Imagine you own an insurance company—your company provides insurance coverage to car drivers. A driver comes to you one day, and you decide to give them premium insurance coverage for a certain price. After a week, the car driver runs into an accident and causes $10,000 worth of damage to the car, which becomes a massive bill your company has to take care of. Did you know that this cost could have been prevented by screening?
Screening ensures that another party involved in a deal reveals all the information about themselves. In the case of a car accident, the driver would have to reveal that they are not very skilled and have had an accident before so that you could have charged an insurance price tailored to their risk level.
Read on to learn more about screening and how it enables the efficient allocation of resources!
Screening Definition
The definition of screening refers to the actions of an uninformed party to push the informed party to reveal private information. Often there are inefficiencies in markets that are caused by asymmetric information. Screening helps the market become more efficient by making information available to everyone involved in a transaction.
Screening is the practice whereby an uninformed party takes action to cause the informed party to reveal information.
Asymmetric information occurs when a party involved in a transaction has more information than the other party. This information affects the transaction.
We have a detailed explanation of Asymmetric Information. Feel free to check it out!
In the stock market, screening is a very important factor that enables much more efficient and safe financial markets. The process of screening in the stock market assures that companies are disclosing all the necessary information pertaining to their financial health. This then enables investors to invest in companies that provide high returns and are financially healthy.
A person interested in purchasing a secondhand vehicle may request that an auto mechanic inspect the car before the sale. If the vendor doesn't agree to comply with this request, it may suggest that the price asked isn't justified by the car's state. As a result of this, the buyer may choose to make a lower offer or search for another vehicle.
Screening Examples
There are many screening examples. Let's consider an auto insurance company as a screening example.
Take, for instance, a company that deals in auto insurance. The company aims to charge cheap premium deals to those drivers who have a lower risk of getting into an accident and charge higher premiums to those drivers who have a higher risk of getting into an accident. How does the company measure the risk of a person getting into an accident?
Instead of taking the driver's word for it, the insurance company conducts extensive research on the driver's background and the amount and types of accidents they've had in the past. In this way, it determines the risk that the driver has of getting into an accident. The process of doing the background check for the driver and estimating a risk associated with them is known as screening.
The screening process then enables the company to differentiate between drivers and offer insurance packages accordingly. Screening allows the company to increase its profit and reduce costs.
If the driver is risky, in the event of an accident, they may already have paid the insurance company enough to cover the expense. However, if it wasn't for screening, and the insurance company had no idea of the risk associated with the driver, it would have resulted in a much higher cost for the company.
Screening Techniques
Screening techniques depend on the type of industries in which they are being used. The screening techniques used in the labor market, for example, differ from those of insurance companies. Some of the most common screening techniques include historical records, health records, aptitude tests, college background, and grade point average.
Figure 1 shows the five main important types of screening techniques.
- Historical record. When assessing a client's degree of risk and the likelihood that they may engage in dangerous conduct in the future, insurers consider both the client's current behavior and the client's history of activity. For instance, if a customer has a record of being involved in a number of automobile accidents in the past, there is a high probability that the client may be in an accident in the future.
- Health record. Health records are used as a screening technique by health insurance providers. When considering whether or not to provide health insurance coverage to a customer, the insurer will be interested in learning about the customer's current health status and the types of diseases the customer suffers from.
- Aptitude tests. Aptitude tests are one of the most common techniques employers use to screen potential candidates. Employers often resort to aptitude tests as one of the most effective screening tools to choose qualified applicants from a larger group of people looking for work.
- College background. When college graduates apply for jobs with little experience, companies will use their college background as a screening technique. The college background will help companies determine whether candidates have acquired the skills required for the job throughout their education.
- Grade point average (GPA). The grade point average is a common screening technique used not only by employers but also by colleges. Students who have had varying levels of success during their time in school are likely to have lower averages than students who have been among the school's top scorers and who have maintained a high level of academic achievement. This reveals information about the student's likelihood to maintain high performance in the company or the college they apply to.
Screening vs. Signaling
The main difference between screening vs. signaling is that signaling occurs when an informed party reveals private information. On the other hand, screening occurs when an uninformed party induces the informed party to reveal information.
Signaling occurs when the informed party reveals private information.
Signaling is very similar to screening, with the key difference being that the agent with all of the information decides to act first to single themselves out as a good agent. That is to say, when signaling occurs, the information is revealed without the need to have another party induce the informed party to disclose information.
The labor market is one of the most common examples of signaling. Individuals fill most occupations in the labor market that require some qualifications with at least some level of postsecondary education.
However, except for professions in the sciences and the medical area, the credentials these individuals possess are often irrelevant to the job they are doing; an example of this would be a financial analyst with a degree in philosophy.
That's because a financial analyst can get the necessary capacity for analysis and logical thinking despite receiving a degree in philosophy. The degree is a signaling technique that the individual uses to reveal information on the type of skills they have.
Obtaining a degree is a method of signaling; it demonstrates that you possess particular qualities, whether innate or developed through experience, that has enabled you to attain that level of education and then complete it.
Similar to screening, signaling reduces asymmetric information. That's because the party is revealing the information; therefore, none of the parties have more information than the other. This enables a much more efficient allocation of resources.
If you want to learn more about Signaling, check out our article!
Advantages of Screening
One of the main advantages of screening is that it reduces asymmetric information in the markets, leading to efficient resource allocation.
Asymmetric information occurs when one of the parties involved in a transaction has access to more accurate information than the other side has.
There are several fields in which some participants in a transaction will always have more information than others involved in the same transaction.
For instance, if we take the example of a sale transaction, the seller will almost certainly have more information than the buyer. This is because sellers typically deal with the same product or a range of products, giving them more excellent product knowledge than some buyers.
There are two main situations that occur as a result of asymmetric information, which are moral hazard and adverse selection as seen in Figure 2 below. Screening helps prevent both of these situations.
A moral hazard occurs when one party participates in a dangerous event while also being aware that it will be shielded from the risk and that the other party will be responsible for bearing the expense of the risk.
It occurs when both parties have inaccurate or partial knowledge about the other person.
In the context of the financial market, the borrower may participate in undesirable behaviors from the perspective of the lender since they make it less likely that the borrower would pay back a loan that has been extended to him.
It takes place when the borrower is aware that another party will be responsible for paying for the error that they make.
Clients with a history of engaging in such activity may be denied a loan or offered an alternative loan with a higher interest rate better suited to their elevated level of risk if the loan provider recognizes such customers and screens them throughout the registration process.
Check out our article if you want to learn more about Moral Hazard!
Adverse selection occurs when participants in a transaction are able to exploit the information they possess about a product to optimize their own outcomes.
When an applicant gets accepted for insurance at a cost lower than their actual degree of risk, this practice is known as adverse selection in the insurance business.
For example, a person with a nicotine addiction is charged the same premium for health insurance as a person who does not have a nicotine addiction. Of course, the person who has nicotine addiction bears more risk. Therefore, the insurance company incurs a loss in such a case.
By screening, the insurance provider could prevent such a situation from happening.
Check out our article if you want to learn more about Adverse Selection!
Screening - Key takeaways
- Screening is the practice whereby an uninformed party takes action to cause the informed party to reveal information.
- The main difference between screening vs. signaling is that signaling occurs when an informed party reveals private information.
- Some of the most common screening techniques include historical records, health records, aptitude tests, college background, and grade point average.
- One of the main advantages of screening is that it reduces asymmetric information in the markets.
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