SummaryIn this LP we cover the implications of asymmetrical information, looking at the most important examples. We start by looking at adverse selection, then we learn more about moral hazard.
Screening is one of the main strategies for combating adverse selection. It is often confused with signalling, but there is one main difference: in both, ‘good’ agents (the cherries of this world) are set apart from the ‘bad’ agents, or lemons, which are weeded out. In signalling, it is the uninformed agent (the victim of asymmetric information) who moves first, and comes up with a strategy to weed out the lemons. In signalling, however, it is the cherries, the informed agents, who make the first move to set themselves apart. The analysis of screening processes was put forward by Michael Spence in his article “Job Market Signaling”, 1973.
The best known theoretical explanation is that of competitive screening, put out by Rothschild and Stiglitz in 1977, in their article “Equilibrium in Competitive Insurance Markets”, which shows how insurance companies can get around the people taking advantage of adverse selection by offering different types of insurance options which will attract only the risk adverse. This is covered in more detail in insurance models, which are covered by the field analysing risk and uncertainty.
There are two basic types of screening: in the first, the ‘victim’ of asymmetric information simply sets about finding out as much as possible about the other agent. For example, carrying out a health check before offering health insurance, or running a background check before offering a job. This, aside from verging on the morally questionable, is often highly regulated in many countries. The second option is using game theory to set up the terms of a contract so that they only interest the cherries. Something as simple as copayment in case of a claim (for example, paying a small percentage of the claim amount in case a car is damaged) can help to weed out those who are not risk adverse.