Two markets that regularly make use of screening are the labor market and the provision of insurance. Adverse selection can limit the quality of workers hired by employers in the labor market and moral hazard creates inefficiency in the provision of insurance. Low information employers often screen potential employees through aptitude tests, grade point averages, and school affiliations. Low information insurance providers often screen customers using historical records and demographic characteristics. In both cases, those with less information use small bits of easily obtained information to indicate more complete information.

Screening can be an effective, but imperfect way of addressing asymmetric information. Unfortunately because screening by its very nature is based on limited information, it can let low quality products slip into the high quality group (in the case of adverse selection) and it need not accurately indicate a change in behavior (in the case of moral hazard). If screening fails to indicate accurate information, then it doesn't work.

Signalling is a related method of addressing the problems of asymmetric information. Signalling arises when those with more information provide indicators to differentiate product quality. Whereas screening is used by those with less information, signaling is undertaken by those with more.

Asymmetric Information

Screening is used when asymmetric information leads to adverse selection and moral hazard.

• Adverse Selection: One important consequence of asymmetric information is adverse selection, which arises when the lack of information limits the quality of goods exchanged. Because buyers have less accurate information about the quality of goods, they are likely to offer a lower price, which discourages sellers from offering higher quality goods. Screening is used in labor markets with adverse selection


• Moral Hazard: Asymmetric information also leads to moral hazard, which arises when one person makes a decision that harms another. The best example is found with insurance in which an insured person undertakes risky behavior knowing the insurance provider incurs the cost. The problem is that the insurance provider is unaware of the risky actions of the insured person. Screening can be used to inform the insurance provider about the change in behavior.

Common Screening Techniques: Labor

• Aptitude Tests: Scores achieved by potential employees on standardized or specialized tests are often used by employees to screen out higher quality workers from lower quality ones. Presumably these test scores indicate worker productivity.


• Grade Point Average: Similar to aptitude tests, grade point average achieved through years of schooling is also used to differentiate among potential employees. In contrast to a single test, grade point reflects performance over several years.


• School Affiliations: Employers also look to quality of the school a student attends as a screening technique. Presumably higher quality schools produce higher quality students and workers.


• Extra Curricular Activity: Another screening technique is noncourse related clubs and other activities. Those who undertake and do well in these activities are usually presumed to possess desired work qualities.

Common Screening Techniques: Insurance

• Historical Record: Insurance provides use past behavior as an indication of risk and future behavior. A driver with a history of car accidents is more likely to have accidents in the future. A person who has had health problems in the past is more likely to have health problems in the future.


• Demographic Characteristics: Another screening technique used by insurance providers is demographic characteristics. For example, a young male between the ages of 16 and 19 might be more likely to have a car accident than a middle-aged woman between the ages of 45 and 50.

Incorrect Screens

A excellent driver, who will never again have an accident, might have had the misfortune of making a couple of mistakes and exist in the "wrong" demographic group. A very bad driver, in contrast, might be in the "right" demographic group and be extremely fortunate to have avoided previous accidents.

Signalling

Whereas screening is a low cost means of used by those with low information to find out more, signalling works in the opposite way. It is a means by which those with more information pass along information from those with less.

When asymmetric information limits the exchange of higher quality products, such as that illustrated by the market for lemons, those who supply these products seek to provide low cost bits of information to the buyers. Because the buyers cannot justify the expense of searching out the information, the sellers offer low cost information signals through such things as advertising, brand name recognition, warranties, and guaranties.