SCREENING TO INDUCE INFORMATION REVELATION

When an informed party takes actions to reveal his private information, the phenomenon is called signaling. When an uninformed party takes actions to induce the informed party to reveal private information, the phenomenon is called screening Some screening is common sense. A person buying a used car may ask that it be checked by an auto mechanic before the sale. A seller who refuses this request reveals his private information that the car is a lemon. The buyer may decide to offer a lower price or to look for another car. Other examples of screening are more subtle. For example, consider a firm that sells car insurance. The firm would like to charge a low premium to safe drivers and a high premium to risky drivers But how can it tell them apart? Drivers know whether they are safe or risky, but the risky ones won’t admit it. A driver’s history is one piece of information (which insurance companies in fact use), but because of the intrinsic
randomness of car accidents, history is an imperfect indicator of future risks. The insurance company ‘might be able to sort out the two kinds of drivers by offering different
insurance policies that would induce them to separate themselves. One policy would have a high premium and cover the full cost of any accidents that occur. Another policy would have low premiums but would have, say, a $1,000 deductible. (That is, the driver would be responsible for the first $1,000 of damage, and the insurance company would cover the remaining risk.) Notice that the deductible is more of a burden for risky drivers because they are more likely to have an accident. Thus, with a large enough deductible, the low-premium policy with a deductible would attract the safe drivers, while the high-premium policy without a deductible would attract the risky drivers. Faced with these two policies, the two kinds of drivers would reveal their private information by choosing different insurance policies.

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