Strategic Economics

Screening and the Self-selecting Menu of Contracts

Design the menu — of plans, policies, fares or contract terms — that makes customers sort themselves honestly, and learn the exact arithmetic that decides how much you must leave on the table to make the sorting work.

  • Advanced
  • 13 min total
  • 13 chapters

What decision this helps you make: How many tiers to offer, what to withhold from the cheap one, and what the expensive one can actually be priced at once you accept that the customer above always has the option of buying the tier below.

What this topic is

Screening is what the uninformed party does about hidden information: instead of waiting to be convinced, you design a menu of options built so that each type of customer, acting purely in their own interest, picks the one you intended for them. The insurance company that offers a high-deductible policy at a low premium and a low-deductible policy at a high one is not offering two products — it is asking a question it cannot ask directly, and reading the answer from which policy you buy.

Why it matters

Nearly every pricing page, insurance schedule, airline fare structure and credit offer in existence is a screening menu, and most are designed by intuition. The arithmetic is not difficult and it produces two results people find counter-intuitive: you must deliberately hand surplus to your best customers, and you must sometimes make your cheap tier worse than you could afford to make it. Both are consequences of one fact — the customer you most want to charge always has the option of buying the cheap tier instead.

Who should learn it

Pricing and packaging teams, insurance and warranty designers, lenders choosing between rate and collateral, marketplace operators setting fee tiers, and anyone whose premium segment keeps buying the entry product.

What you will understand

  • The incentive-compatibility constraint applied to a menu, and how it caps what the top tier can charge
  • Why the top tier gets efficiency and the bottom tier gets deliberately degraded — no distortion at the top
  • The exact comparison that decides whether to shrink your cheap tier or leave it alone
  • How to read a pricing page or policy schedule and tell a real cost difference from a pure fence

Prerequisites

Common misconception

"If we build the right tiers, everyone will buy the one that suits them." They will buy the one that leaves them best off, which is a different thing entirely. A customer who values your top tier at $1,250 and your entry tier at $500 will buy the entry tier at $200 unless the top one is priced at or below $950 — no matter how obviously the top tier is "for them". The second misconception is that the cheap tier should be as good as you can afford. Its quality is not a generosity decision; it is set by comparing the margin you earn on it against the discount it forces you to give everyone above it.