An insurer cannot observe whether applicants are high-risk or low-risk. It offers two contracts: Contract A (high premium, full coverage) and Contract B (low premium, high deductible). A high-risk applicant prefers A, a low-risk applicant prefers B. What has the insurer accomplished without asking anyone to disclose their risk type?
ANothing useful — the insurer still cannot verify which applicants are actually high-risk
BIt has induced self-selection: each type reveals their private information through their contract choice
CIt has screened out high-risk applicants by making Contract A unattractive to them
DIt has eliminated moral hazard by aligning premiums with expected claims
This is the central mechanism of screening. The insurer never asks 'are you high-risk?' — that would be cheap talk. Instead, the menu is designed so each type's incentive-compatible choice reveals their type through revealed preference. High-risk applicants, expecting many claims, rationally choose full coverage even at higher cost. Low-risk applicants, who rarely claim, prefer lower premiums. The choice itself is the signal. Note that option A misidentifies the goal: the insurer gains valuable information precisely because the choice is informative, even if it cannot be independently verified.
Question 2 Multiple Choice
In a screening model, the low-risk insurance customer ends up with a contract offering less than full coverage — even though full coverage would be efficient for them under symmetric information. Why does the principal deliberately distort the low-risk contract?
AThe insurer is unaware that these customers are low-risk, so offers them a cautious contract
BFull coverage for low-risk customers would encourage them to take more risks (moral hazard)
COffering the low-risk type less than full coverage makes that contract unattractive to high-risk types who might otherwise mimic them
DRegulators require that deductibles be included in all insurance contracts
This is the cost of asymmetric information: the principal distorts the low-risk (bottom-type) contract to prevent high-risk (top-type) customers from claiming low-risk status. If low-risk customers received full coverage at low premiums, high-risk customers would prefer that contract too — it would fail the incentive compatibility constraint. By reducing coverage for low-risk types, the principal makes the contract unattractive to high-risk types who value comprehensive coverage highly. The distortion is not about moral hazard (that is a separate problem) but about deterring mimicry.
Question 3 True / False
In a two-type screening model, the high type receives a distorted contract in order to prevent the low type from mimicking them.
TTrue
FFalse
Answer: False
It is the LOW type's contract that is distorted, not the high type's. The 'no distortion at the top' result says the highest type always receives their first-best contract — distorting it would only reduce the principal's profit without relaxing any incentive constraint. The low type's contract is distorted because: (1) the distortion makes the high type unwilling to pretend to be the low type, and (2) the principal sacrifices efficiency for the low type to reduce the information rent that must be left to the high type. The high type gets the best deal; the low type pays the price of asymmetric information.
Question 4 True / False
A screening mechanism can recover some surplus compared to no mechanism at all, but never achieves the first-best outcome possible under full information.
TTrue
FFalse
Answer: True
True. Screening extracts partial information and allows the principal to offer differentiated contracts that are better than offering a single pooling contract. But it never achieves first-best efficiency because: (1) the low type's contract must be distorted away from first-best, and (2) the high type must receive an information rent — surplus beyond their outside option — to prevent them from claiming to be the low type. The first-best would require observing types directly; screening is a second-best mechanism that trades off efficiency losses for information gains.
Question 5 Short Answer
Why must the principal leave an 'information rent' to the high type in a screening model, and what happens if the principal tries to reduce it to zero?
Think about your answer, then reveal below.
Model answer: The information rent is the extra surplus the high type receives above their participation constraint — the payoff they would get by accepting their designated contract versus their outside option. It exists because the high type's contract must be good enough that the high type prefers it to the low type's contract (incentive compatibility). If the principal tries to reduce this rent to zero by lowering the high type's payoff, the high type would prefer to claim to be the low type and take that contract instead. The only way to eliminate the rent entirely is to make both types' contracts identical — a pooling equilibrium that sacrifices all informational benefit of the menu.
Information rent is the price of private information. The principal cannot extract all surplus from the high type without violating the IC constraint. The tradeoff is between extracting more rent from the high type (requiring more distortion of the low type's contract) and reducing distortion (but leaving more rent to the high type). The optimal mechanism balances these two costs. This is why screening is always second-best: asymmetric information forces the principal to leave value on the table.