Adverse Selection
Amine Ouazad
Microeconomics C
Where are we?
1. Bayesian games.
– a.k.a games with imperfection information.
2. Adverse selection.
– George A. Akerlof.
3. Solution #1: Screening.
– Joseph E. Stiglitz.
4. Solution #2: Signaling.
– A. Michael Spence.
•
Common thread:
– Information is imperfect.
– Information is asymmetric.
Outline
1. Markets with asymmetric information
– Insurance premiums
– Mortgage Backed Securities
– The market for used cars
2. Market for Lemons
– Akerlof’s “The Market for Lemons: Quality
Uncertainty and the Market Mechanism.”
3. Empirical Evidence of the Market for Lemons.
Asymmetric Information:
Insurance premiums
(healthcare/car insurance)
• Probability of a medical condition is p. Cost of medical
treatment is c. Fixed cost of handling the patient is FC.
Medical insurance covers x percent of the medical costs.
• A profitable insurer sets a premium?
• Role of competition in the healthcare industry?
• Solution? Forecasting exercise.
– Preexisting medical conditions. (Stronger problem with age).
– Age, gender, genetic determinants.
• Unobservability of the probability of a medical condition.
– Legal constraints: use of some variables is constrained by law.
– Technological constraints: variables cannot be observed using current
technology or due to contracting problems (sport, diet).
Mortgage Backed Securities
• Borrower has a risk of default of p, receives a
loan l, and makes mortgage payments m. Value
of the collateral is C.
• Value of the mortgage to the originator?
• Observability of the risk of default?
– Credit score (FICO Score of the applicant)
– Income, geographic location.
• Value of the collateral?
– Use of Zillow.com, Multiple Listing Services, Case Shiller
survey.
Bank
Loan
repayment
Capital
Conduit
Cash $
Accounts
receivables
Originator
Securitization process
• Unobservability of the risk of default:
– Legal constraints: gender and race cannot be used in
pricing mortgages. But interest rates are shown to
depend on them (negotiation process).
– Technological constraint: relevant information is not
available – income is transitory or permanent.
• Credit score is not sufficient to characterize the
risk of default !
Asymmetric information,
adverse selection, and the financial crisis.
“They structured like mad and travelled the world, and worked their tails to make
some lemonade from some big old lemons.”
- Former head of Goldman Sachs’ mortgage department in an internal email released
during the U.S. Senate Permanent Subcommittee on Investigations hearings of April
27, 2010.
2. Market for Lemons
Homogeneous goods | observables
vs Unobservable quality.
• Goods of a grade, e.g. commodities.
• Goods of different grades/qualities, e.g. used cars, wine, mortgages/loans
(Stiglitz: banks as holders of information about consumers/collaterals),
some agricultural products.
– Typically observable information is not sufficient to define the product’s
quality.
• Used cars?
– Maintenance records. Electronic record of driving habits.
– Visual inspection.
• Old common law doctrine of caveat emptor.
– Buyer required to perform due diligence.
– But experience needed. Seller can also tamper with odometer, etc.
– FTC’s Trade Regulation Rule concerning the Sale of Used Motor
Vehicles.
Market for Lemons
• Good is a good car with probability q.
• A lemon with probability 1-q.
– Also proportion of lemons and good cars.
• Asymmetric information between seller and buyer?
– Valuation of a car for the buyer/the seller?
• One single price?
• What is the equilibrium of the market?
Understand this in the context of
• Healthcare? Mortgage Backed Securities? Reverse mortgages?
Life insurance?
Market for Lemons
• Such result may be due to the simple “2-type”
model.
B. Asymmetric information
Supply and demand diagram
C. Symmetric information
Supply and demand diagram
Exercises
1. Write the “market” for lemons for insurance
premiums using the previous framework.
– Discuss the assumption of risk neutrality. Why
doesn’t a voluntary healthcare market collapse?
2. Same question with Mortgage Backed
Securities.
Development of institutions and mechanisms
• Institutions developed in reaction to the adverse
selection problem:
– Mandatory health insurance. Mutualization of risk, where
some individuals overpay and others underpay.
• Britain, France, Spain, Austria, Belgium, Germany.
• US: Patient protection and affordable care act (2010), with
mandatory health insurance (but little enforcement). Before,
typically employer-provided health insurance plans.
– “Premium” used cars guaranteed by the dealer, with
extended guarantees.
➭Signaling session #4.
– Menus of choices such that individuals self-select into the
choices.
➭Screening session #3.
Markets where “Trust” is important
(conclusion, page 500)
Next session:
1. Bayesian games.
– a.k.a games with imperfection information.
2. Adverse selection.
– George A. Akerlof.
3. Uninformed party’s solution: Screening.
– Joseph E. Stiglitz.
4. Informed party’s solution: Signaling.
– A. Michael Spence.
•
Common thread:
– Information is imperfect.
– Information is asymmetric.