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Chapter 19: The Problem of Adverse Selection

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1 Chapter 19: The Problem of Adverse Selection
Ordering Information: Betty Jung Marketing Specialist, Finance/Economics/Decision Sciences South-Western | Cengage Learning 5191 Natorp Boulevard, Mason, OH 45040 The ISBN for your 2e book alone is:  The Bundle ISBN for your 2e book + the printed access card for MBA Primer is:  Managerial Economics: A Problem Solving Appraoch (2nd Edition) Luke M. Froeb, Brian T. McCann, Website, COPYRIGHT © 2008; Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Slides prepared by Lily Alberts for Professor Froeb

2 Summary of main points Insurance is a wealth-creating transaction that moves risk from those who don’t want it to those who are willing to bear it for a fee. 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.

3 Summary of main points (cont.)
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 in- formed party. Every successful screen can also be used as a signal. Online auction and sales sites, like eBay, address the adverse selection problem with authentication and escrow services, insurance, and on-line reputations.

4 Introductory anecdote: Zappos is an online shoe retailer that depends heavily on customer service – a key differentiator for Zappos. As part of the hiring process, Zappos recruits are required to complete a four-week training process. Zappos discovered that training alone could not imbue employees with the attitude and personality required to maintain Zappos’ reputation for customer service. Specifically, Zappos was having trouble measure such intangible qualities and devised a system to get the employees with these qualities to identify themselves. After one week of training, Zappos offers $2000 to any person who will quit on the spot. About 3% of employees take this offer, and the remaining group generally deliver the quality of service Zappos desires.

5 Introduction: adverse selection
The problem Zappos faces is known as adverse selection. Zappos want to hire only good employees, but cannot distinguish the good from the bad. For Zappos, the employees known whether they are hard workers with the attitude and personality that Zappos seeks, but Zappos does not know which employees possess those attributes. When one party in a transaction has more or better information than the other, adverse selection is a problem. Low-quality employees generally have more incentive to accept an offer of employment (they might not get another), which exacerbates the problem of adverse selection. Employers need to find a way to distinguish the high- from the low- quality workers. Zappos $2000 offer is one way to “screen” out the low-quality applicants, and is a solution to the adverse selection problem.

6 Insurance and risk The problem of adverse selection is easily illustrated in the market for insurance. The demand for insurance comes from consumers who do not like risk. We model risk as a lottery – a random variable with a payment attached to each outcome. A risk-neutral consumer values a lottery at its expected value. A risk-averse consumer values a lottery at less than its expected value. For example, flipping a fair coin. If the coin lands on heads the payoff is $100; on tails, $0. A risk-adverse consumer would value the lottery at $40, while a risk-neutral consumer would value it at %50. Insurance moves “risk” from the risk adverse consumer (lower value) to a risk neutral insurance company (high value). For example, farmers face uncertain future prices for their crops. To get rid of the risk, they sell futures contracts to speculators. The buyer of the contract takes possession of the crop on a specified delivery date and accepts the possibility that the crop may be worth less than he paid for it. Selling crops before they are planted moves risk from the farmer to the speculator.

7 Insurance and risk (cont.)
Insurance is also a wealth creating transaction, except that it moves a “bad” from someone who doesn’t want it (risk averse consumer) to someone who willing to accept the risk for a fee (insurance company). Numerical example: Rachel owns a bicycle valued at $100. The bike has a possibility of being stolen, meaning Rachel’s ownership is like a lottery: lose $100 if it’s stolen, lose $0 if it isn’t. If the probability of theft is 20%, then the expected cost of the lottery is (0.2)($100) = ($20). If Rachel buys a bike insurance policy that will reimburse her for the value of the bike if stolen for $25, she eliminates the risk of owning a bike. Both insurance company and Rachel are better off with this policy. The company earns $5 ($25-$20), on average, and Rachel can stop worrying about bike theft, i.e., she “pays” the insurance company $25 each year so she doesn’t have to face the risk of bike theft.

