Adverse Selection and Moral Hazard in Contract Law

Table of Contents

1 Introduction

2 Legal and economical interpretations
a) Contract, contract law and contract theory
b) Asymmetric information
c) Adverse selection
d) Moral Hazard

3 Negative effects of adverse selection and moral hazard
a) Transaction costs
b) Incomplete contracts

4 Incentives to avoid adverse selection and moral hazard
a) Signaling
b) Deductible provision
c) Indemnity contracts versus valued contracts

5 Summary

References

1 Introduction

To an economist a contract is an agreement under which two parties make reciprocal commitments in terms of their behavior, thus being a “bilateral coordination arrangement”. This formulation touches on the legal concept of the contract but also transcends it. Over the last thirty years, the “contract” has become a central notion in economic analysis, giving rise to three principal fields of study: “incentives”, “incomplete contracts” and “transaction costs”.

This paper will focus on the topic of adverse selection and moral hazard in contract law. While adverse selection, a problem involving hidden information, anticipates ex ante, moral hazard, a problem involving hidden action, reveals an ex post phenomenon. Both imply negative effects on contract efficiency and prices and touch either field of study: incentives, incomplete contracts and transaction costs.

The paper will approach the topic by defining the objective of each both adverse selection and moral hazard first, starting from a definition on both and including definitions on contract, contract law and contract theory.

Negative effects, such as the effect on transaction costs as well as the influence of incomplete contracts will be talked about in the third part.

Contractual and economic solutions such as signaling, deductibles as well as indemnity and valued contracts in order to minimize or avoid both adverse selection and moral hazard is been looked upon thereafter.

2 Legal and economical interpretations

a) Contract, contract law and contract theory

A contract is any promise or set of promises made by one party to another. In case of a breach of contract, the law provides a remedy. The promise or promises may be expressed either written or oral or may be implied from circumstances.

Where a contract is a single connection between parties, contract law is the portion of civil law that interprets written agreements between parties and resolves disputes between them in general.

Contract theory in its place is the body of legal thought that investigates normative and conceptual problems in contract law. The central problem of contract theory is the question, “Why are contracts enforced”. A prominent answer to this question focuses on the economic benefits of enforcing bargains. Contract theory bases itself on the principle of pareto-efficiency, where the pareto-optimum shall be achieved.

Contract law itself has several purposes to achieve efficiency also such as to enable people to cooperate by converting games with a non-cooperative solution into a game with a cooperative solution and thus to achieve efficient results. Optimal commitment to performance and the securing of optimal reliance are other purposes of contract law that shall ensure an efficient outcome. Contract law also supplies default terms that shall be efficient in order to minimize transaction costs of negotiating contracts and the law shall correct market failures by regulating the terms of a contract.

If a contract would be complete and efficient, without gaps and failures contract law would not be necessary, at least not in the sense of settling arguments in court. But a complete contract implements that every possible contingency is anticipated, associated risks are efficiently allocated and all relevant information has been communicated. However, this would imply tremendous transaction costs and thus collide with the 4th purpose of contract law, which is to minimize those costs for the goal of efficiency.

In Economics, the theory of contracts is a part of the information economics and describes how economic actors use particular contractual arrangements to deal with information asymmetries. Contracts itself or better to say the cooperation and commitment towards a contract can be and are basically modeled in games (bargain theory/ game theory) using the principal-agent approach.

b) Asymmetric information

Asymmetric information or “information asymmetry” describes the situation where one party in a contract has information which is superior to that of the other party – or in common words: one party knows more than the other party does. It basically describes the failure of the parties to communicate to each other all the relevant information, needed for both parties within the contract. But information asymmetries also occur when information is intentionally hidden (hidden information). Those asymmetries consequently lead to inefficient behavior, due to being the cause of “adverse selection”.

c) Adverse selection

Adverse selection in its place is a term from the new institution economics and designates a condition, in which on a market unwanted results are systematically obtained. The basic model to describe adverse selection was first derived by George A. Akerlof in 1970, where he used the now well-known “market of lemons” example to demonstrate adverse selection in practice:

Imagine a market for used cars. Staying close to reality it is quite likely that there will be both good and bad quality cars available. For simplicity we assume a distribution of 50% good cars – the “cherries” – and 50% bad cars – the “lemons”. Only people selling cars know the exact quality of the car, while the potential buyers/ the clients are not able to observe the quality of a car to 100% certainty. Once again for simplicity, we even assume that they do not know the quality at all.

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