Question

Can you provide some examples of signalling and screening in adverse selection

Answer 1

Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality - in other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party. Typically, the more knowledgeable party is the seller. Symmetric information is when both parties have equal knowledge.

Screening in economics refers to a strategy of combating adverse selection, one of the potential decision-making complications in cases of asymmetric information, by the agent(s) with less information. The concept of screening was first developed by Michael Spence and should be distinguished from signalling, a strategy of combating adverse selection undertaken by the agent with more information. Contractual arrangements originating from uniformed side of market to elicit information from informed market participants. Buyers must find ways to screen out erroneous information but allow in truthful information. These problems do not exist in markets in which products are simple and easily evaluated.

In contract theory, signalling is the idea that one party credibly conveys some information about itself to another party (the principal). Signaling can least to wasteful resource allocation and the market outcome may thus be inefficient. Signaling is an action by a party with good information that is confined to situations of asymmetric information. Screening, which is an attempt to filter helpful from useless information, is an action by those with poor information.

Examples of Screening in adverse selection:

• A consumer with a high willingness to pay for quality may choose to purchase a more expensive computer with more hard drive space over a cheaper version with less hard drive space.
• An employer seeking a salesperson may offer a contract with a low base salary supplemented with a commission when sales are made. A potential employee who privately knows he is bad at sales will self-select away from this firm while a potential employee who privately knows he is good at sales would accept such a contract.

Examples of Signalling:

• Employees send a signal about their ability level to the employer by acquiring education credentials. The informational value of the credential comes from the fact that the employer believes the credential is positively correlated with having greater ability and difficult for low ability employees to obtain. Thus the credential enables the employer to reliably distinguish low ability workers from high ability workers.
• One way a seller can signal the quality of its product is by offering guarantees or warranties. If a firm offers a warranty on a poor product, it will suffer a loss. Therefore, it is in the firm's interests to only offer a warranty on a quality product. The warranty tells potential buyers that the firm will stake money on its belief that it has a good-quality product.