Adverse selection

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Repeat:Repeat: Information asymmetries

Problems before a contract is written: Adverse selection i.e. trading partner cannot observe quality of the other partner

Use signaling or screeningg g g

Problem after contract is written: 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)

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OBJECTIVES

Explain how managers can use their informational

advantage to increase performance and g p how managers at an information disadvantage

can mitigate the effect by using creativecan 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 b dthan the buyer does.

buyers might know about average quality of cars (by reading consumer reports) and do not want to payreading 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’dll d t t t ll b lit sellers do not want to sell above-average quality cars

for such low price only sellers with a lemon want to sell their cars, y ,

buyers know that and assume all offered cars are lemons

eventually the average price of a used car will be eventually, the average price of a used car will be equal to the value of a lemon because no one will sell a gem. mean quality on the market must fall mean quality on the market must fall

willingness to pay will fall even more

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Market for “lemons”

Ackerlof’s model: used car market cont’d

this is a case of adverse selection in that the market dynamic leads to only lemons being offered for sale y y gon the used car market.

market can break down completely

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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 25loss will reduce wealth to 25. Insurance company wants to cover expected losses:

High-risk drivers have a loss with probability 0 75 and their High risk drivers have a loss with probability 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 25)(100) = 25expected loss is therefore (0.25)(100) = 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:High risk without insurance U (0 25)(125)0 5 + (0 75)(25)0 5

High risk without insurance U = (0.25)(125)0.5 + (0.75)(25)0.5

= 6.545High risk with insurance U = (125 - 75)0.5 = 7.071L i k ith t i U (0 75)(125)0 5 (0 25)(25)0 5

Low risk without insurance U = (0.75)(125)0.5 + (0.25)(25)0.5

= 9.635Low 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 risk-

drivers, and there are equal numbers of each, then the average premium should be 50premium should be 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 attainableinformation is not attainable.

Resolving adverse selection throughResolving adverse selection through self-selection

Full insurance: When every loss is paid in full

Ded ctible Deductible: 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

information about their loss probabilities to select policiesp p

Resolving adverse selection throughResolving 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 Policy B: Low premium and high deductible (designed to appeal to

low-risk drivers)

Example 2p 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 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 throughResolving 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 l W 125 2 5 122 5 With no loss: W = 125 – 2.5 = 122.5

With a loss: W = 125 – 2.5 – 100 + 10 = 32.5

Separating equilibrium: Separating equilibrium: This solution to adverse selection induces policy

holders to selective their relative risk typesholders to selective their relative risk types.

Resolving adverse selection throughResolving 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: Low risk drivers: No insurance: .75 (125)^.5 + .25 (125 – 100)^.5 = 6.545

P li 1 (125 75)^ 5 7 071 Policy 1: (125 -75)^.5 = 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 willcontract if health is unobservable to the insurance company… will drive price for insurance contract up. Private insurance may be impossible – group insurance or

t i t tigovernment intervention necessary „Pflichtversicherung“ or „Versicherungspflicht“

Example: crises in an enterprise, total wage bill must be reduced Cut wages for all workers?

Di i ? Wh ill b di i d? Dismiss some? Who will be dismissed?

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Remedies for Adverse Selection:Remedies for Adverse Selection: Signaling and screeningg g g

Often the better informed party would benefit from Often the better informed party would benefit from communicating this information.

Simply claiming “I’m high quality (or low risk)” is not p y g g q y ( )convincing, because also the “bad risks” will tell you so.

Signaling: the informed party takes the lead.g g p y High-quality seller must do something costly and verifiable to

signal quality convincingly.

S i th i f d t t k th l d Screening: the uninformed part takes the lead Offer different contracts

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Signaling examples

Signal must be so expensive that low-quality supplier is unable to do sois 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)prevent entry of other firm in the market)

Education certificatesP d t t b k t Product warranty, money-back guarantee

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Using education as a signal: adverseUsing 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 getnumber of courses they are required to complete to get a higher paying job.

Using warranties as signals: adverseUsing warranties as signals: adverse selection in the product market

How Managers Can Construct Warranties to Mitigate Adverse Selection Experience goods: Goods that can be evaluated with p g

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 Productwillingness of buyers to pay a higher price. Product warranties can accomplish this goal by acting as a separating mechanism.pa a g a

Using warranties as signals: adverseUsing 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)

f d h h h l d CH = cost of producing the high-quality good CL = cost of producing the low-quality good (CL < CH) Warranty cost of a high-quality good is XW and for a low- Warranty cost of a high quality good is XWH and for a low

quality good it is XWL, where WL > WH

Using warranties as signals: adverseUsing 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 p y g

warranty (X) to be a high-quality good. Profit from a high-quality good with a warranty is PH – CH -

XWXWH. 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: adverseUsing warranties as signals: adverse selection in the product market

How Managers Can Construct Warranties to Mitigate Adverse SelectionMitigate Adverse Selection Scenario 1: Consumers perceive any good with a

warranty (X) to be a high quality good (Continued)warranty (X) to be a high-quality good. (Continued) Profit from a low-quality good with a warranty is PH – CL - XWL. Profit from a low-quality good without a warranty is PL – CL. The q y g y L L

low-quality producer will not issue a warranty if PH – CL – XWL < PL – CL X > (PH – PL) / WL

Credible warranty: (PH – PL)/WH > X > (PH – PL)/WLy ( H L)/ H ( H L)/ L

Using warranties as signals: adverseUsing warranties as signals: adverse selection in the product market

How Managers Can Construct Warranties to Mitigate Adverse Selection Scenario 2: Consumers perceive the good with the p g

longer warranty (X) to be the high-quality good. The longest warranty a low-quality producer can afford to offer

is X Y where Y (P P )/Wis 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 product will not have a warranty.q y p y

Screening

Under screening the uninformed part takes the lead. Check the other‘s quality Specific tests in applicant selection

Self-selection contracts offeredCar insurance (example from before) Car insurance (example from before)

offer different age/wage profiles in order to reduce turnover pay based on performance attracts most productive workers p y p p Offer a menu of contracts to salespeople: those with the

best region (motivation) will select high-commission, low-salary contracts

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y

Self selection in recruitmentWage

W fil I

Wage profile II

Wage profile I

Timet1 t2

• 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

•25takes only worker who chooses profile II

Books for reading: you will g yenjoy them!

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