SafeDrive Insurance sells comprehensive car insurance policies. Once a driver has bought a policy, SafeDrive cannot observe every decision the driver makes. For example, how carefully they drive, or whether they always park in a secure, well-lit area overnight. (a) Define asymme…

Answer: ((a)) Asymmetric information exists when one party to a transaction has access to relevant information that the other party does not (here, the driver knows how carefully they drive and park, but SafeDrive cannot fully observe this); it is a source of market failure because SafeDrive… ((b)) Moral hazard occurs when a person changes their behaviour after entering an agreement in a way that increases risk for the other party, because they no longer bear the full cost of that risk themselves; a driver with comprehensive cover may take less care since SafeDrive bears m… ((c)) SafeDrive could include a compulsory excess (deductible) in its policies, so the policyholder must still pay the first part of any claim themselves, restoring some financial cost to the policyholder and preserving an incentive to take reasonable care. Part (a): Asymmetric information as a source of market failure Asymmetric information exists when one party to a transaction or agreement has access to relevant information that the other party does not. Here, the driver knows how carefull…

A Level Economics 9708: Asymmetric Information and Moral Hazard

Part (a): Asymmetric information as a source of market failure

Asymmetric information exists when one party to a transaction or agreement has access to relevant information that the other party does not. Here, the driver knows how carefully they actually drive and park, but SafeDrive cannot fully observe or verify this once the policy has been sold.

This is a source of market failure because it prevents the market from allocating resources (in this case, insurance cover and the risk it is priced to reflect) efficiently. SafeDrive cannot charge each individual policyholder a premium that accurately reflects the risk that policyholder actually poses, since it cannot observe their true behaviour. This mismatch between the price charged and the true underlying risk is itself a form of market failure.

Part (b): Moral hazard

Moral hazard occurs when a person changes their behaviour, after entering into an agreement, in a way that increases risk for the other party, because they no longer bear the full cost of that risk themselves. Once a driver has bought comprehensive cover, they bear less of the financial cost if their car is damaged or stolen, since SafeDrive pays out instead, so they may take less care, for example driving slightly less carefully or leaving the car in a less secure car park, than they would if they had to pay for any damage or theft entirely out of their own pocket.

This arises specifically because of asymmetric information: if SafeDrive could perfectly observe and verify every policyholder’s driving and parking behaviour, it could simply charge a higher premium to (or refuse to pay out for) anyone who took less care, removing the incentive to behave riskily. Because it cannot fully monitor behaviour after the policy is sold, some policyholders can change their behaviour without SafeDrive being able to detect or price for it.

Part (c): Reducing the moral hazard problem

SafeDrive could include a compulsory excess (deductible) in its policies, so that the policyholder must still pay the first part of any claim (for example, the first $200 of any repair or replacement cost) themselves. This restores some financial cost to the policyholder if their car is damaged or stolen, giving them an incentive to continue taking reasonable care, even though they remain insured against the largest part of any loss.

Final answers

(a) Asymmetric information: one party (the driver) knows relevant information the other party (SafeDrive) cannot observe, so risk cannot be priced accurately. A source of market failure
(b) Moral hazard: reduced care by the driver once insured, arising because SafeDrive cannot monitor behaviour after the contract is signed
(c) A compulsory excess/deductible restores some cost to the policyholder, preserving their incentive to take care