Solutions to Informational Problems: Videos & Practice Problems

In the context of informational problems such as adverse selection and moral hazard, signaling serves as a crucial mechanism for addressing information asymmetry between informed and uninformed parties. Signaling occurs when the informed party takes action to reveal their private information to the uninformed party, thereby facilitating more effective transactions.

For instance, consider the scenario of a used car sale. Here, the informed party is the salesman, who possesses knowledge about the car's condition, while the buyer lacks this information. To signal that the car is in good condition, the salesman might offer a warranty. This warranty not only provides the buyer with assurance that they are protected against potential defects (often referred to as "lemons") but also indicates to the buyer that the salesman is confident in the car's quality. If the car is indeed good, the salesman is unlikely to incur costs from repairs or replacements under the warranty, thus reinforcing the signal of quality.

Similarly, in the job market, the job applicant represents the informed party. The applicant knows their own skills and work ethic, which the employer (the uninformed party) does not. To signal their capabilities, applicants often include a college degree on their resumes. This degree serves as a signal to potential employers, suggesting that the applicant possesses intelligence and perseverance, as they successfully completed their education. In this way, signaling helps bridge the gap of information asymmetry, allowing both parties to make more informed decisions.

Overall, signaling plays a vital role in reducing uncertainty in transactions by allowing informed parties to communicate their private information effectively, thereby enhancing trust and facilitating smoother exchanges.

Information asymmetry occurs when one party in a transaction has more or better information than the other. Screening is a method used by the uninformed party to encourage the informed party to disclose their private information. This contrasts with signaling, where the informed party takes action to reveal their information. A common example of screening can be found in health insurance, where the insurer (the uninformed party) seeks to understand the health risks of policyholders (the informed party).

In health insurance, the insurer faces uncertainty regarding the health status of applicants. To screen for risky policyholders, insurers may offer plans with varying deductibles. A deductible is the amount a policyholder must pay out of pocket before insurance coverage kicks in. For instance, a plan with a low premium and a high deductible (e.g., $5,000) will likely attract healthier individuals who do not expect to incur high medical costs. Conversely, a plan with a high premium and a low deductible will appeal to riskier individuals who anticipate needing more medical care and prefer lower out-of-pocket expenses. This differentiation allows insurers to categorize applicants based on their risk levels, effectively screening out those who are more likely to file claims.

Another context for screening is the employer-employee relationship. Here, the employer (the uninformed party) cannot directly observe the effort level of employees, leading to potential issues of shirking, or slacking off. To mitigate this, employers can implement performance-based compensation structures. For example, offering commission-based pay incentivizes employees to work harder, as their earnings are directly tied to their sales performance. Similarly, year-end bonuses can motivate employees to maintain high performance levels by rewarding them for their efforts. These strategies help employers screen for diligent employees who are less likely to shirk their responsibilities.

Overall, screening serves as a valuable tool for addressing information asymmetry in various scenarios, including health insurance and employment. By designing incentives that align the interests of both parties, the uninformed party can gain insights into the informed party's characteristics, thereby reducing the risks associated with adverse selection and moral hazard.