Our weekly explainer on economics using lessons from popular culture. In Installment 6, Ajay Devgan becomes a victim of Adverse Selection.
As we have learned in an earlier installment of Housefull Economics, Salman Khan’s movies offer us unparalleled economic wisdom. In the photo above, for example, Salman dramatically demonstrates an average variable cost curve.
But that’s not what we shall be talking about this week. Our latest lesson at the Salman School of Economics comes from the Sanjay Leela Bhansali epic, Hum Dil De Chuke Sanam, which was long enough to have two intervals (one for caramel popcorn and the other for cheese because only barbarians mix the two). In the movie, Sameer (Salman Khan) is a singer who falls in love with Nandini (Aishwarya Rai). After some song, dance and heavy jewellery, things somehow get messed up, and Nandini ends up marrying Vanraj (Ajay Devgan) in an arranged marriage. Nandini still longs for Sameer, but Vanraj is not aware of this when they get married.
The Economics Lesson
Think about marriage like a two-sided market; for this market to work efficiently, there needs to be information symmetry or completely transparency of information between the two parties transacting with each other (the transaction here being marriage). When it is absent, as in the case of Vanraj and Nandini, it leads to Adverse Selection.
Adverse selection takes place when one side in a two-sided market has more information about the other side at the time of the transaction taking place. In this case, Vanraj does not have any information about the Nandini’s affection for Sameer.
The fear of misrepresented trade with information asymmetry can prompt the parties to withdraw from future transactions, reducing the overall trade in the market and making it ‘thinner’. A thinner market usually results in less efficient trades and could potentially lead to a complete collapse, what economists often call the unraveling of a market.
The Arranged Marriage Market
Adverse selection in the arranged marriage market is not limited to Vanraj and Nandini. With information asymmetry prevailing in the market, the bride or groom seeker is not able to differentiate between a superior quality partner and an inferior quality partner (assuming a few standard desirable traits such as a good education, kindness, attractiveness etc. exist in the market). The absence of differentiation between the two results in fewer matches in the market. This leads to the superior quality partners exiting the arranged marriage market, and only the inferior quality partners continuing because of lack of choice. Thus, it can be said that they are being adversely selected. The bad here drives out the good.
Making the market work
The problem of adverse selection in the arranged marriage market has been solved to an extent by online market intermediaries (think shaadi.com) where information about both the parties is readily available to partner seekers. According to a paper, “Marital Satisfaction and Breakups Differ Across Online and Offline Meeting Venues,” by John Cacioppo, Professor of Psychology at the University of Chicago, meeting online leads to happier, more enduring marriages. It shows that couples who meet online are more likely to have greater marital satisfaction and lower rates of divorces than relationships that begin in face-to-face meetings. Barring some deviation in traits such as weight or height, partners tend to deceive each other much less on these websites as compared to face-to-face interactions.
A courtship period before marriage is another solution to ensure symmetry of information. Interestingly, in the movie, Nandini and Vanraj after spending some time together while chasing Sameer in Italy, get to know each other better. This exchange of vital knowledge makes Nandini reject Sameer and accept Vanraj as her husband.
Another case of adverse selection can be witnessed in the insurance market. People with higher risk of death are more willing to buy insurance products and pay greater premiums for policies. In that case, the insurance company charges an average price, which only high-risk consumers buy, and the company incurs financial loss by spending more on more benefits. This problem is usually solved by charging a greater premium for high-risk policyholders, thus giving the company more funds with which they can pay for the benefits. Life insurance companies ensure this by going through an underwriting process. Underwriters usually assess an applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record and lifestyle risks such as smoking; all these issues impact an applicant’s health and the company’s potential for paying a claim. A health insurance company will thus charge higher premiums for customers who smoke compared to those who don’t.
Hum Dil De Chuke Sanam aptly ends with a corny quasi-philosophical realisation from its protagonist Nandini:
Kurbaani hi sacche pyaar ka aadhaar hai. True love is sacrifice.
Meh, I scoff at these romantics.
True love, dear reader, is information.
Further reading: Economist George Akerlof investigated the asymmetry of information in the market for second hand cars in his 1970 seminal paper, ‘The Market For Lemons’. The paper laid the foundation stone for information economics, and Akerlof was awarded the Nobel Prize in Economics (2001) for it. Through the example of second-hand cars he examines how the quality of goods traded in a market can deteriorate in the presence of information asymmetry between buyers and sellers, leaving behind only “lemons,” cars that are found to be defective after they’ve been purchased.