In a world where effort cannot be observed

Unlike the hypothetical world in the economics books, the real world is one where asymmetric information causes inefficiencies. What is asymmetric info? Asymmetric information consists of 2 parts: moral hazard and adverse selection. Today we will talk more about adverse selection.

Adverse selection occurs when someone has hidden information, and cause the other party to select 'adversely'. In the very common example of insurance, because high riskers have info tt insurers dont know (eg. high riskers have poor health), the insurers may often end up selecting high risk insurers. This happens because effort cannot be observed. What do I mean?

When effort cannot be observed, inefficiencies result. How? Very simple. We all study so hard for exams, and we are judged based on results, something tt is controlled by many other factors apart from we amount of time we spent studying. On the day of exams, we may feel nervous, have stomachache blah blah, which can affect the outcome, and outcome won't accurately reflect our effort. Ideally, we should be judged based on effort. But, because of asymmetric information, tt cannot happen. Then is it fair tt we are judged based on outcomes? Of cos not! If the school were to judge us based on outcomes, den there must be efficient risk sharing. We, in general, are risk averse. When we bear too much risk, we get panicky n jittery, and we hence cannot perform optimally. The other party needs to share risk with us if they want us to perform well.

What can we conclude? Exams are not an indication of your abilities. We could have performed better without exams. So if u don't do well for exams, blame the school for not sharing risk.