Adverse selection
•1
Repeat:
Information asymmetries

Problems before a contract is written:


Adverse selection
i.e. trading partner cannot observe quality of the other partner


Problem after contract is written:



Use signaling
g
g or screening
g
Moral hazard
i.e. trading partner cannot be sure if the other is behaving ok after
contract is written
Nobel prize in economics 2001 for informational asymmetries
(Akerlof, Spence and Stiglitz)
•2
OBJECTIVES

Explain


how managers can use their informational
advantage
g to increase performance
p
and
how managers at an information disadvantage
can mitigate the effect by using creative
defenses.
Market for “lemons”

Ackerlof’s model: used car market



used cars are either gems (which is good) or lemons
(which is bad)
information asymmetry means that sellers have more
information about the quality of the car they are selling
th th
than
the b
buyer does.
d
buyers might know about average quality of cars (by
reading consumer reports) and do not want to pay
more than average price to break even in expectation
Market for “lemons”

Ackerlof’s model: used car market cont’d





sellers
ll
do
d nott wantt to
t sellll above-average
b
quality
lit cars
for such low price
 onlyy sellers with a lemon want to sell their cars,,
buyers know that and assume all offered cars are
lemons
eventually the average price of a used car will be
eventually,
equal to the value of a lemon because no one will
sell a gem.
 mean quality on the market must fall
 willingness to pay will fall even more
•5
Market for “lemons”

Ackerlof’s model: used car market cont’d


this is a case of adverse selection in that the market
y
leads to onlyy lemons being
g offered for sale
dynamic
on the used car market.
market can break down completely
•6
Adverse selection in the car
insurance market

Model



Drivers are either high risk or low risk.
Both types of drivers start with wealth = 125 and a
loss will reduce wealth to 25.
25
Insurance company wants to cover expected losses:


High risk drivers have a loss with probability 0.75
High-risk
0 75 and their
expected loss is therefore (0.75)(100) = 75.
Low-risk drivers have a loss with probability 0.25 and their
expected loss is therefore (0
(0.25)(100)
25)(100) = 25.
25
Adverse selection in the car
insurance market

Perfect Information


high-risk drivers will be charged 75 and low-risk drivers
will be charged 25 and, because both are risk averse,
both will buy insurance.
Assume that U = (Wealth)0.5 for both types of drivers:


0 5 + (0.75)(25)
05
High risk without insurance U = (0
(0.25)(125)
25)(125)0.5
(0 75)(25)0.5
= 6.545
High risk with insurance U = (125 - 75)0.5 = 7.071
0 5 + (0.25)(25)
05
L
Low
risk
i k without
ith t insurance
i
U = (0.75)(125)
(0 75)(125)0.5
(0 25)(25)0.5
= 9.635
Low risk with insurance U = (125 - 25)0.5 = 10
Adverse selection in the car
insurance market

Asymmetric Information


If the insurer cannot distinguish between high- and low riskdrivers, and there are equal numbers of each, then the average
premium should be 50.
50
High-risk drivers will buy insurance at this price, but low-risk
drivers will not



(Low risk with high insurance U = (125 - 50)0.5 = 8.660)
Since only high-risk drivers will buy insurance, the insurance
premium must increase to 75.
p
Insurers can compete by collecting better information so that
lower premiums can be charged to low-risk drivers, but perfect
information is not attainable
attainable.
Resolving adverse selection through
self-selection

Full insurance:


Ded ctible
Deductible:


When every loss is paid in full
When the insurer does not pay the full loss but pays the
loss minus some fixed amount
Self-selection menu:

buyers act in their own self-interest and use their private
probabilities to select policies
p
information about their loss p
Resolving adverse selection through
self-selection

Example 1



Policy A: High premium and full insurance (designed to appeal to
high-risk drivers)
Policy B: Low premium and high deductible (designed to appeal to
low-risk drivers)
Example
p 2


Policy C: High premium that is constant from year to year
(designed to appeal to high-risk drivers)
Policy D: High premium at first that declines from year to year if
there are no claims (designed to appeal to low-risk drivers)
Resolving adverse selection through
self-selection

Simple Adverse Selection


Policy 1: Premium of 75 and full insurance (designed
to appeal to high-risk drivers); W = 125 – 75 = 50
Policy 2: Premium is 2.5 and payoff is 10 (designed to
appeal to low-risk drivers)



With no loss:
l
W = 125 – 2.5
2 5 = 122.5
122 5
With a loss: W = 125 – 2.5 – 100 + 10 = 32.5
Separating equilibrium:

This solution to adverse selection induces policy
holders to selective their relative risk types
types.
Resolving adverse selection through
self-selection

High risk drivers:

No insurance: .25 (125)^.5 + .75 (125 – 100)^.5 = 6.545

Policy 1: (125 -75)^.5 = 7.071


Policy 2: .25 (125 – 2.5)^.5 + .75 (125 – 100 – 2.5 + 10)^.5 =
7.043
Low risk drivers:

No insurance: .75 (125)^.5 + .25 (125 – 100)^.5 = 6.545

P li 1:
Policy
1 (125 -75)^.5
75)^ 5 = 7.071
7 071

Policy 2: .75 (125 – 2.5)^.5 + .25 (125 – 100 – 2.5 + 10)^.5 =
9.726
Other examples

Private health insurance: only bad risk people will buy insurance
contract if health is unobservable to the insurance company
company… will
drive price for insurance contract up.