8 Insurance and risk (cont.)
It’s important to note, the insurance company never actually earns $5. Either the company loses $75 if the bike is stolen, or earns $25 if it’s not. The expected value of offering insurance, though, is $5 0.2 x ($75) x ($25) = $5 One main function of the financial industry is also the allocation of risk, moving risk from lower- to higher-valued uses. Discussion: Describe precisely how a futures contract transfers risk from the seller of the contract to the buyer of the contract. Farmers also face a lottery. There is a 0.5 chance the price of wheat will go up to $200; and a probability of 0.5, the price will go down to zero. To get rid of the risk the farmer sells a futures contract at the time of planing (for about $100) If the price of the wheat goes up to $200, the farmer sells the wheat and then buys back the futures contract for $200; if the price of wheat goes down to zero, he buys back the futures contract at a price near zero. In each case, he has earned $100—it is the speculator who either wins big (if the price goes up) or loses (if it goes down).

9 The first lesson of adverse selection
To explain on adverse selection, we modify the bike example. Now suppose that there are two equally sized risk-adverse consumer groups: Group 1 with a probability of theft of 0.2 Group 2 with a probability of theft of 0.4 What happens when you try to sell insurance at a price of $35? HINT: do NOT assume that both groups will purchase at this price Because only high-risk consumers would be willing to pay the higher price, the company would consistently be paying out policies. So, anticipate adverse selection and protect yourself against it. This means anticipate that only the high-risk types will buy, so price the insurance at $45 If the company offers to sell insurance at an average price of $30, only the high-risk consumers would purchase the insurance. They perceive it as a great deal because they would be willing to pay as much as $45 for the insurance. In contrast, the low-risk consumers perceive it as a bad deal. In fact, they would rather face the possibility of theft than purchase insurance for $30. At a price of $40, insurance company “breaks even” but is not compensated for assuming the risk. Its expected costs are $40. If the insurance company correctly anticipates that only high-risk consumers will buy, it will offer insurance at $45. At this price, only high-risk consumers buy the insurance, but the company does make money on the policies it sells.

10 The first lesson (cont.)
In 1986, D.C. passed the Prohibition of Discrimination in the Provision of Insurance Act outlawing HIV testing by health insurance companies. As a result many insurance companies left D.C. The companies were unable to distinguish the low-risk from the high-risk consumers. If the companies sold only to HIV-positive consumers they would lose money. In 1989, the law was repealed, and the adverse selection problem disappeared. Companies could once again differentiate between high- and low-risk consumers and offered two differently priced policies to cover each group. By eliminating asymmetry of information (insurance companies could tell who was high- risk and who was low-risk) the problem of adverse selection was solved.

11 Anticipating adverse selection (cont.)
In financial markets, adverse selection becomes a problem when the owners of a company want to sell shares to the public but know more information about the prospects of the company than potential investors. Potential investors should thus anticipate that companies with poor prospects are most likely to sell to the public. For example, small initial public offerings (IPOs) of less than $100 million lose money, on average, whereas large IPOs have “normal” returns. The winner’s curse of common-value auctions is also a type of adverse selection. Unless the winning bidder anticipates that she will win only when she has the most optimistic estimate of the item’s true value, she’ll end up overbidding. Only if bidders anticipate the winner’s curse—by bidding as if theirs is the highest estimate—will they bid low enough to avoid overpaying.

12 The second lesson of adverse selection
In the bicycle example, if the insurance company sells policies at $45, low-risk consumers wont buy (because with their lower risk, their cost is only $35) But these consumers would be willing to pay $25, which is still more than the cost to the company of insuring the bike ($20). This means the low-risk consumers are not served because it is difficult to profitably transact with them. The problem of adverse selection presents many potentially profitable (unconsummated) wealth-creating transactions. Using screening or signaling helps overcome the adverse selection problem so that low-risk individuals can be transacted with profitably.

13 Screening One simple solution to adverse selection is to gather enough information to distinguish high-risk from low-risk consumers. But this can be difficult and costly to do. Privacy and anti-discrimination laws frequently prevent insurance agencies, and other companies, from gathering or using certain information (race, gender, credit scores). To solve this problem more indirect methods can be used to identify individual risk. Screening is an effort by the less- informed party to induce of consumers to reveal their types. Information may be gathered indirectly by offering consumers a menu of choices, and consumers reveal information about their risks by the choices they make.

