Ch. 19 adverse selection Flashcards
Adverse selection refers to a situation where
sellers have more information than buyers have, or vice versa, about some aspect of product quality, although typically the more knowledgeable party is the seller.
Adverse selection occurs when _________ information is exploited.
asymmetric
adverse selection per book
refers to the fact that “bad types” are likely to be selected in transactions where one party is better informed that the other.
examples of adverse selection includes
higher risk individuals being more likely to purchase insurance, more low-quality cars (lemons) being offered for sale, or lazy workers being more likely to accept job offers.
Adverse selection is a _________ problem that arises from hidden information about risks, quality, or character.
precontractual
adverse selection problem is more easily illustrated in the market for ________.
insurance
insurance is a wealth creating transaction that moves _________ from those who don’t want it to those who are willing to bear it for free.
risk
risk-neutral individual values a lottery at ______ expected value.
its (as is)
A risk-averse consumer values a lottery at _____ than its expected value.
less
For instance, a risk-averse consumer might be willing to sell the $100 coin toss lottery for $40, whereas a risk-neutral consumer would be willing to pay $50 for the same lottery. If the two of them transact, say at a price of $45, they create wealth by moving an asset—the lottery—to a higher-value use. After the transaction, the risk-averse seller has $45, a sure payout that he values more than the lottery, and the risk-neutral buyer pays only $45 for a lottery that she values at $50.
risk neutral buyer values at 50.
risk averse seller values at 40.
transaction = 45$.
therefore, risk-neutral buyer pays only $45 for a lottery that she values at $50.
A lottery is a ________ with a payment attached to each outcome.
random variable
For example, suppose that Rachel owns a $100 bicycle that might be stolen. The possibility of theft means that the payoff from owning the bicycle is like that of a lottery: lose $100 if the bike is stolen and lose nothing if it isn’t. If the probability of theft is 20%, the expected cost of the lottery is ___________.
($100)(20%) = 20$
If Rachel purchases insurance for $25 that reimburses her for the value of her stolen bicycle, she eliminates the risk.
If Rachel purchases insurance for $25 that reimburses her for the value of her stolen bicycle, she eliminates the risk. By voluntarily transacting, both Rachel and her insurance company are made better off. Rachel pays to eliminate the risk, and the insurance company earns $5, on average, for accepting it.
Note that the insurance company never earns $5. If the bike is stolen, it loses $75; if not, it earns $25, so the expected value of offering insurance is ___________.
(20%)( - 75$) + 80% (25$)
= 5$
another way to reduce or remove risk is to ______
sell forward contracts
If you are risk averse:
a. You value a lottery at more than its expected value. b. You like to take gambles. c. A lottery is worth less to you than its expected value. d. You advertise your attitude toward risk.
c. A lottery is worth less to you than its expected value.
Those who choose to insure against theft:
a. Reduce the risk they face. b. Pay insurance premiums greater than your expected loss. c. Are better off than if insurance was not available. d. All of the above
d. All of the above
When farmers sell forward contracts in spring for the harvest they will reap in Autumn:
a. Their planting decisions are riskier due to increased uncertainty. b. They accept a price higher than the expected price during harvest. c. They are worse off because the price today is less than what they could expect to sell their crops for in the autumn. d. They are better off because they have a preference for reducing risk.
d. They are better off because they have a preference for reducing risk.
adverse selection disappears. if the information _________ disappears.
asymmetry
anticipate adverse selection and ________ yourself against it.
protect
when you eliminate the information asymmetry - when the company knows who is high risk and who is low risk, then
there is no adverse selection
by requiring everyone to purchase insurance
you reduce low risk purchasers to exit the market
In financial markets, adverse selection arises when owners of companies seeking to sell shares to the public __________ than do potential investors.
know more about the prospects of the company
winner’s curse of common value is a type of ___________.
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 they have the highest estimate—will they bid low enough to avoid overpaying.
adverse selection
People are more willing to buy an insurance product when:
a. They are less risk averse. b. They face greater risk. c. They face less risk. d. They are no risk.
b. They face greater risk.
If an insurance company cannot distinguish between the riskiness of potential customers, then:
a. Their risk pool will have relatively more high risk customers than the population at large. b. They primarily sell to low risk customers. c. They earn more because they can overcharge the low risk customers. d. They can break at least even if they charge a rate based on the average risk in the population at large.
a. Their risk pool will have relatively more high risk customers than the population at large.
The low-risk consumers are ________ because it is difficult to transact with them profitably.
not served
Adverse selection represents a ________ profitable, but _________ , wealth-creating transaction
potentially
unconsummated/unfinished
screening and signaling are two ways to overcome the obstacles to transacting with ________.
low-risk individuals
screening
a solution to the problem of adverse selection that describes the efforts of a less informed party to gather information about the more informed party.
uninformed party’s effort to learn the information that the other party has.
A successful screen means that
it is unprofitable for bad types to mimic the behavior of good types. Any successful screen can also be used as a signal.
obvious solution to adverse selection is to
gather information so you can distinguish high risk from low risk
for example, the insurance company can distinguish between high- and low-risk consumers, then ___________
it can offer two different policies to the two groups—a low-price policy to the low-risk group and a high-price policy to the high-risk group.
for example - If you give an insurance company permission to look at your credit report,
you can get car insurance at a low price, provided your credit is good.
