Chapter 8: Adverse Selection

Overview

I refuse to join any club that would have me for a member.

Groucho Marx

Let’s say that after reading this book you feel compelled to learn more about business, and so you apply to 10 MBA programs. You get into nine but are rejected by one. Tragically, you most wanted to attend the school that rejected you. Bad karma? No, adverse selection. Adverse selection manifests when you attract those with whom you least wish to interact.

You probably want to attend the most exclusive MBA program that will have you. An exclusive school, by definition, is difficult to get into. Therefore, the lower a school’s admissions standards, the less you should want to attend.

What would it signal if an MBA program really wanted you? It might show that the school believed you were a good match for its program. More likely, however, the school believed that admitting you would significantly increase the quality of its student body. Of course, if you were far better than the program’s average students, you should probably look elsewhere. This means that if you were a bad enough student, you would not want to attend any school that would admit you, for by admitting you, the school signals its exceptionally low quality.

I attended a law school that admitted me from its waitlist long after it had made most of its admission decisions. Of all the schools that accepted me, it considered me the least worthy. This law school therefore was obviously the best that I could get into, and naturally the one that I decided to attend. When adverse selection applies, you should want most those who least want you.

From the viewpoint of a college, the students most likely to accept an offer of admittance are the ones the school probably least wants. Imagine that a college randomly chooses 100 high school seniors and guarantees them admittance. Which students would be most likely to accept the offer? The ones with really high SAT scores? Unfortunately, no; they would be the students who wanted to attend college but couldn’t get into any other college. They would be the students whom the college probably least desired.

Employers also need to worry about adverse selection. Imagine that your company advertises to hire a computer programmer for $80,000 a year. Twenty people apply for the position. Which of these twenty would most want the job? The answer is, obviously someone whose talent would ordinarily bar him from making anywhere near $80,000. Adverse selection would manifest because the least qualified person would have the greatest desire to get hired. The person you would most want to hire would probably not even bother applying because she would be such a talented programmer that she could easily make more that $80,000.

To combat the appearance of adverse selection, a job candidate should avoid appearing overeager. Rather, a candidate should consider playing hard to get and let his prospective employer believe that he has many attractive offers. If a job candidate really is hard to get, then he is not desperate, and an employer doesn’t have to worry about adverse selection.

Hidden information causes adverse selection. Because of hidden information, players often need to rely on signals. To see the value of signals, consider the following silly example: Your boss wants to reward you and punish either Rachel or Fred. He says you can have all the money in either Rachel or Fred’s wallet. Your boss won’t completely reveal the contents of each person’s wallet, but he does say that Rachel’s wallet contains 14 bills while Fred’s contains only 9. Assuming you know nothing else about Rachel and Fred’s wallet, which do you choose? I imagine you would pick Rachel’s because it has more bills. Of course, you care about the total dollar value of the bills, not the total number of bills. While you can’t directly observe what you care about, the number of bills in each wallet does provide you with some information about the total value of the bills. Thus, although this information is, by itself, irrelevant to you, it would still help you make your decision because on average, the more bills a person carries the more money he has. Consequently, the total number of bills provides a signal as to the value of each wallet. This signal might be faulty because Fred’s wallet could easily contain more money than Rachel’s does. For a signal to be useful, however, it need only be right on average.

When you consider hiring someone, you don’t have complete information about his qualities, so you must guess based upon signals. A candidate’s desire to work for you provides a useful signal about her quality. On average, job candidates who would be the happiest with your salary would be the candidates who are of the lowest quality since the marketplace values them the least.

Adverse selection is a powerful force in the universe that illuminates many strategies such as avoiding telemarketers offering investment advice.