GSBS6410

Economics of Competitive Advantage

Week 11
Adverse Selection & Moral Hazard
 OUTLINE

1. Readings
2. Adverse selection
3. Moral hazard
4. Questions for discussions

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 GSBS6410
Readings for this lecture

• Froeb et al 2018, Managerial Economics, Chapters 19

& 20, and/or
• Arnold, Roger A., (2016) Microeconomics, 12th
Edition, Cengage. Chapter 17.
 Adverse selection
• 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.

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 Adverse selection
• 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 informed 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.

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 Zappos
• Zappos.com 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. 6
 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.
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 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). 8
 Insurance and risk
• 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. 9
 • continued
Insurance and risk
• 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) + 0.8 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.
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 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

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 Anticipating adverse selection

• 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.

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 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.

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 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.

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 Screening
• 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.
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 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. 16
 Car buying
• 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.
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 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.
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 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.

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 Signaling
• 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.)
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 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.
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 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
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 Moral Hazard
• Moral hazard refers to the reduced incentive to exercise care
once you purchase insurance.
• Moral hazard occurs in a variety of circumstances: Anticipate
it, and (if you can) figure out how to consummate the
implied wealth-creating transaction (i.e., ensuring that
consumers continue to take care when the benefits of doing
so exceed the costs).
• Moral hazard can look very similar to adverse selection—
both arise from information asymmetry. Adverse selection
arises from hidden information about the type of individual
you’re dealing with; moral hazard arises from hidden actions.

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 • continued
Moral Hazard
• Solutions to the problem of moral hazard center on
efforts to eliminate the information asymmetry (e.g.,
by monitoring or by changing the incentives of
individuals).
• Shirking is a form of moral hazard.
• Moral hazard in loans: Borrowers prefer riskier
investments because they get more of the upside
while the lender bears more of the downside. The
problem is worse for borrowers who have nothing to
lose.
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 TripSense
• In 2004, the Progressive Direct Group of Insurance Companies
introduced TripSense – a service that provided a free device to
record mileage, speeds and times driven in a vehicle.
– Progressive then used this information to offer discounted renewal
policies to customers who drove fewer miles at slower speeds during
non-peak hours.
• This helps the insurance company solve two problems. Adverse
selection, from the Chapter 19, and moral hazard, the focus of this
Chapter 20.
– The decision of how frequently, how far, or how fast to drive is equivalent
to choosing your probability of having an accident.
– The cost of having an accident goes down when you buy insurance.
• Drivers respond to this reduced cost by “choosing” to have more
accidents. This is called “moral hazard.” 25
 Introduction: Moral hazard
• Once you have insurance, the cost of an accident is
reduced, which also reduces the cost of the risky
behavior.
• This is the problem of “moral hazard” and exists in many
contexts, not just in the market for insurance.
• Moral hazard and adverse selection are closely related
problems. Both,
– are caused by information asymmetry: moral hazard results
from hidden actions; while adverse selection results from
hidden information
• The cost of managing both problems can be reduced by
reducing uncertainty (gathering more information).

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 Moral Hazard in Insurance
• To illustrate moral hazard, lets return to the bicycle
insurance example of chapter 19.
– Suppose that bike owners stand a 40% chance of theft when
parking their bike on the street overnight. However, if the bike
owner exercises care (locks the bike), the chance of theft is
reduced to 30%.
– Suppose the cost of taking care (buying a lock) is $5.
– For uninsured bike owners, the benefit of exercising care is
(0.40 - 0.30)($100) = $10 and is greater than the costs of
exercising care, $5.
– Moral hazard suggests that once customers purchase insurance,
they exercise less care because there is less incentive to do so.
– Is this really the case?