14 Screening (cont.) Screening is frequently used in the insurance market. Suppose high-risk individuals prefer full insurance at $45, to partial insurance (for instance receiving only $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. Using a screening method allows companies to consummate the unconsummated wealth-creating transactions by eliminating information asymmetry. If the high-risk individuals prefer full insurance at $45 to partial insurance for $15, then they will purchase the full insurance while low-risk individuals will purchase partial insurance. At these prices, the insurance company can make money because the cost to the insurance company of offering full insurance to the high risk group is (0.4)*$100=$40 and the cost of offering the partial insurance to the low risk group is (0.2)*$50=$10. By offering partial insurance, the insurance company can transact (partially) with the low-risk consumers.

15 Car Buying Screen In the used car market, adverse selection is known as the lemons problem. On a car lot there are bad cars (“lemons”) worth $2000 and good cars (“cherries”) worth $4000. Sellers know which cars are cherries and which are lemons. So, if an uninformed buyer walks onto the lot and offers to buy a car for $3000, only the lemons owner would sell. The result is that the buyer overpays by $1000 for a bad car. But if the buyer offers to pay $4000, both lemons owners and cherry owners will sell. However, the expected value of the car in both cases will be $3000, so again the buyer overpays. Anticipating adverse selection, the buyer will offer only $2,000, ensuring a lemon, but at least he won’t overpay. If the buyer anticipates adverse selection, then he offers to pay only $2,000. At this price, only lemon owners sell, but at least the buyer does not overpay for the car. Another option is to offer $4,000 for a car but demand a money-back guarantee. Sellers with of good cars will accept the offer because they know the car will not be returned. Lemon owners are unwilling to offer warranties like this.

16 Car buying (cont.) Owners of good cars are analogous to low-risk insurance consumers – they are unable to transact. How can this unconsummated wealth-creating transaction be consummated? In other words, how can you design a screen for those who want to buy a cherry, and not a lemon? One option is to offer to buy a car for $4000 and demand a money-back guarantee. If the car is really worth $4000, the cherry owner knows that it won’t be returned. But the lemons owner will refuse the offer.

17 Marriage screen HINT: What is adverse selection problem in marriage?
Discussion: Louisiana offers a choice between two marriage contracts: a covenant contract which makes divorce expensive; and a regular contract which makes divorce relatively cheap. How does Louisiana marriage law function as a screen? HINT: What is adverse selection problem in marriage? Screening is also useful as implemented by Zappos to identify high- from low-quality employees. Zappos made it profitable for low-quality employees to identify themselves by offering the $2000 payment to quit. Incentive compensation is another tool companies use to identify low-quality workers. In a relationship there are two types of prospective partners: gold-diggers (who want short-term lucrative relationships) and soul mates (who want to stay together forever). The two contracts help couples make sure they are on the same page, either both gold-diggers or both soul mates.

18 Incentive compensation as a screen
When hiring sales people there are hard workers, who will sell 100 units per week, and lazy workers, who will sell only 50 units per week. Asymmetric information means only workers known if they’re lazy or hard working. A Straight salary leads to adverse selection. Because both types of employee will accept an offer of $800/week, you will attract a mix of lazy and hard workers. Incentive pay ($10 per sale) solves the problem: hard workers earn $1000 and lazy workers will reject the offer (they expect to earn only $500). Incentive pay imposes risk on the workers – some sales factors are out of their control. Another screen with less risk: offer a base salary of $500 plus $10 per sale for every unit above 50 sales. To screen out the bad workers, offer a straight $10 commission. Hard workers will accept the offer because they know they will earn $1,000. Lazy workers know they will make only $500, so they will reject the offer. This is a perfect screen because the choices (accept or reject) of the workers identify their type (hard workers or lazy ones). The second option guarantees each worker a base salary of $500 with no risk and offers higher compensation to the hard worker. Again, the good workers will accept the offer while lazy worker, who expects to earn only $500, will not.

