An insurance company cannot observe whether a customer is high-risk or low-risk. It designs a menu: Plan A (low deductible, high premium) and Plan B (high deductible, low premium). Which customer type will select Plan B, and why?
AHigh-risk types, because the high deductible deters frequent claims
BLow-risk types, because they rarely file claims and prefer lower upfront costs
CBoth types equally, since the menu is designed to be neutral
DHigh-risk types, because they want to signal their willingness to absorb risk
Low-risk customers self-select into the high-deductible plan because they rarely file claims — the high deductible rarely costs them anything, while the low premium saves money. High-risk customers prefer the low-deductible plan because they expect frequent claims, making the high deductible too costly. The menu works as a self-selection device precisely because the two types have different preferences over this trade-off. The uninformed insurer designed the menu so that each type reveals itself through its own choice.
Question 2 Multiple Choice
In a screening equilibrium, the principal intentionally distorts the contract for the low type below the efficient quantity. Why?
ATo punish the low type for having less valuable private information
BTo reduce production costs, since low types consume less
CTo make the low-type contract unattractive to high types, preserving separation
DTo satisfy the individual rationality constraint for the high type
The distortion is not punitive — it is strategic. If the low-type contract were fully efficient, the high type might prefer it (especially since the high type is already getting more). By making the low-type option less attractive (less quantity, higher deductible, lower quality), the principal ensures the high type has no incentive to mimic the low type. The distortion is the precise cost of information asymmetry: the principal cannot observe types, so it must sacrifice some efficiency at the bottom to maintain separation.
Question 3 True / False
In a screening equilibrium, the high type typically earns information rents — meaning they receive more than they would if their type were directly observable.
TTrue
FFalse
Answer: True
This is a fundamental result of screening theory. Because the principal cannot observe types, it must make the high type's contract genuinely more attractive than the low type's to prevent the high type from mimicking the low type. This extra attractiveness constitutes an information rent — the premium the principal pays for being uninformed. Under full information (observable types), the principal would extract all surplus. Under asymmetric information, the high type retains a rent.
Question 4 True / False
In a screening equilibrium, the contract offered to the highest type is distorted below the efficient level, following the general principle that most contracts involve distortions.
TTrue
FFalse
Answer: False
This reverses the 'no distortion at the top' result. In standard screening models, the highest type receives an efficient contract — no distortion. Distortions are applied to lower types' contracts to make them unattractive to higher types. Once the highest type is already at the top of the menu, there is no type above it that needs to be deterred from mimicking it, so no distortion is needed. Distortions propagate downward, not to the top.
Question 5 Short Answer
Why must a principal designing a screening menu leave information rents to the high type, even though the principal's goal is to maximize profit by extracting as much surplus as possible?
Think about your answer, then reveal below.
Model answer: To maintain incentive compatibility: the principal must ensure the high type genuinely prefers the contract designed for it over the low type's contract. If the high type's contract were no more attractive than the low type's, the high type would misrepresent itself and pick the lower-cost option, collapsing the separation. The information rent is the minimum premium that keeps the high type from defecting. It is the price the principal pays for not being able to directly observe the agent's private information.
The information rent is an unavoidable cost of information asymmetry, not a design failure. The only way to eliminate information rents would be to observe types directly (first-best) or to offer a single pooling contract (which loses the benefits of type separation). The principal optimizes by minimizing the rent while still maintaining separation — typically by distorting the low type's contract, making it less desirable to the high type, which reduces how much extra the high type must be given.