Screening (economics)

Screening in economics refers to a strategy of combating adverse selection, one of the potential decision-making complications in cases of asymmetric information, by the agent(s) with less information. The concept of screening was first developed by Michael Spence (1973), and should be distinguished from signalling, a strategy of combating adverse selection undertaken by the agent(s) with more information.

For purposes of screening, asymmetric information cases assume two economic agents—which we call, for example, Abel and Cain—where Abel knows more about himself than Cain knows about Abel. The agents are attempting to engage in some sort of transaction, often involving a long-term relationship, though that qualifier is not necessary. The "screener" (the one with less information, in this case, Cain) attempts to rectify this asymmetry by learning as much as he can about Abel.

The actual screening process depends on the nature of the scenario, but is usually closely connected with the future relationship.

In education economics, screening models are commonly contrasted with human capital theory. In a screening model used to determine an applicant's ability to learn, giving preference to applicants who have earned academic degrees reduces the employer's risk of hiring someone with a diminished capacity for learning.

Examples

• Second degree price discrimination is an example of screening whereby a seller offers a menu of options and the buyer's choice reveals his private information. For example, a business traveler that refuses a weekend stay over reveals to the airline that he is in fact a business traveler and therefore has a higher willingness to pay than a leisure traveler. As another example, a consumer with a high willingness to pay for quality may choose to purchase a more expensive computer with more hard drive space over a cheaper version with less hard drive space.
• An employer seeking a salesperson may offer a contract with a low base salary supplemented with a commission when sales are made. A potential employee who privately knows he is bad at sales will self-select away from this firm while a potential employee who privately knows he is good at sales would accept such a contract.

Contract theory

In contract theory, the terms "screening models" and "adverse selection models" are often used interchangeably. An agent has private information about his type (e.g., his costs or his valuation of a good) before the principal makes a contract offer. The principal will then offer a menu of contracts in order to separate the different types. Typically, the best type will trade the same amount as in the first-best benchmark solution (which would be attained under complete information), a property known as "no distortion at the top". All other types typically trade less than in the first-best solution (i.e., there is a "downward distortion" of the trade level). Optimal auction design (more generally known as Bayesian mechanism design) can be seen as a multi-agent version of the basic screening model. Contract-theoretic screening models have been pioneered by Roger Myerson and Eric Maskin. They have been extended in various directions, e.g. it has been shown that in the context of patent licensing optimal screening contracts may actually yield too much trade compared to the first-best solution. Applications of screening models include regulation, public procurement, and monopolistic price discrimination. Contract-theoretic screening models have been successfully tested in laboratory experiments and using field data.

See also

• Adverse selection
• Joseph E. Stiglitz