lenders can’t monitor, borrowers may behave recklessly because losses are borne by lenders → moral hazard.  
- Thus a single root—information asymmetry—generates both phenomena at different contract stages (before and after).

3) Calculations
- No numerical calculations are needed; the logic is conceptual and causal.

4) Why the correct answer is correct
- Asymmetric information directly causes both adverse selection (hidden characteristics) and moral hazard (hidden actions). The textbook definitions of these problems explicitly link them to information problems.

5) Why the other options are incorrect
- a. Noncollateralized risk: lack of collateral raises lender exposure but does not by itself create hidden-information problems.  
- b. Free-riding: relates to public goods and monitoring problems in groups, not the primary cause of adverse selection/moral hazard.  
- c. Costly state verification: is a consequence of information problems (monitoring is costly) and a possible institutional response, not the root cause.

6) Conclusion
- Therefore the presence of asymmetric information leads to adverse selection and moral hazard; final answer: d. asymmetric information.

The presence of ________ in financial markets leads to adverse selection and moral hazard problems.Single choice

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