Adverse Selection

1. Adverse Selection Amine Ouazad Microeconomics C

2. Where are we? • Bayesian games. • a.k.a games with imperfection information. • Adverse selection. • George A. Akerlof. • Solution #1: Screening. • Joseph E. Stiglitz. • Solution #2: Signaling. • A. Michael Spence. • Common thread: • Information is imperfect. • Information is asymmetric.

3. Outline • Markets with asymmetric information • Insurance premiums • Mortgage Backed Securities • The market for used cars • Market for Lemons • Akerlof’s “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” • Empirical Evidence of the Market for Lemons.

4. 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).

5. 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. • 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 ! Bank Loan repayment Capital Conduit Cash $ Accounts receivables Originator Securitization process

6. 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.

7. 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.

8. 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?

9. Market for Lemons • Such result may be due to the simple “2-type” model.

13. B. Asymmetric information Supply and demand diagram

15. C. Symmetric information Supply and demand diagram

16. Exercises • 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? • Same question with Mortgage Backed Securities.

17. 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.

18. Markets where “Trust” is important (conclusion, page 500)

19. Next session: • Bayesian games. • a.k.a games with imperfection information. • Adverse selection. • George A. Akerlof. • Uninformed party’s solution: Screening. • Joseph E. Stiglitz. • Informed party’s solution: Signaling. • A. Michael Spence. • Common thread: • Information is imperfect. • Information is asymmetric.