Distinguish adverse selection from moral hazard with examples.

• A. Adverse selection occurs after contract; moral hazard before.
• B. Adverse selection occurs when bad risks are more likely to be selected; moral hazard occurs when risk changes after purchase.
• C. Adverse selection and moral hazard are the same concept.
• D. Adverse selection occurs when you underestimate prices; moral hazard occurs when you over-insure.

Answer: (B)

Adverse selection happens when information is asymmetric before a contract is signed, so higher-risk individuals are more likely to participate or purchase, pulling the pool’s average risk upward. Moral hazard arises after the contract is in place, when having insurance changes incentives and people may take on more risk or use more services because they don’t bear the full cost.

For example, in health insurance, sicker people are more likely to buy coverage, which can drive up premiums for everyone and attract a riskier pool. After buying auto insurance, a driver might drive more recklessly or file more claims because they’re insured.

This distinction is captured by saying adverse selection is about who is selected before the contract, while moral hazard is about riskier behavior after purchase. The other options mix up timing, equate the two concepts, or misstate the idea (such as underestimating or over-insuring).