Market Failure Due to Asymmetric Information - Adverse Selection and Moral Hazard

In the book based on an inquiry into the nature and causes of the 2008 Global Financial Crisis entitled "FREEFALL - Free Markets and the Sinking of the Global Economy", Economics Nobel Prize Laureate (2001) and Columbia University Professor Joseph E. Stiglitz wrote:


"Finding root causes is like peeling back an onion. Each explanation gives rise to further questions at a deeper level: perverse incentives may have encouraged shortsighted and risky behavior among bankers, but why did they have such perverse incentives? There is a ready answer: problems in corporate governance, the manner in which incentives and pay get determined. But why didn't the market exercise discipline on bad corporate governance and bad incentive structures? Natural selection is supposed to entail survival of the fittest; those firms with the governance and incentive structures best designed for long-run performance should have thrived. That theory is another casualty of this crisis."


Market failure is a common term in microeconomics to reflect the need for some form of regulations and accountability of agents (consumers and producers) in the unfettered free market when externalities, imperfect information, socially undesirable market dominance etc arise. In the area of perverse incentives in the market place, two forms of asymmetric information can be associated with such possible market failure. One, adverse selection; and two, moral hazard. To simplify the understanding of such market failure, let's take two simple examples.

For moral hazard, a similar example in day to day economic activities is that of motor insurance. Why is moral hazard considered a form of market failure and thus socially undesirable? This is because no insurance company can be certain, at the point of underwriting the motor insurance of any driver, of the future behaviour of the driver. Motor insurance companies would be OUT of Business if there is no way of ensuring the responsible FUTURE behaviour of drivers insured under them. Thus, there is this concept of CO-PAYMENT known as "EXCESS" or "DEDUCTIBLES" mechanism built into a motor insurance agreement. For example, if the excess of a motor insurance is $3,500, then any accident repair amount below that sum is fully borne by the driver/ owner of a vehicle. By having the co-payment mechanism built-in, motor insurance become feasible in the market place and minimise the moral hazard of reckless FUTURE behaviour.

In the banking sector where executives take undue risks for short term gain (such as those causing the 2008 GFC), inherently similar moral hazard exists but DOES NOT seem to be mitigated by any "co-payment' mechanism in the {perverse} incentive packages they receive.

In 1970, another Economics Nobel Prize Laureate (2001) Professor George Akerlof (husband of former FED chair Professor Janet Yellen) of University of Berkeley, California published a paper entitled "The market for 'lemons': quality uncertainty and the market mechanism" which led to the growth and research in the field of asymmetric information. This publication subsequently led to the enactment of the "Lemon Law" in many countries including the United States, Canada, Australia, and in recent years Singapore {Consumer Protection (Fair Trading) Act} where it addresses the market failure arising from adverse selection in the used car market and other consumer goods.

Now, market failure due to asymmetric information arising from moral hazard and adverse selection in different sectors of an economy is CERTAINLY NOT NEW as it can be traced as far back as 1970 which is almost half a century ago.

ALAS, in the field of banking, unfortunately and mostly, moral hazard in the area of excessive risk taking is left to the free market mechanism (as what happened during the 2008 GFC). There does not seem to have any material "co-payment mechanism" to keep the market failure of moral hazard in check. What were the consequences?

Professor Joseph Stiglitz wrote in his book "FREEFALL":


"In the great recession that began in 2008, millions of people in America and all over the world lost their homes and jobs. Many more suffered the anxiety and fear of doing so, and almost anyone who put away money for retirement or a child's education saw those investments dwindle to a fraction of their value. A crisis that began in America soon turned global, as tens of millions lost their jobs worldwide -- 20 million in China alone -- and ten of millions fell into poverty.'


What is the lesson learned?

Quoting from Professor Stiglitz again: "We have to be wary of too facile explanations: too many begin with the excessive greed of the bankers. That may be true, but it doesn't provide much of a basis for reform. Bankers acted greedily because they had incentives and opportunities to do so, and that is what has to be changed."

