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 problem? Explain.

When purchasing a product, especially one as significant as a car, buyers often face uncertainty about the quality of their potential purchase. This is particularly the case in markets where sellers have more information about the product than the buyers, which economists refer to as adverse selection.

Adverse selection describes a scenario where products of lower quality (in this instance, lemons) dominate the market because the seller’s knowledge about defects is not available to the buyer. Over time, buyers, recognizing their informational disadvantage, lose trust and are only willing to pay a price that reflects the average quality of all cars, including the 'lemons'. High-quality car sellers may then exit the market, as they cannot fetch a price that justifies the quality of their product, a phenomenon that ultimately degrades the market's overall quality.

An illustrative example is the used car market, where the difficulty in distinguishing between a high-quality car and a 'lemon' can discourage buyers and prevent sales of good cars. To counter adverse selection, companies need to find ways to assure buyers of the quality they will get, often through signaling mechanisms.

In addressing the problem of adverse selection, companies can use signaling to differentiate their high-quality product from the low-quality alternatives. In economics, signaling is a way to credibly communicate information from the well-informed seller to the less-informed buyer.

In the case of American car companies with a reputation for poor repair records, offering extensive warranties functions as a signal of product quality. For these companies, the warranty serves as proof that they are willing to stand behind their cars for a significant period, implying a commitment to quality and reliability. The cost of offering such warranties is high if the product is defective, so it wouldn't make sense for a company to provide them for a poor-quality car.

This action aligns with the company's interests in moving away from the negative perception of their cars being 'lemons' and instills confidence among potential customers. When buyers see that a company backs its cars with a seven-year warranty, they interpret it as a signal that the cars are less likely to be 'lemons', which can significantly boost sales.

The concept of moral hazard comes into play once a transaction has occurred, and there is a risk that one party may change their behavior to the detriment of the other party because they do not bear the full cost of their actions.

With car warranties, there is a potential moral hazard problem. After the purchase of a car with an extensive warranty, an owner might take less care to maintain their car, knowing that any mechanical failures would be repaired at no cost to them. This is because the warranty effectively transfers the risk of repair from the owner back to the company. In this case, the warranty may inadvertently encourage neglectful behavior that can lead to increased maintenance costs for the company.

This factor must be considered when designing warranties, as the inclusion of certain terms can mitigate moral hazard, such as requiring regular servicing as a condition of the warranty. By understanding these implications, companies can better structure their offerings to minimize potential negative effects while still providing signals of quality that can combat adverse selection.