Adverse Selection

• Individuals have different levels of capability, which they are aware of,
but always try to present themselves as having higher capability
• Firms who are trying to select employees for their firms have to be
able to separate individuals who are high on capability from those
who are low on capability
• If whatever selection process the firm choses to be able to filter high
capability individuals leads to some errors, the firm may end up
selecting low capability individuals.
• This selection of low capability individuals due to an
incorrect/inefficient selection mechanism is known as Adverse
Selection.
Information Asymmetry
• The fundamental conflict in the case of adverse selection is that
of information asymmetry
• The individual withholds the information about their true
capability
• The firm does not begin with having full information about the
individual’s capabilities
• As a result, the firm has to employ a selection mechanism to be
able to identify future performers.
Moral Hazard
• While adverse selection is a case of hidden information, there is another type of
information asymmetry known as moral hazard
• “Moral hazard is a problem that arises when one person, called the agent, is performing
some task on behalf of another person, called the principal. If the principal cannot
perfectly monitor the agent’s behavior, the agent tends to undertake less effort than the
principal considers desirable. The phrase moral hazard refers to the risk, or “hazard,” of
inappropriate or otherwise “immoral” behavior by the agent. In such a situation, the
principal tries various ways to encourage the agent to act more responsibly.”

(p. 452, Principles of Economics, 8th Edition, Cengage Learning, N. Gregory Mankiw)
Example
• If the owner of an apple orchard chooses to hire a worker for
harvesting apples, the owner may choose to compensate the
worker by paying on a per crate basis
• As a result there is a possibility that the worker harvests even
the bad apples, or apples that are not ripe enough, creating the
need for investment in monitoring costs in the form of wages for
a supervisor.
• This tendency of the worker to exploit the agreement with the
owner, thereby filling the crates with unripe apples is an
example of moral hazard.
The Taxi Driver Problem
• If you owned a fleet of cars which you planned to run as taxis, which of the
following contracts would you advertise to be able to attract the most efficient
driver?
• The driver gets a fixed salary every month, and is required to report to work every day
for a fixed number of hours, and returns all revenue from riding the taxi to the owner
(option 1)
• The driver has to pay a certain rent to the owner every month and can keep all the
revenue from riding the cars as taxis ( option 2)

• Option 2 is likely to attract the more efficient driver

• Option 1 also means, that the owner has to invest in a mechanism to monitor
how much revenue the driver is generating by installing a meter in the car.
Contd.
• This is because, the driver who is aware of their own high
capability knows that they can make “unlimited” amount of
money by taking Option 2.
• The driver who is aware of their low capabilities will choose
option 1, because they can be assured of a salary at the end of
the month.
• Therefore, the right contract acts as a self-selection mechanism,
whereby the efficient workers sort themselves into firms that
offer variable pay.
However…
• This logic assumes that all workers are risk neutral, which is not
the case. It is possible that a worker who is aware of their own
high capabilities still prefers Option 1, because they do not want
any possible scenario where they end up getting no pay. (E.g.,
due to rain, the taxi may not run)
• Secondly, the driver who chooses Option 2, may not necessarily
take good care of the car, and in the medium run end up causing
damage to the car.
Extension
• The taxi driver problem can be extended to several types of
compensation such as salespersons or CEOs.
• The CEO who is paid exclusively on a variable pay basis, may
end up instituting policies that are beneficial to them personally
in the short term, but damaging to the company in the long term
Option 1
• Why do some companies then persist with option 1?
• The organizational purpose of certain firms in not necessarily
profit.
• Public Sector organizations such as the Army, are compensating
their employees not to incentivize profit making, but to
compensate individuals for their ‘service’ to a larger cause.
• This is also applicable to other non-profits such as the NGOs.