In short, could perverse incentives be the ROOT CAUSE?

Professor Stiglitz made the following observations in the same book: "In peeling back the onion, we need to ask, Why did the financial sector fail so badly, not only in performing its critical social functions, but even in serving shareholders and bondholders well? Only executives in financial institutions seem to have walked away with their pockets lined -- less lined than if there had been no crash, but still better off than say, the poor Citibank shareholders who saw their investments virtually disappear."

Could it be the skewed structure of "perverse incentives"? Despite technology disruption and what not, this so called supposedly modern economic system and technological advancement in this age of AI (artificial intelligence) seems to be at a loss (and clueless) in the field of building in a mechanism of accountability and "co-payment" when potentially rogue high pay executives run amok and threatened to bring down the entire system, just as what happened in the 2008 GFC (Global Financial Crisis).

Leo 81


Anonymous said...

May The Truth Be Told

This letter by an Anonymous was circulated in Facebook before the untimely and tragic death of NS soldier Dave Lee, which might have been prevented:

I am a soldier from 1 guards. One of our fellow soldier is currently in critical condition heat stroke (possibly brain dead) due to the reckless behavior of my fellow commanders. I want to bring this to light so that the commanders involved are duly punished and nothing gets hidden as part of the investigation.

Dave is still in critical condition in the hospital, and it has almost been one week since the incident.

But there has been rumours that his condition has worsening .

**Illegal turnout**

The night before a 8km fast march (an activity considered high key) our entire recce platoon was turned out after lights out by our sergants, forcing us to bear crawl to the SOC grounds at bedok camp, doing thier usual tekan of making us roll in the sand and have water poured on us, to satisfy their own sadistic pleasure. As a result we did not have the adequate 7 hours of rest mandated by the traning safety regulation required for our fast march the next day.

**Commanders forcing trainees**

During the fast march, Dave struggled to complete his fast march and was dragged by senior commanders, forcing him to finish the fast march even though he was showing signs of extreme physical exhaution.

Dave collapsed after collecting his timing chip at our company line. We saw Dave breathing frantically, going through delirium, with his tounge out and only the white in his eyes visible. he was not articulate.

**inability of commanders to spot heat exhaustion**

It was obvious that even to an untrained soldier, especially commanders who went to OCS / SCS, that dave was going through Heat Exhaution or even heat stroke. yet they still acted as though there as nothing severe or that he could even be acting “keng”

**non-administering of ice packs / BCU / water mist**

the commanders did not follow the proper protocol for a soldier in heat exhaution. His cloths were not removed, no ice pack were place at the vital heat dissapation points in his body and the medic was even blur not knowing what to do. The safety officer was nowhere to be found during this whole time and the commnders left his body under the hot sun instead of bringing it to a shaded area. it took them almost 30minutes to an hour before they even stretched him away to the medical center before he was even transported to a hospital using the Military ambulance.

**Lack of seriousness towards the incident**

To add insult to injury, the sergeants were just surrounding him, talking cock and laughing and cracking jokes around him, obviously thinking the soldier is trying to keng. I hope sgt Justin, ren zong, nich, ren jie and jonas is punished for this. I really hope the army safety throughly investigates this incident and punishes the people involved. Its no point doing lip service to “safety” by adding it as a core value when safety is not given heed.

if anything happens to him, i believe its the fault of the commanders who did not know eve how to administer the proper procedure for Heat Stroke, wasting vital time before his temperature reached 42deg. As well as commanders who dont understand the seriousness of the uninteruppted rest that is required as per training safety regulation, especially for high key activities.

The letter has since been deleted.

Anonymous said...

Skewed risk/reward structure:
1. Mash Selamat escape, Home Affairs Towkay bo tai chee, and collect millions.
2. Ah Ping Kor died in training, Paper General Towkay bo tai chee, and waiting to rotate to Pappies MIW or GLCs and collect millions.
3. GDP at 1% to 3% still collect millions despite open-leg FT policy that boost GDP.
4. Hike taxes, tariffs, charges on citizens, still bo tai chee, and collect millions and voted in.
5. Kaki pay ownself with Public money.
6. Kaki check ownself with Public money.
7. Kaki justify ownself with Public money.
Free options to play all the way with no downside. Bo Tai Chee consequences.