Some restrictions for checking credit score and credit report reduce the amount of information available to insurance companies and raises the cost of insurance to ______________ .
good drivers
By offering consumers a _______ , you can get them to reveal information about themselves (risk) by the ______ they make.
menu of choices
choices
By offering _________ , the insurance company can transact (partially) with the low-risk consumers.
partial insurance
screening is essentially the efforts of the less informed party, the __________, to gather information about the more informed party, the ________.
insurance company
consumers
A successful screen has one critical requirement: it must not be __________ for high-risk consumers to ________ the choice of low-risk consumers.
profitable
mimic
if high risk individuals purchase partial insurance, the screen fails and the insurance company, _________.
loses money
If you’re a low-risk individual, you may be able to ________ your own expected insurance costs by purchasing a policy with a ___________.
lower
large deductible or copayment
Buying a policy with a ________ deductible signals that you expect your insurance costs to be ______.
small
high
this allows insurance companies and software companies like discussed in other chapters to
price discriminate
the lemons problem
used car market and adverse selection
to solve a lemon (bad car) problem
you can ask for a money back guarantee, that way sellers of good cars will accept because the car won’t be returned.
Lemon owners would be unwilling to offer guaranties like this. Warranties on products serve a similar purpose.
Manufacturers of high-quality, durable products are ___________ because they don’t expect to have to make many repairs.
more willing to offer longer warranties
Zappos - adverse selection.- by offering a 4,000 to quit
the company made it profitable for low quality workers to identify themselves as such
Incentive compensation is another way that employers ___________.
identify and avoid low-quality workers
The asymmetric information means that workers know which type they are but you don’t.
sellers are the employees
buyers are the employers
therefore, the sellers know more information than the buyer.
employees offering their time and employers accepting and purchasing their time to offer a service.
offering commission is another way to
screen out lazy vs hard workers.
commission is a perfect screen because
the workers’ own choices (accept or reject) identify their type (lazy or hardworking).
most incentive compensation schemes ________ workers to risk.
expose
for ex: factors that affect sales like consumer income, rival prices, or interest rates.
best screens would be
contract with a flat salary ($500) and combination with commission ($5) on each sale
good workers get a compensation scheme that exposes them to less risk.
When offering insurance to groups with different risk profiles:
a. Insurers tend to cater products to the higher risk group. b. Insurers serve the lower risk groups because they make fewer claims. c. Lower risk groups get more insurance coverage than higher risk groups. d. The higher risk groups are offered only get only partial insurance.
a. Insurers tend to cater products to the higher risk group.
Screening:
a. represents efforts made by the more informed party. b. is when the more informed party reveals her type by the choices she makes. c. is when the less informed party gathers information by the choices the more informed party makes. d. represents the more informed party being persuaded to reveal information about their type.
c. is when the less informed party gathers information by the choices the more informed party makes.
adverse selection results in unconsummated wealth-creating transactions, such as those between:
insurance companies and low-risk consumers;
car buyers and sellers with good cars; or
employers and hardworking employees.
When consumers identify themselves by their choices, then
wealth-creating transactions can be consummated
Signaling describes the efforts of the more informed parties (consumers) to
to reveal information about themselves to the less informed party (the insurance company).
A successful signal is one that
bad types will not mimic.
signaling are efforts made by informed parties, the ____________, to get rid of asymmetric information.
low risk consumers
hardworking employees
sellers with good cares
signaling is closely related to screening. And every successful screen can also be __________.
used as a signal.
to signal, the informed party could use the mechanisms just described: low-risk consumers could ___________ , good employees could ___________ , and sellers with good cars could ___________.
offer to buy insurance with a big deductible
offer to work on commission
include a warranty with the purchase
The crucial element of a successful signal is that it must not be profitable for the ________ to mimic the signaling behavior of the good types.
bad types
education is another signaling value
students signal they are hardworking when they drop out of the labor force and spend their money to pursue an education. thus earning a higher salary to recoup their investment.
any student that is a low quality worker
will not be promoted or retained.
advertising and branding can also serve as signals
By investing significant money into branding and advertising a product, firms signal to consumers that theirs is a high-quality product.
Low-quality firms won’t mimic this signal because even consumers who buy will
soon learn of its low quality and avoid the brand in the future.
branding and advertising signals are called burning money because
the message of the advertisement is less important than the fact that money was spent on it.
for ex - male peacocks in wild - reflect better genes preferred by females.
example of burning money
before FDIc, banks were built in granite.
Signaling:
a. represents efforts to share information made by the more informed party. b. is when the less informed party signals her type by the choices she makes. c. is when the less informed party gathers information by the choices the more informed party makes. d. represents the less informed party being persuaded to reveal information about their type.
a. represents efforts to share information made by the more informed party.
For signaling to work in insurance:
a. It must be profitable for low risk types to reveal their type. b. It must not be profitable for high risk types to mimic low risk signals. c. The insurer must be able to distinguish between high and low risk types based on the signal. d. All of the above.
d. All of the above.
adverse selection and internet sales
amazon has made it a point to have good sellers on their marketplace as bad sellers could potentially reflect on all sellers.
amazon has also worked to give sellers a seal of approval and bans incentivized review to design a proper review system without fake reviews and more helpful information. that is how its become a dominant online retailer worldwide.
other online sites like eBay will address adverse selection by
authentication and escrow services, insurance, and online reputation.
Yelp and adverse selection with positive reviews result in
8% increase in revenues
E-commerce platforms, like Amazon.com, restrict their sites to high quality sellers by:
a. Suing all firms with "too many" product reviews. b. Soliciting third-party reviews with compensation. c. Prominently displaying reviews that other customers considered less informative. d. Banning sellers from offering inducements for favourable reviews.
d. Banning sellers from offering inducements for favourable reviews.
