Week 7 Discussion
Asymmetric information and/or imperfect information can cause two forms of market failure: 1) adverse selection and 2) moral hazard. Asymmetric information is where one party in the transaction has more information than the other party in the transaction. Imperfect information is a situation in which neither party has perfect information about the good/service being exchanged in a transaction. Such goods and services are sometime referred to as “experience goods.”
In the late 1990s, car leasing was very popular in the United States. A customer would lease a car from the manufacturer for a set term, usually two years, and then have the option of keeping the car. If the customer decided to keep the car, the customer would pay a price to the manufacturer, the “residual value,” computed as 60% of the new car price. The manufacturer would then sell the returned cars at auction. In 1999, the manufacturer lost an average of $480 on each returned car. (The auction price was, on average, $480 less than the residual value.)
Instructions
For your discussion post, address the following within the context of the above scenario:
1. Why was the manufacturer losing money on this program? Was this a problem of adverse selection or moral hazard?
Adverse selection refers to the situation where one party in a transaction has more information than the other party, and this information asymmetry leads to a situation where the less informed party is disadvantaged. In this case, the customers leasing the cars had more information about the condition of the cars than the manufacturer. They knew how the cars had been driven and maintained, which impacted the residual value of the cars when they were returned. As a result, the manufacturer was unable to accurately predict the residual value of the cars and was losing money on the program. Moral hazard refers to the situation where one party in a transaction is incentivized to act in a way that is not in the best interest of the other party. In this case, the customers who leased the cars were incentivized to use the cars in a way that would lower the residual value of the cars when they were returned. For example, the customers may have driven the cars more aggressively or neglected to maintain the cars, which reduced the residual value of the cars. This behavior is referred to as moral hazard because the customers were not fully responsible for the costs of their actions, as the manufacturer was left to bear the losses from the reduced residual value of the cars.
2. What should the manufacturer do to stop losing money? Will rational actors use rules of thumb?