Agents in this case in order to ensure their

  • Boston University
  • ECON 501
  • Notes
  • EleanZ
  • 42
  • 75% (4) 3 out of 4 people found this document helpful

This preview shows page 33 - 35 out of 42 pages.

agents in this case in order to ensure their compliance with the wishes of the principals. 8.6 Methods to Overcome Inefficiencies in Risk Markets In the previous section, we looked at some factors that cause inefficiencies in markets characterized by uncertainty, particularly the problems that arise when the parties to transactions have informational asymmetries. As economists have become more aware of these problems, they have also become more aware of var- ious ways in which economic agents attempt to lessen the impact of asymmetric information. We discuss a few of these in this section. 8.6.1 Screening In any situation of asymmetric information, the economic actor who has less information has an incentive to acquire more. Activities by which this agent can acquire more information about the other are known as screening . Screening is particularly important in situations involving adverse selection, when one side of the transaction doesn’t know the other’s “type.” The basic approach is to try to observe characteristics that are observable and are correlated with the type in order to learn more about the type. A more sophisticated approach is to screen through tests or other such methods that induce the different types to choose differently, thereby self-sorting themselves and revealing their types.
CHAPTER 8. UNCERTAINTY AND INFORMATION 252 Consider the insurance example. Someone seeking life or health insurance probably knows more about their type than an insurance company would. The most direct form of screening would be for the insurance company to require that a questionnaire be filled out, in which they ask questions about the person’s health history and lifestyle habits such as smoking and drug use. Perhaps they might ask also about their parents’ and grandparents’ health history in order to learn about any genetic predispositions. To the extent that there may be information that could be damaging to the respondent’s interests, the answers on such a questionnaire may not always be truthful. The insurance company therefore has an incentive to gather information independently. They may, for example, require a medical examination. For car insurance, they may look to see if the applicant has a clean driving record or has been involved in accidents or been cited for traffic violations. For property insurance, they may inspect the property to learn the construction quality and whether or not safety equipment has been installed. All these are forms of screening to learn more about the applicant’s type or risk of loss. The more sophisticated form of screening would involve offering those seeking insurance a menu of choices in such a way that they would self-select into groups according to their different types. We saw an example of this in Figure 8.9 where, by offering two types of policies, B and P , the insurance company was able to induce the types to sort themselves. Only the high-risk types would select the policy B and the low-risk types would choose P . Employers similarly screen potential or actual employees. They look at re-

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture