Question

Identify which of the following situations currently faced by international investors are examples of adverse selection and which are examples of moral hazard.

$\left(a\right)$Among the governments of several developing countries that are attempting to issue new bonds this year, it is certain that a few will fail to collect taxes to repay the bonds when they mature. It is difficult, however, for investors considering buying government bonds to predict which governments will experience this problem.

$\left(b\right)$Foreign investors are contemplating purchasing stock in a company that, unknown to them, may have failed to properly establish legal ownership over a crucial capital resource.

$\left(c\right)$. Companies in a less developed nation have already issued bonds to finance the purchase of new capital goods. After receiving the funds from the bond issue, however, the company's managers pay themselves large bonuses instead.

$\left(d\right)$When the government of a developing nation received a bank loan three years ago, it ultimately repaid the loan but had to reschedule its payments after officials misused the funds for unworthy projects. Now the government, which still has many of the same officials, is trying to raise funds by issuing bonds to foreign investors, who must decide whether or not to purchase them.

Short answer

Part $\left(a\right)$

$\left(a\right)$The government's ability to collect taxes successfully also affects bond repayment.

Part $\left(b\right)$

$\left(b\right)$Negative selection due to investors' failure to find a firm that correctly creates legal ownership of all of its capital resources.

Part$\left(c\right)$

$\left(c\right)$As a result,Moral hazard, since corporations in developing countries have issued bonds to fund investment initiatives in their countries.

Part $\left(d\right)$

$\left(d\right)$As a result,the government should decide not to include officials who have misappropriated monies.

Step-by-step solution

Step: 1 Introduction:

Adverse selection occurs when sellers have more information about a product's quality than consumers have, or vice versa, despite the fact that the seller is usually the more knowledgeable party. When something that is used, adverse selection develops.

Step: 2 Government's ability: (Part a)

International investors are today confronted with two situations: adverse selection and moral hazard. Investors failed to foresee the government's ability to repay its debts on time, resulting in adverse selection. The government's ability to collect taxes successfully also affects bond repayment.

Step: 3 Negative selection:(Part b)

Negative selection due to investors' failure to find a firm that correctly creates legal ownership of all of its capital resources.

Step: 4 Moral hazard:(Part c)

Moral hazard, since corporations in developing countries have issued bonds to fund investment initiatives in their countries.

Step: Discriminatory selection: (Part d)

Discriminatory selection since the government should decide not to include officials who have misappropriated monies.