Question

Discuss in detail the two ways (screening and signaling) in which the principal or the agent can try to resolve the problem of adverse selection. Give an example of screening and signaling and explain how the parties involved benefit from these strategies.

Answer 1

A scenario in which one individual takes an action that is harmful to another individual after an agreement has been concluded between the two individuals. The issue is that the damaged individual is unaware of the other's behavior. It is seen most frequently in the insurance industry. An insured individual is encouraged to take more risks because costs are incurred by the insurance supplier. Two associated issues arising from asymmetric information are adverse selection and the issue of the principal agent. Signaling and screening are two ways of teaching the moral hazard issue.

This issue occurs because of asymmetric information, which is when distinct individuals have distinct data. Asymmetric information happens because it is expensive to obtain data although it is useful. Some individuals are bound to discover that acquiring data is more useful or less expensive than others. They understand more, they understand less from others. If insurance companies understand less than their clients, this is probable to result in moral hazard.

Signalling refers to any activity by a party whose purpose is to ináuence the perception and thereby the actions of other parties. This presupposes that one market participant holds private information that for some reason cannot be veriÖably disclosed, and which a§ects the other participantsí incentives.

Screening can reduce the issues created by moral hazard. Screening is an effort by those with restricted data to identify indicators that suggest more comprehensive data. An insurance company may attempt to resolve moral hazard issues by screening people who are more likely to engage in dangerous conduct from those less probable. Traffic tickets are often used as screening indices for automotive insurance. Screening may also be incorrect, of course. A healthy driver may have the same amount of traffic tickets as a poor driver, with a small danger of an accident.

The issue with the principal agent is a disconnection or conflict between the "principal"'s goals and objectives and those of the "officer" permitted to represent the main. The issue occurs because the principal lacks precise data about the agent's conduct. This issue is prevalent in businesses when owners (principals) employ executives (agents) to operate the business. However, the officials may create choices that benefit themselves (greater wages, fringe benefits) that are unknown to the owners (profit) and not in their best interests.