The problem of 'Adverse Selection' in financial markets,

Solution

• Asymmetric information problems are of two main types, distinguished by timing:
• Adverse Selection:  A  pre-contract  problem. It occurs when one party (e.g., a lender/insurer) cannot distinguish between high-risk and low-risk agents (e.g., borrowers/policyholders) before entering an agreement. This leads to a "market for lemons" scenario where the  riskiest agents are the most eager to participate  (because they get a good deal given their true risk), which can drive out good risks and cause market failure. Example: A bank offering a standard loan rate attracts mostly high-risk borrowers who know they are likely to default.
• Moral Hazard:  A  post-contract  problem (option b). It occurs when one party's behavior changes after the agreement is made in a way that is hidden and harmful to the other party (e.g., a borrower taking on riskier projects after getting a loan).