19 Signaling Definition: Signaling describes the efforts of the more informed party (consumers) to reveal information about themselves to the less informed party (the insurance company). A successful signal is one that bad types will not mimic. Proposition: Any successful screen can also be used as a signal Low-risk consumers could offer to buy insurance with a big deductible, good employees could offer to work on commission, and sellers with good cars could include a warranty with the purchase. The crucial element of a successful signal is that it must not be profitable for the bad-types to mimic the signaling behavior of the good- types.

20 Signaling (cont.) Some of the value of education is in its signaling value. Students can signal employers that they’re hardworking, quick-learning, dedicated, etc. by spending the time and money necessary to pursue an education. Firms brand and advertise products to signal quality to consumers. As a result, most consumers are now willing to pay more for branded and advertised goods. Low-quality firms wont find it profitable to advertise because once consumers use the product and notice the difference, they will switch brands and the firm will have wasted money on the advertising. (Note that some states prohibit advertising, e.g., for financial advisors, that would serve as a signal of quality.) For branding and advertising to serve as a signal, it must be the case that low-quality producers cannot sell enough to recover their advertising and branding expenditures.

21 Adverse Selection on eBay
Sellers have better information than buyers about the quality of goods being offered for sale. Anticipating adverse selection leads buyers to offer less, which makes sellers less willing to sell high quality goods. Consummated transactions are more likely to leave buyers disappointed in the quality (“lemons”). How does eBay try to solve this problem? By providing: Escrow services Fraud insurance Seller ratings – provided by past buyers 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. Discussion Question: Robert and Teri La Plant paid $2950 for a 1.41-carat marquise-cut diamond on eBay sold by power user “MrWatch.” When they received the diamond, it had a visible chip in it and they sent it back. The seller refused to refund their money, alleging that the La Plants chipped the diamond themselves to avoid having to pay for it – he also noted that the diamond had an appraisal with it when shipped. The La Plants counter by noting that the appraisal was one and a half years old, and have collected the standard $200 insurance policy offered by eBay for all its purchases. eBay refuses to suspend MrWatch from the site, noting that he has 1800 positive responses from customers and only eight negative ones. As a consequence of the adverse selection, low-quality goods drive out high-quality goods, just as bad risks drive out good risks from the insurance market. All of these actions solve the adverse-selection problem, but only for relatively inexpensive items. For high-value items, the adverse selection problem remains large, and, consequently, there are few high-value items sold on eBay.

22 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 does not know which customers are high-risk (likely to file a claim) If policies are priced at the average risk, only high risk consumer will purchase. If policies are priced at low risk, both high and low-risk consumers purchase, leading to expected costs above price. 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. This story illustrates a solution to the problem known as “adverse selection.” It arises when one party to a transaction is better-informed than another – in this case companies know more about their risk profile than does the insurance company. Unless insurance companies can distinguish low from high risk companies, they can not profitably write policies. In general, the problem arises in any transaction where one party to a transaction is better informed than the other. In this chapter we show you how to anticipate the adverse selection problem, protect yourself from its consequences, and, in some cases, how to solve it.

23 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 This story illustrates a solution to the problem known as “adverse selection.” It arises when one party to a transaction is better-informed than another – in this case workers know more about their work habits than does their employer. Unless employers can distinguish good from bad workers, they end up hiring both.

24 Managerial Economics - Table of contents
1. Introduction: What this book is about 2. The one lesson of business Benefits, costs and decisions 4. Extent (how much) decisions 5. Investment decisions: Look ahead and reason back 6. Simple pricing Economies of scale and scope 8. Understanding markets and industry changes 9. Relationships between industries: The forces moving us towards long-run equilibrium 10. Strategy, the quest to slow profit erosion 11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing 13. Direct price discrimination 14. Indirect price discrimination 15. Strategic games 16. Bargaining 17. Making decisions with uncertainty 18. Auctions The problem of adverse selection The problem of moral hazard 21. Getting employees to work in the best interests of the firm 22. Getting divisions to work in the best interests of the firm 23. Managing vertical relationships 24. You be the consultant EPILOG: Can those who teach, do? Managerial Economics - Table of contents

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