Adverse Selection vs Moral Hazard

Adverse selection occurs when asymmetric information leads undesirable participants to dominate a market before a transaction takes place.

For example, if insurers cannot tell high-risk from low-risk buyers, mostly high-risk people buy insurance, raising prices and driving out low-risk buyers. It stems from hidden information before a deal is made. Screening and signaling help reduce it.

Moral hazard occurs when one party takes greater risks because they do not bear the full consequences of those risks, often due to insurance or government protection.

This happens after a transaction, such as when people drive recklessly because they have car insurance. It leads to market inefficiency because behavior changes in ways that increase costs for others. Governments may respond with co-pays or monitoring to reduce the incentive to take excessive risks.