Insurance or Signals? An Experimental Analysis of Behaviour Under Risk
Posted: 3 Nov 2004
The actions that individuals take to minimize the impact of risk generally involve cost. Thus, the actions that provide insurance often provide signals with regard to the individuals' underlying quality characteristics. Since the same action affects risk exposure and signals quality, individual objectives are difficult to disentangle. In this paper we use an experimental approach to distinguish between the two distinct objectives served by the same action.
A sample of 528 students taking a single course were provided with 4 optional pre-final tests. Increasing the number of pre-final tests reduced the weight of the mandatory final exam in the overall course grade. The literature on insurance markets predicts that poorer students would take more pre-final tests (tests as insurance); and further that a greater number of pre-final tests would, ceteris paribus, cause final exam performance to decline. However, the literature on market signaling predicts that better students would take on more pre-final tests (tests as signals), and hence a greater number of pre-final tests would be associated with a better final performance. The results provide strong support for the signaling hypothesis. This suggests that individuals' choices in risky situations are likely to have both direct (risk alleviation) and indirect (signaling) aspects.
Keywords: adverse selection, moral hazard, choice under risk
JEL Classification: C91, D81, D82, G22
Suggested Citation: Suggested Citation