many economists argued that the expectation of similar future policies
would lead the banks to continue their excessively risky behaviour. The
problem of moral hazard in financial markets is an important topic in
macroeconomics, about which we will say more in Chapter 26.
Adverse Selection
Adverse selection refers to the tendency for people who are more at
risk than the average to purchase insurance and for those who are less at
risk than the average to reject insurance. A person who has a heart
condition may seek to increase his life insurance coverage by purchasing
as much additional coverage as is available without a medical
examination. People who buy insurance almost always know more about
themselves as individual insurance risks than do their insurance
companies. The company can try to limit the variation in risk by requiring
physical examinations (for life or health insurance) and by setting up
broad categories based on variables, such as age and occupation, over
which actuarial risk is known to vary. The rate charged is then different
across categories and is based on the average risk in each category, but
there will always be much variability of risk within any one category.
People who know they are well above the average risk for their category
are offered a bargain and will be led to take out more car, health, life, or
fire insurance than they otherwise would. Their insurance premiums will
also not cover the full expected cost of the risk against which they are
insuring. Once again, their private cost (their insurance premium) is less
than the total cost (the expected insurance payout by the insurance