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Chapter 17: Problem 5

Faced with a reputation for producing automobiles with poor repair records, a number of American companies have offered extensive guarantees to car purchasers (e.g., a seven-year warranty on all parts and labor associated with mechanical problems). a. In light of your knowledge of the lemons market, why is this a reasonable policy? b. Is the policy likely to create a moral hazard probIem? Explain.

Short Answer

Expert verified
The policy of offering extensive warranties is reasonable in a lemons market because it serves as a signal of quality, addressing the asymmetric information problem. However, it could potentially lead to a moral hazard problem, where owners take less care of their cars, knowing that the repair costs are borne by the company.

Step by step solution

01

Understanding the Lemons Market

In a lemons market, sellers have more information about the product's quality than buyers. This can lead to a 'market for lemons' where only poor-quality goods (the 'lemons') remain on the market. Warranties can serve as a signal of quality. A seller willing to guarantee a product for a certain period is, in effect, expressing confidence in the product's quality.
02

Role of Warranties

Warranties can alleviate the lemons problem. Let's consider a liberal seven-year warranty on all parts and labor associated with mechanical problems offered by car companies. By taking on the cost of repairs, the company is signaling that it stands by the quality of its products. Hence, it addresses the asymmetric information problem by boosting consumer's confidence in the quality of cars they sell, making this a reasonable policy from the perspective of the lemons market.
03

Moral Hazard Problem

The existence of a warranty might also induce a 'moral hazard problem'. This refers to a situation where the assured guarantee could lead to changes in the behavior of the car owners. Since the company bears the repair cost, car owners might neglect regular maintenance or take more risks, leading to more frequent repairs. The policy could potentially create a moral hazard problem, as some buyers, knowing that the costs of repair are covered, might treat their cars less carefully.

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Most popular questions from this chapter

You have seen how asymmetric information can reduce the average quality of products sold in a market, as low-quality products drive out high-quality products. For those markets in which asymmetric information is prevalent, would you agree or disagree with each of the following? Explain briefly: a. The government should subsidize Consumer Reports. b. The government should impose quality standards e.g.r, firms should not be allowed to sell low-quality items. c. The producer of a high-quality good will probably want to offer an extensive warranty. d. The government should require all firms to offer extensive warranties.

Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells high quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry's \(\$ 8000\) to buy and service each car that it sells. The second dealership, Lew's Motors, always sells lower-quality cars. On average, it costs Lew's only \(\$ 5000\) for each car that it sells. If consumers knew the quality of the used cars they were buying, they would pay \(\$ 10,000\) on average for Harry's cars and only \(\$ 7000\) on average for Lew's cars. Without more information, consumers do not know the quality of each dealership's cars. In this case, they would figure that they have a \(50-50\) chance of ending up with a high-quality car and are thus willing to pay \(\$ 8500\) for a car. Harry has an idea: He will offer a bumper-to bumper warranty for all cars that he sells. He knows that a warranty lasting \(Y\) years will cost \(\$ 500 Y\) on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew \(\$ 1000 Y\) on average. a. Suppose Harry offers a one-year warranty on all of the cars he sells. i. What is Lew's profit if he does not offer a oneyear warranty? If he does offer a one-year warranty? ii. What is Harry's profit if Lew does not offer a one-year warranty? If he does offer a one-year warranty? iii. Will Lew's match Harry's one-year warranty? iv. Is it a good idea for Harry to offer a one-year warranty? b. What if Harry offers a two-year warranty? Will this offer generate a credible signal of quality? What about a three-year warranty? c. If you were advising Harry, how long a warranty would you urge him to offer? Explain why.

Many consumers view a well-known brand name as a signal of quality and will pay more for a brand-name product (e.g., Bayer aspirin instead of generic aspirin, or Birds Eye frozen vegetables instead of the supermarket's own brand). Can a brand name provide a useful signal of quality? Why or why not?

Professor Jones has just been hired by the economics department at a major university. The president of the board of regents has stated that the university is committed to providing top-quality education for undergraduates. Two months into the semester, Jones fails to show up for his classes. It seems he is devoting all his time to research rather than to teaching. Jones argues that his research will bring prestige to the department and the university. Should he be allowed to continue exclusively with research? Discuss with reference to the principal-agent problem.

A firm's short-run revenue is given by \(R=10 e-e^{2}\) where \(e\) is the level of effort by a typical worker (all workers are assumed to be identical). A worker chooses his level of effort to maximize wage less effort \(w-e\) (the per-unit cost of effort is assumed to be 1 ). Determine the level of effort and the level of profit (reventue less wage paid) for each of the following wage arrangements. Explain why these different principalagent relationships generate different outcomes. a. \(w=2\) for \(e \geq 1\); otherwise \(w=0\) b. \(w=R / 2\) \(\mathbf{c}, w=R-12.5\)
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