Search, adverse selection, and the services of financial experts

Financial Services Review,  Winter 2003  by Ligon, James A

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The study is organized as follows. section 2 presents the assumptions underlying the model. section 3 develops the demand and revenue functions. section 4 presents the comparative statics results regarding the likelihood of skill enhancement by planners. section 5 discusses the implications of the model. section 6 summarizes and concludes the study.

2. The model

Assume that in the market there are N risk neutral firms providing planning services, M consumers (who may be risk averse) consuming these services, and nature. ' Henceforth, I will refer to the services being provided as financial planning services to simply the exposition.2 The market exists for [xi] units of physical time, where [xi] is finite, randomly chosen by nature (with [xi] > N), and unobservable by all parties (except nature) until the last period. Each consumer has an exogenously determined identical demand of [straight phi] > 0 planning episode(s) per unit of physical time, where[straight phi] is fixed for the duration of the market. A period is defined as a partition of physical time containing a single planning episode. The market is then operational for T([straight phi]) periods within the [xi] units of physical time.

At each period nature determines the status of the consumer, [sigma], which determines the appropriate class of planning services appropriate for that consumer. Given the status of the consumer, any financial planner can recommend a standardized financial plan for that customer. In addition, at time 0, financial planners can make an unobservable investment in additional planning expertise at a cost [rho]. Planners who make this investment can provide a customized financial plan for consumers. Both standardized and customized plans vary with status.

The investment in additional skills is assumed to be unobservable to simulate unobservable quality differences between experts. One can think of planners capable of producing standardized plans as meeting certification or licensing requirements while those making the additional investment have made a quality enhancement observable only by experience with the planner. As suggested in the introduction, in actuality, a number of different certifying boards certify individuals who offer themselves as financial experts. There may be different signals regarding the qualifications of the expert across these designations. This study is concerned with the incentives for developing quality differentials that are not directly observable. Accordingly, it may be helpful to think of all planners in the model as holding the same professional designation. Customization and standardization are intended to serve as plausible examples of unobservable differences in the quality of planning services. One way to think about the problem is that planners who do not make the investment in expertise receive a coarser (i.e., more discrete) signal on status than planners that do. Consequently, these planners' recommendations must be more standardized, given their observation on status, than the plans of planners receiving a more precise signal on the consumer's status. With appropriate modifications, the study applies to any unobservable quality difference between sellers along a single dimension that cannot be signaled in advance of consumption.