1. Adverse selection Abhinash adhikari Astha gyawali Bijay chalise
Salim l. awale
Sweta bhattarai

3. Adverse selection
It refers to that market condition where sellers have information that buyers do not, or vice-versa, about some aspect of product quality.
The asymmetry of information often leads to making bad decisions.
Focus on how and when mangers use their informational advantage to increase performance.

4. The market for lemon Ackerlof’s model: used car market
Used cars are either gems(which is good) or lemons ( which is bad)

5. The market for lemon
Sellers have more information than buyer does about the quality of the car
Buyers assume car must be of average quality so they don’t want to pay more than average (Break even point)
Buyers
Sellers

6. The market for lemon Ackerlof’s model: used car market
Sellers will sell car if the quality of car is average or low then average, “Lemon”.
Average price of a used car finally equal to the value of a lemon.
This is a case of adverse selection where only lemons being offered for sale on the used car market.

7. Adverse selection in automobile insurance
Insurers distinguish the drivers bases on various characteristics
Good drivers pay low premiums
Bad drivers pay high premiums

8. Asymmetry of information
Buyers have more information
Sellers
Buyers

9. example Wealth=125 In the case of loss, Loss=100
High-risk drivers
Low risk drivers
Wealth=125
In the case of loss,
Loss=100
Wealth is reduced to 25
Probability of loss= 75%
Thus,
Expected loss=(0.75*100)=75
Wealth=125
In the case of loss,
Loss=100
Wealth is reduced to 25
Probability of loss= 25%
Thus,
Expected loss=(0.25*100)=25

10. graph
Utility=(Wealth)0.5

11. Perfect information Premium=Expected loss=75
High risk drivers
Low risk drivers
Premium=Expected loss=75
Utility with insurance = (125-75) =7.071
Utility with no insurance =(0.25)(125)0.5+(0.75)(25)0.5 =6.545
Premium=Expected loss=25
Utility with insurance = (125-25) =10
Utility with no insurance =(0.75)(125)0.5+(0.25)(25)0.5 =9.635

12. Asymmetric information
Average premium=0.5(25+75)=50
High risk drivers
Low risk drivers
Utility with insurance = (125-50) =8.660
Utility with no insurance =(0.25)(125)0.5+(0.75)(25)0.5 =6.545
Utility with insurance = (125-50) =8.660
Utility with no insurance =(0.75)(125)0.5+(0.25)(25)0.5 =9.635

13. Result!! Market failure!!
Only the people who most likely need insurance will actually end up paying for it.

14. Restoring the market
Competition between insurers
Strategic designs

16. It is a form of insurance or investment entitling the investor to a series of annual payment.
Annuity helps solve problem of income guarantee after retirement.

17. Insurance Company

18. Insurance Company

22. What are the incentives of the managers at the annuity firm ?
For this let us consider year-old women who pay $300,000 for the annuity plan.
There are two possible scenario:
The health status of each individual is known to both manager and that person. i.e. Annuity with full information.
There is asymmetric information, the person knows her health status the manager does not. i.e. Annuity with asymmetric information.

23. MARKET WITH FULL INFORMATION
A quarter of our population lives for 5 years
Half are in good health and live for 15 Years
A quarter is in excellent health and live for 25 Years

24. MARKET WITH FULL INFORMATION
yr-old women are paid =$300,000/5 =$60,000/yr
yr-old women are paid =$300,000/15 =$20,000/yr
yr-old women are paid =$300,000/25 =$12,000/yr

25. MARKET WITH ASYMMETRIC INFORMATION: ADVERSE SELECTION
Because Managers do not know health status, they estimate the firm can break even if it receives $300,000. who should be offered annuity of $20,000
Here Receipt:
=1000 times $300,000 =300,000,000
Payments:
=250*$20,000*5 =$25,000,000 or $100,000/person
=500*$20,000*15 =$150,000,000 or $300,000/person
=250*$20,000*25 =$125,000,000 or $500,000/person
Total Payments = $300,000,000

26. WHO BUYS THE ANNUITY ?
Of course managers can anticipate that only those in average or better than average health will buy the policy.

