Adverse selection arises in a business situation when an individual has hidden characteristics before a business transaction takes place. With hidden characteristics, one party knows things about himself that the other party doesn’t know. This leads to a self-selection bias where individuals act in their own self interest and use private information to determine their optimal action, usually at another party’s disadvantage or cost.
One method for dealing with adverse selection is to force everyone to participate. For example, states commonly require drivers to have car insurance. Thus, it’s possible for car insurance companies to charge a premium that reflects the average claim. However, participants who are unlikely to submit a claim may believe it’s unfair for them to be forced to subsidize those likely to file a claim.
An alternative method for dealing with adverse selection is to group individuals through indirect information, such as statistical discrimination. Insurance companies can’t get individuals to admit whether they’re good or bad drivers, so the companies develop statistical profiles of good and bad drivers. By determining who is most likely to be a bad driver, the insurance company can establish different premiums.
Thus, young males are likely to pay more for insurance. Somebody living in Los Angeles pays more than someone in Hanover, Indiana. Drivers with speeding tickets and other traffic violations pay higher premiums. The list goes on and on because the better the characteristics, the more accurate the premiums, and competition among insurance companies helps develop better statistical profiles.
But neither of these alternatives — requiring participation or statistical discrimination — has the actual participants share information to overcome the asymmetry. Both direct and indirect methods lead to the revelation of information that resolves, or at least reduces, adverse selection. The direct method is to use an appraisal, while indirect methods include screening and signaling.
How to appraise asymmetric information
Appraisal resolves asymmetric information by examining a characteristic that’s objectively verifiable. In the case of a used car, if the buyer decides to take the car to his mechanic, the mechanic can provide a knowledgeable assessment of its condition. Or in the case of art, an appraiser can verify the painting as an original or a fake.
Appraisal directly resolves asymmetric information under two conditions:
The characteristic associated with the asymmetric information must be objectively verifiable.
The appraisal’s benefit must exceed the seller’s cost.
In the case of health insurance, a medical exam becomes an appraisal. The medical exam yields objective information about the individual’s current health.
Signaling with warranties
While appraisal directly conveys information from one party to another, signaling is a method for indirectly conveying information. By using signaling, the individual with better information convincingly communicates that information to the individual who has less information.
To return to the example of the used car, going to your own mechanic provides you an appraisal of the car’s value. Alternatively, the current owner of the car could signal to you that the car is well taken care of by offering a warranty — a guarantee to fix any repairs during a certain period of time or providing a CARFAX or similar report.
To be successful in resolving asymmetric information, signaling must induce self selection among the better-informed participants. Only participants offering well cared for used cars are willing to offer warranties or a CARFAX report. A warranty carries a real cost to the seller if the car breaks down.
While a warranty may convince you, the buyer, that the car is well taken care of, a sign that simply states “Best Used Cars In Town” isn’t likely to be convincing, because it doesn’t cost much for those selling lemons to make the same sign.
How to control for asymmetry through screening
Another indirect method for resolving information asymmetry is screening. In screening, the participant with less information controls a variable that leads to the participant with better information revealing that information. One screening method with insurance is the use of deductibles. An insurance deductible is an amount the insured must pay before the insurance company pays on a claim.
High risk participants are likely to know they’re high risk. Thus, high risk participants are likely to file a claim and want low deductibles — they don’t want to have to pay very much before the insurance company starts paying. On the other hand, low risk participants know they’re unlikely to file a claim — they’re willing to have a higher deductible because they’re less likely to have to pay it.
The deductible provides a mechanism that leads the better-informed participant, the insured, to reveal information to the less well-informed participant, the insurance company.
The number of screening options must correspond to the number of choice characteristics. For example, individuals choosing low deductibles can do so because they’re high risk or alternatively, because they’re risk averse. Thus, deductibles are a good, but not perfect, screening device.