Private insurance may be impossible – group insurance or
governmentt iintervention
t
ti necessary
„Pflichtversicherung“ or „Versicherungspflicht“
Example: crises in an enterprise, total wage bill must be reduced


Cut wages for all workers?
Di i some?? Who
Dismiss
Wh will
ill be
b dismissed?
di i d?
•15
Remedies for Adverse Selection:
Signaling
g
g and screening
g



Often the better informed party would benefit from
communicating this information.
Simply
p y claiming
g “I’m high
g quality
q
y (or
( low risk)”
) is not
convincing, because also the “bad risks” will tell you so.
Signaling:
g
g the informed p
partyy takes the lead.


High-quality seller must do something costly and verifiable to
signal quality convincingly.
S
Screening:
i
th uninformed
the
i f
d partt ttakes
k th
the llead
d

Offer different contracts
•16
Signaling examples





Signal must be so expensive that low-quality supplier
is unable to do so
==> low and high-quality suppliers are separated
Set very low prices to signal low cost (in order to
prevent entry of other firm in the market)
Education certificates
P d t warranty,
Product
t money-back
b k guarantee
t
•17
Using education as a signal: adverse
selection in the job market

Information asymmetry in job markets:


Applicants know more about their job skills, abilities,
and ambitions than a potential employer.
Premise:

Highly skilled applicants can complete courses at a
lower cost than applicants with low skills. Therefore, the
employer can get applicants to self-select based on the
number of courses they are required to complete to get
a higher paying job.
Using warranties as signals: adverse
selection in the product market

How Managers Can Construct Warranties to
Mitigate Adverse Selection


Experience
p
goods:
g
Goods that can be evaluated with
regard to their quality only after they have been
consumed
There is an incentive for producers of high-quality
goods to signal their quality and increase the
willingness of buyers to pay a higher price.
price Product
warranties can accomplish this goal by acting as a
pa a g mechanism.
a
separating
Using warranties as signals: adverse
selection in the product market

How Managers Can Construct Warranties to
Mitigate Adverse Selection

Model





PH = consumer reservation price for high-quality good
PL = consumer reservation price for low-quality good (PL < PH)
CH = cost off producing
d
the
h high-quality
h h
l good
d
CL = cost of producing the low-quality good (CL < CH)
Warranty cost of a high-quality
high quality good is XWH and for a low
lowquality good it is XWL, where WL > WH
Using warranties as signals: adverse
selection in the product market

How Managers Can Construct Warranties to
Mitigate Adverse Selection

Scenario 1: Consumers p
perceive anyy good
g
with a
warranty (X) to be a high-quality good.


Profit from a high-quality good with a warranty is PH – CH XWH.
Profit from a high-quality good without a warranty is PL - CH.
The high-quality producer will not issue a warranty if

PL - CH < PH – CH – XWH  X < (PH – PL) / WH
Using warranties as signals: adverse
selection in the product market

How Managers Can Construct Warranties to
Mitigate Adverse Selection

Scenario 1: Consumers perceive any good with a
warranty (X) to be a high
high-quality
quality good.
good (Continued)


Profit from a low-quality good with a warranty is PH – CL - XWL.
Profit from a low-quality
q
y good
g
without a warrantyy is PL – CL. The
low-quality producer will not issue a warranty if


PH – CL – XWL < PL – CL  X > (PH – PL) / WL
Credible warranty:
y ((PH – PL)/
)/WH > X > ((PH – PL)/
)/WL
Using warranties as signals: adverse
selection in the product market

How Managers Can Construct Warranties to
Mitigate Adverse Selection

Scenario 2: Consumers p
perceive the good
g
with the
longer warranty (X) to be the high-quality good.




The longest warranty a low-quality producer can afford to offer
is X = YL where YL = (PH – PL)/WL.
The longest warranty a high-quality producer can afford to offer
is X = YH where YH = (PH – PL)/WH.
Since WL > WH, YH > YL.
In practice, the high-quality product will have a warranty YH = YL
+ 1 and the low-quality
q
y product
p
will not have a warranty.
y
Screening

Under screening the uninformed part takes the lead.
Check the other‘s quality
Specific tests in applicant selection

Self-selection contracts offered






Car insurance (example from before)
offer different age/wage profiles in order to reduce turnover
payy based on performance
p
p
attracts most productive
p
workers
Offer a menu of contracts to salespeople: those with the
best region (motivation) will select high-commission, lowsalaryy contracts
•24
Self selection in recruitment
Wage
Wage profile II
W
Wage
profile
fil I
t1
t2
Time
• Firm has to train the worker, is interested in workers who stay longer (loyal workers)
• Firm offers two wage profiles, (or: general market pays profile I, our firm pays profile II)
• takes only worker who chooses profile II
•25
Books for reading:
g you
y will
enjoy them!
•26