27. EVIDENCE OF ADVERSE SELECTION
IN ANNUITY
Managers can use simple test to see whether annuity markets are subject to adverse selection.
In early example life expectancy calculated as:
= (250*5+500*15+250*25)/1000 = 15 years
If $20,000 was annuity only 750 people will buy annuity so
= (500*15+250*25)/750 = years

28. MORTALITY DISTRIBUTIONS FOR US POPULATION AND ANNUITANTS

29. The Absence of Adverse Selection in Life Insurance
Whereas annuities insure against “living too long "life insurance protects the survivors of people who “die too soon”.

30. Managers at life insurance firms have been very effective in establishing the health status of their policy holders.
There seems to be no traceable adverse selection here.

31. Resolving adverse selection through self selection
While Ackerlof described the adverse selection Problem, Michael Rothschild and Joseph Stiglitz laid out a solution to adverse selection.
i.e. managers should design policies that separate behavior between good and bad drivers.

32. Resolving adverse selection through self selection
Example 1:
Policy A:high premium and full insurance
Policy B:low premium high deductible
Example 2:
Policy C:high premium that is constant from year to year
Policy D:higher(than C) premium at first that declines from year to year

33. Separating equilibrium
This solution to adverse selection induces policy holders to select their relative risk types
High risk drivers
Low risk drivers

34. Separating equilibrium
This solution to adverse selection induces policy holders to select their relative risk types
High risk drivers
Low risk drivers

35. High risk drivers No insurance:0.25(125)^0.5+0.75(125-100)^5 = 6.545
Policy 1: (125-75)^0.5
= 7.071
Policy 2: 0.25( )^ ( )^5
=7.043

36. Low risk drivers No insurance:0.75(125)^0.5+0.25(125-100)^0.5 =6.545
Policy 1: (125-75)^0.5
=7.071
Policy 2:0.75( )^ ( =10)^0.5
=9.726

37. USING EDUCATION AS A SIGNAL: ADVERSE SELECTION IN THE JOB MARKET
How can managers predict which job applicant will have good work skills???
Applicants have some self-awareness about their job market skills,
Information asymmetry,
Simply asking applicants to reveal their private information does not work.
Relationship between job skills and academic performance,

38. Example: Average direct and indirect cost per course are,
High-quality job skills = $2000 per course
Low-quality job skills = $3450 per course ( they take longer to finish)
Now assume that if employers knew the skill levels of applicants, they would pay the following wages:
High-quality job skills = $50000 per year for 5 years
Low-quality job skills = $30000 per year for 5 years

39. The benefit and cost of achieving x courses:
High skill:
Benefit of achieving x courses = $100000
Cost of achieving x courses = $2000 times x
The benefit exceeds the costs if x is less than 50.
Low skill:
Cost of achieving x courses = $3450 times x
The benefit exceeds the costs of x is less than 29.

40. Contd. So the employers choose a level of x between 29 and 50,
Another way of thinking about this is provided by our MBA students,
Must set its standards sufficiently high to discourage low- skilled people,
Other functions in addition to sorting people according to job skills,
Ideally people learn something as well.

41. USING EDUCATION AS A SIGNAL: ADVERSE SELECTION IN THE PRODUCT MARKET
Experience goods,
Unable to determine the true quality of the goods,
Separating equilibrium so consumer can accurately determine product quality,
Common method use to create this separation: Product Warranty
Credible signal of product quality,
Product that carry a credible warranty is most desirable in market.

42. How Managers Can Construct Warranties To Mitigate Adverse Selection
Competitive market: too many competitive products with same functions,
Products of different qualities (high and low quality),
Price and production cost of the product differs according to their qualities,
Separate market for high quality product and low quality product,
Firms producing high-quality product want to construct a separating mechanism,

43. Here is how they can do so using a product warranty:
Two possible scenarios:
First scenario: Consumers perceive any good with a warranty (X years) to be a high- quality good.
Second scenario: Consumers perceive the good with the longer warranty (X years) to be the high-quality good.

44. Contd.

45. Contd.

46. Contd.

47. Contd.

48. Contd. But now, think strategically…
If the high-quality producer issued a warranty of YH,
The low-quality producer can’t afford to offer more than YL,
High-quality producer out-warranty the low-quality producer,
A warranty of YH = YL + 1
** Notice the similarity to auctions..