Anonymous said...

No worry lah, they are going to review how to prevent heat injury. This must be something new, so they are acting very fast to nip the problem in the bud.

Ⓜatilah $ingapura⚠️ said...

@ Ginger 1225:

There is no way to stop people being killed during NS training. Military activities are risky. Some people will die. You can viralize any stupid letter or video you like. It still wouldn't prevent the occasional death. Most mishaps are due to poor human judgement or error. There's no prevention for either of those, because if there were, accidents and misjudgements won't occur.

The sooner you stop subscribing to the fiction of "how the world should be", I reckon, the calmer your life. ;-)

@ Nobel Prize winner Joey Stiglitz:

I am surprised that a Nobel Prize winner in econs like Joey-boy doesn't understand markets. How could this be?

Markets don't fail. They always work....but not in ways many people would like them to. There's always someone on the "otherside of the trade" who has an oppinion, and a bet (financial stake) opposite to you. Obviously Joey-boy Stiggy-baby doesn't dig this idea from his tenured ivory-tower, high and mighty position.

Human desires are infinite. Which is why we still have very active nd LARGE markets operating 24/7. People want to OWN stuff. Once they own stuff, they want more stuff. This keeps them wanting the "basic tools" to own stuff: education, job, credit, long lives to enjoy "more stuff".

Although humans always "want stuff", only "some stuff" can be produced at any one time. Human wants are unlimited, resources used for production of those wants are limited and so we have markets and PRICES to determine "whose stuff gets made FIRST", and thus human producers have to go to the market to buy or sell the stuff used to make "human-desired things".

Joey The Stig, supposedly an "economist" doesn't like the fact that some people have better information than others because they are prepared to PAY PREMIUM for something of "value". Sorry chaps, you might believe information should be "free", but it ain't. If is VALUABLE, it is probably SCARCE and therefore if it is in demand, it will be EXPENSIVE.. Joey, are you there? Stick that in your Nobel Prize Pipe and smoke it man. :-)

Markets don't fail. What fails is human judgement. If you go long, and you lose, the fucker who went short (the other side of the trade) WINS. Your money, goes to them. :-)

See? The market always works.

Anonymous said...

@ Sour grapes MATILAR SinPAPura 9.47am
>>> Stick that in your Nobel Prize Pipe and smoke it man. :-) <<<

At least he won it lah but with trillions spent for 50+ years in education, SinPAPura still DUN even hv a single nomination, much less won one ...

Guess who is smoking a pipe (& daydreaming in the 1000th storey cloud scrapping iTOWER)?

Lol ... chio si lang

Anonymous said...

Matilah SinPAPura logic >>>Markets don't fail. What fails is human judgement.<<<

So if cigarettes are sold without PIGOUVIAN TAX at say at $2 per pack and if some JIAK LIAO BEE &/ or JIAK SAI minionsters happened to be at an eatery with uncles smoking like chimneys, then it is the human failure of the JLB and JS blood sucking minionsters to open their nostrils and breathe in the 2nd hand smoke?

It is human failure and NOT market failure?

Matilah SinPAPura creates new economic theory?

AnyboLEE wants to send their children to the Matilah SinPAPura School of UpSideDownKongCumSiaoTingTongAhGong-nomics?


Anonymous said...

@ Matilah SinPAPura Free for All logic >>>Although humans always "want stuff", only "some stuff" can be produced at any one time. Human wants are unlimited, resources used for production of those wants are limited and so we have markets and PRICES to determine "whose stuff gets made FIRST", and thus human producers have to go to the market to buy or sell the stuff used to make "human-desired things".<<<

If that is the case, why even regulate traffic junction?

Let the market decide lah and remove all the traffic lights?

Free MARKET mah?

SinPAPura LOGIK mah?