Any Questions from Last Class?

Chapter 16 The Problem of Adverse Selection COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South- Western are trademarks used herein under license.

Chapter 16 – Take Aways Insurance is a wealth-creating transaction that moves risk from those who don’t want it to those who are willing to bear it. Adverse selection is a problem that arises from information asymmetry— anticipate it, and, if you can, figure out how to consummate the unconsummated wealth-creating transaction (e.g., between a low-risk customer and an insurance company). The adverse-selection problem disappears if the asymmetry of information disappears.

Chapter 16 – Take Aways Screening is an uninformed party’s effort to learn the information that the more informed party has. Successful screens have the characteristic that it is unprofitable for bad ‘‘types’’ to mimic the behavior of good types. Signaling is an informed party’s effort to communicate her information to the less informed party. Every successful screen can also be used as a signal. eBay addresses the adverse-selection problem with authentication and escrow services, insurance, and on-line reputations.

Review of Chapter 15 Random variables quantify uncertainty Pricing with uncertainty  Discrimination raises profits Oral or English auctions Vickrey or second-price auction Sealed-bid or first-price auction Bid rigging is more common in  Open auctions  Small and frequent auctions  Auctions with lots of information Common-value auctions and winner’s curse  Oral auctions release information and lead to higher prices

Anecdote: Pre-Hire “Training” South Carolina manufacturing firm hiring new employees  Requires 24 unpaid classroom hours over 8 days in 4 week period  Final step before full-time employment  If candidate is tardy, he/she is sent home and not allowed to return Results  Of 30 people, two candidates are sent home  Only ten of the 1,300 workers hired under the program have had significant attendance issues  Program reduced the rate of bad hires from about eight percent to less than one percent

Insurance Definition: risk-averse vs. risk-neutral. Example: Owner with expected loss (0.2)$100=$20 pays $25 to get rid of risk. Discussion: Describe precisely how a futures contract transfers risk from the seller of the contract to the buyer of the contract.

Adverse Selection Two consumer types  Probability of theft is 0.2  Probability of theft is 0.4 What happens when you try to sell insurance to informed buyer?  At price of $30?  At price of $40? Definition: problem of adverse-selection is unconsummated wealth creating transaction Problem disappears if the asymmetry of information disappears

Adverse Selection Lessons First Lesson: Anticipate adverse selection  In bicycle example, realize you have to price at $45 Second Lesson: Sometimes you can gather information or design screens to consummate the unconsummated wealth creating transaction

Examples of Adverse Selection Adverse selection  Pre-contractual problem  Case of hidden “information” about types Discussion: “Prohibition of Discrimination in the Provision of Insurance Act of 1986” Discussion: When buying a used car, describe the adverse selection problem

More Adverse Selection Examples Discussion: Why do smaller IPO’s earn minus 50% return over 5 years. Discussion: What is adverse selection problem in bank loans?

Screening as Response to Adverse Selection Definition: Screening is effort by less-informed party to force “types” to reveal themselves  Consummate the unconsummated wealth-creating transactions by eliminating information asymmetry Insurance Screen  Suppose high-risk individuals prefer full insurance at $45, to partial insurance ($50 if your bike is stolen) at $15. For a successful screen, it must not be profitable for the high-risk consumers to mimic the choice of the low-risk consumers.

Car Buying Screen Discussion: In car-buying example, design a successful screen. Answer: Offer to buy for:  $2,000 without warranty; or  $4,000 with warranty

Discussion: $10 / sale  “Hard workers,” willing to sell 100 units (worth $1,000)  “Lazy workers,” willing to sell only 50 units (worth $500) Straight salary leads to adverse selection Incentive pay ($10/sale) solves problem but imposes risk on the workers, for which they must be compensated. Labor Market Screen

More Screens Discussion: Design screens for  Bank loans  IPO’s Discussion: How does Louisiana marriage law (two contracts, with different penalties for divorce) function as a screen?  HINT: what is adverse selection problem in marriage?

Signaling Definition: Signaling is an effort by the informed- party to communicate her type to the less-informed party.  A successful signal must not be profitable for the other type consumers to mimic Proposition: Any successful screen can also be used as a signal Education signal Advertising and branding signals

Adverse Selection on eBay Sellers have better information than buyers about the quality of goods being offered for sale. Buyers offer less, which makes sellers less willing to sell high quality goods. Consummated transactions are more likely to leave buyers disappointed in the quality. How does eBay try to solve this problem?  Escrow services  Fraud insurance  Seller ratings  eBay’s ability to address the adverse selection problem has allowed them to begin selling more expensive items, like cars, where the problem can result in much bigger losses.

Alternate Intro Anecdote Insurance Company X provides group disability insurance products to businesses, who in turn offer the product to their employees Pricing policies to prevent a loss is difficult since the company has poor information about how which customers are high-risk (likely to file a claim)  If policies are priced too low, high-risk clients will be attracted and losses incurred.  If policies are priced too high, not enough clients will be attracted. By using available geographic and industry experience information as a screening tool, the company was able to identify groups prone to higher risks and to price those policies appropriately  Companies in Miami, Florida had (on average) higher long-term disability claims while companies in Washington, D.C. had lower long-term disability claims  Short term disability for a teacher might cost 18% more than the base cost; the same policy for a group of automotive exhaust repairers would cost 107% more than the base.