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 Moral Hazard in Insurance
• In our example,
– The cost of bike theft is reduced when an insurance
policy is purchased.
– Lily, the consumer stops taking the extra time to lock up
the bicycle every night once she buys insurance.
– The probability of theft then increases from thirty back
to forty percent.
– The insurance company anticipates this moral hazard, and now charges
$45 for every policy it sells.
• If you do NOT anticipate that the probability of theft will
increase from 30% to 40%, you will lose money on the insurance
you sell.
• In other words, anticipate moral hazard and protect yourself
against it.

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Creating wealth with moral hazard
• Moral hazard can also represent an unconsummated wealth-
creating transaction.
– This opportunity exists because the benefits of taking care are bigger
than the costs of taking care.
• But how can the insurance company induce the bike owner to
take care?
– If the insurance company could observe whether the customer was
exercising care, then it could lower the price of insurance to those
taking care.
– This is exactly what Progressive’s MyRate/TripSense system tries to do.
– It could also purchase the lock for the bike owner.
• Note that these kinds of prevention and wellness programs do NOT reduce
health care costs.
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 Moral Hazard or Adverse Selection?
• To distinguish between moral hazard and adverse
selection, ask whether:
– Information is hidden (adverse selection) or the action is
hidden (moral hazard)
– The problem arises before a transaction (adverse selection)
or after (moral hazard)
• Discussion: Give a moral hazard and an adverse
selection explanation for each the following:
– Drivers with air bags are more likely to get into traffic
accidents.
– Volvo drivers are more likely to run stop signs.
– At all-you-can-eat restaurants, customers eat more food.
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 Moral Hazard in Lending
• Banks face a moral hazard in loans: borrowers who are least likely
to repay loans are the most likely to apply for them.
• Example: a $30 investment opportunity arises. The investment has
a 50% chance of a $100 payoff and a 50% chance of a $0 payoff
• The bank offers a $30 loan at 100% interest based on the expected
value of the investment.
• If the investment pays off, then the bank gets $60, if the investment
fails the bank gets $0.

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 Moral Hazard in Lending
• However, after the loan is made, the borrower “discovers” a
different investment.
• This second investment pays off $1000 but only has a 5% probability
of succeeding.
• Here the borrower receives more if the investment pays off, so the
bank receives a smaller payoff, $3 = (.05)($60) + (.95)($0)
• The lender prefers the less risky investment because she receives a
higher expected payoff. But, the borrower prefers the riskier
investment.

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 Moral Hazard in Lending
• Moral hazard is a problem for both the lender and the borrower in this
situation.
– If the bank anticipates moral hazard they will be less willing to lend, or demand a
higher interest rate.
• This incentive conflict is only made worse when the borrower can put
other people’s money at risk.
– Borrowers take bigger risks with other people’s money than they would with their
own.
• To control this, lenders must find ways to better align the incentives of
borrowers with the goals of lenders.
– Banks sometimes do this by requiring borrowers to put some of their own money
at risk.
– This is why banks are much more willing to lend to borrowers who put a great deal
of their own money at risk, but it also leads to the complaint that banks lend
money only to those who don’t need it. 33
 Moral hazard in financial crisis
• Regulators try to reduce the costs of moral hazard by requiring banks
to keep about 10% of their equity in case depositors want their
money back.
– But when the value of assets fall by more than 10%, (as they did in 2008)
banks become insolvent and the risk of moral hazard increases.
• In late 2008, the US treasury guaranteed short-term loans to help
banks make riskier loans – if loans payoff, the bank profits; but if they
fail, taxpayers cover the loss.
– A better solution may have been to simply give the banks more equity. The
government would own equity and thus share in the upside gain, i.e., should
the loans payoff.
• Companies that are “too big to fail,” such as AIG, take bigger risks
because they know the government will bail them out. 34
 Questions for Discussion

1. Many police officer positions require the applicant to

have a college degree even though the tasks of a police
officer rarely call upon college course material. Why
don’t police departments increase their applicant pool
by dropping this requirement?
2. Frequent flyer programs are targeted more toward
business travelers (who do not pay for their own tickets)
than leisure travelers (who do). Explain their effect on
each type of traveler. Why is there a difference?

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