Solutions to Informational Problems: Videos & Practice Problems

Signaling and screening are key methods to address information asymmetry in transactions. Signaling involves the informed party revealing private information, such as a car salesman offering a warranty to indicate a car's quality. Screening, on the other hand, is the uninformed party's action to elicit information, like insurers using high deductibles to filter out risky policyholders. Employers can also screen employees through commission-based pay, incentivizing hard work and reducing shirking. These strategies help mitigate adverse selection and moral hazard, enhancing market efficiency and informed decision-making.

Solutions to Informational Problems:Signaling

Alright, so now let's discuss some of the solutions to informational problems like adverse selection and moral hazard. The first solution is signaling. We might have mentioned signaling before in another video, but let's go over it again here. Signaling is an action by the informed party. The informed party is going to try and reveal their private information. They have some private information and they're going to try and reveal it to the uninformed party, to try and get rid of this information asymmetry. When we don't have the same information, it makes it a little tougher to do the transaction. So let's see how signaling can solve some of our problems here. Let's go back to that used car sale. The informed party in this case was the salesman, right? The salesman knew about the condition of the car. And when you walked in to buy the car, you didn't know that same information, right? You didn't know if it was going to be a good car or not, but what can the salesman do to signal to you that it's a good car? They can provide a warranty. If the salesman provides a warranty on the used car, now you're going to feel more comfortable purchasing it. Because if something is wrong with the car, if it ends up being a lemon, you can bring it in and they'll repair it, they'll replace it. You have this warranty, protecting you from a lemon. And this signals from the salesman too because if the salesman truly has a good car, they're going to want to provide a warranty. Because if it's a good car, they're not going to have to replace anything, they're not going to have to repair the car under the warranty because it's a good car. So the salesman, knowing they have a good car, can signal to the purchaser by offering this warranty. So the signal is the warranty that this is a good car.

How about on a job application? Let's think about a job application. The informed party in this case, when you apply for a job, they don't really know much about you. You're showing up, you just show up to the job, hey, I can make pizzas, right? Well, the informed party is the applicant. The job applicant is going to be our informed party because they know more about themselves, how hardworking they are, how good they are at their job, and their secret is how good they are. And their secret might be that hey, I'm smart. I'm a smart person. And how do we signal to employers that we're smart? We signal maybe with a college degree. By having a college degree on a resume, it signals to them, hey, they were able to get through college, they got a good degree, so they are probably smart. This college degree acts as a signal to the employer who doesn't know much about you. We're signaling to them how smart you are. So there's how signals can help relieve the problems of information asymmetry. Alright, let's pause here and then we'll continue with screening.

Solutions to Informational Problems:Screening

Alright, another way we can solve information asymmetry problems is with screening. This is an action by the uninformed party to induce the informed party to reveal their information, right? Notice the difference here between screening and signaling. Signaling was where the informed party is trying to reveal their information, so they're the ones taking the action. In screening, it's the uninformed party taking the action. They're trying to get the informed party to reveal some of their private information. Let's start here with health insurance. In this case, the uninformed party is the insurer. They don't know how healthy you are. The secret is the riskiness of the policyholders. How many health problems they have that they didn't tell the insurance company. How can they screen these risky policyholders? Well, they can offer a deductible plan. What does this deductible plan do? A deductible is where you have to pay an out-of-pocket cost. You pay these premiums monthly for your health insurance, you might have to pay $100, $200, $300 a month to have health insurance, but then if something really bad happens, you have the deductible. The deductible could be $5,000, and you would have to pay, let's say, you break your leg, you would have to pay the first $5,000 and the insurance would cover the rest of it. This deductible is going to screen out the risky people. Because the risky people don't want to pay this big out-of-pocket cost and they expect to use the insurance more. They're expecting risky things to happen, they have health problems, they're expecting to use the insurance more. By having this high deductible, they're going to essentially screen themselves out. Let's see two different plans here. Plan 1 could be a plan with a low premium and a high deductible. And plan 2 could be the opposite where we have a higher premium and a low deductible. Think about that deductible. If we go and have an injury or something that takes us to the hospital, we're going to have to pay this huge out-of-pocket amount. And risky people would expect to have to pay that deductible. Because they're going to the hospital or they're expecting to go to the hospital, then they would expect to pay the deductible. So they don't want that. They would rather have a low deductible when they're risky because they don't want to have those out-of-pocket costs. What's going to happen is that this bottom plan is going to attract the risky people and this top plan will attract the non-risky people. Because they have the lower premium, so they still want to be covered, but they're not expecting to have to pay this deductible, maybe they're going to use the doctor's appointment here and there, but they're not expecting a big catastrophic kind of spending of money here. This is how screening can happen.

The uninformed party, the health insurance company was able to screen the patients. They were able to break them up into two groups and have the riskier group have plan 2. They were able to screen and get private information based on how the people buying the insurance chose which plan they wanted to buy. Now let's discuss the employer-employee relationship. We talked about this one a bit too, where the uninformed party is going to be the employer. The employer doesn't know how hard you're working. They don't know whether or not you are slacking off. Another word that they love to use for slacking off in economics is 'shirking'. Shirking is the same thing as slacking off; it's just the word they like to use. So you might see that on the test and wonder, 'shirking, what is that?' That's just slacking off. How can an employer screen these slacking employees? Well, the first thing they could do is offer commission-based pay. Think about a sales position. If we offered a salesman a fixed amount of salary, they were going to get a fixed amount, let's say $50,000 a year no matter how many sales they made, well they wouldn't really be incentivized to really push out sales. Since they're going to make the same amount anyway, they might just slack off. They're going to be shirking. By offering commission-based pay, they have the incentive to work harder, make a lot of sales to increase their commissions. Another way they can do it is with year-end bonuses. With year-end bonuses, they're basically in essence withholding some of the payment to the employee. By having this year-end bonus, they're basically dangling this carrot in front of the employee saying, 'Hey, if you work hard you're going to get this extra money.' So now the employee has the incentive to work harder and to not shirk. They're screening away these shirking employees by offering commission-based pay or year-end bonuses. With commission, you would imagine that a slacking-off kind of employee wouldn't want a commission-based pay. They'd rather settle for some kind of fixed pay so that they don't have to work as hard. So this commission-based pay is going to get those aggressive salesmen that want to work hard and will not be shirking. Cool? This screening helps the uninformed party get information out of the informed party. That's some ways that we can help solve our informational problems, adverse selection, and moral hazard through signaling and screening. Let's go ahead and move on to the next video.

Jen has a family history of medical problems, which leads her to purchase health insurance. Her friend, Mark, has a healthier family, decides not to buy health insurance. This is an example of:

• A. Moral hazard
• B. Adverse selection
• C. Signaling
• D. Screening

Answer: (B)

Safe Times Insurance requires a medical examination for all applicants for medical insurance. Those with significant preexisting conditions are charged more. This is an example of:

• A. Moral hazard
• B. Adverse selection
• C. Signaling
• D. Screening

Answer: (D)

Here’s what students ask on this topic:

What is signaling in economics and how does it solve informational problems?

Signaling in economics refers to actions taken by the informed party to reveal private information to the uninformed party, thereby reducing information asymmetry. For example, a car salesman might offer a warranty to signal the quality of a used car. The warranty indicates that the car is likely in good condition, as the salesman would not want to incur repair costs if the car were faulty. Similarly, a job applicant might use a college degree to signal their intelligence and capability to potential employers. By providing these signals, the informed party helps the uninformed party make better decisions, mitigating issues like adverse selection and moral hazard.

How does screening work as a solution to information asymmetry?

Screening is a method used by the uninformed party to induce the informed party to reveal their private information. For instance, health insurers might offer plans with high deductibles to screen out risky policyholders who expect to use the insurance more frequently. Risky individuals are less likely to choose high-deductible plans due to the high out-of-pocket costs. Similarly, employers might use commission-based pay to screen out employees who are likely to shirk. Employees who prefer fixed salaries may not be as motivated to work hard, whereas those who opt for commission-based pay are likely more driven and productive. Screening helps reduce information asymmetry by eliciting private information from the informed party.

What are some examples of signaling in the job market?

In the job market, signaling can take various forms. One common example is the use of educational qualifications, such as a college degree, to signal a candidate's intelligence, skills, and work ethic to potential employers. Another example is professional certifications, which indicate specialized knowledge and competence in a particular field. Additionally, past work experience and references can serve as signals of a candidate's reliability and performance. These signals help employers make more informed hiring decisions by reducing the information asymmetry between them and the job applicants.

How do health insurers use deductibles to screen policyholders?

Health insurers use deductibles as a screening mechanism to differentiate between low-risk and high-risk policyholders. A deductible is an out-of-pocket cost that policyholders must pay before the insurance coverage kicks in. By offering plans with high deductibles, insurers can screen out high-risk individuals who expect to use the insurance more frequently and would prefer plans with lower out-of-pocket costs. Low-risk individuals, who do not anticipate frequent medical expenses, are more likely to choose high-deductible plans. This screening process helps insurers manage risk and reduce adverse selection by attracting healthier policyholders.

What is the difference between signaling and screening in addressing informational problems?

Signaling and screening are both methods to address informational problems, but they involve different parties taking action. Signaling is an action taken by the informed party to reveal their private information to the uninformed party. For example, a car salesman offering a warranty to indicate the quality of a car. Screening, on the other hand, is an action taken by the uninformed party to induce the informed party to reveal their information. For instance, health insurers offering high-deductible plans to screen out risky policyholders. Both methods aim to reduce information asymmetry, but they differ in who initiates the action.