Question

For each of the following situations, do the following: first describe whether it is a situation of moral hazard or of adverse selection. Then explain what inefficiency can arise from this situation and explain how the proposed solution reduces the inefficiency. a. When you buy a second-hand car, you do not know whether it is a lemon (low quality) or a plum (high quality), but the seller knows. A solution is for sellers to offer a warranty with the car that pays for repair costs. b. Some people are prone to see doctors unnecessarily for minor complaints like headaches, and health maintenance organizations do not know how urgently you need a doctor. A solution is for insurees to have to make a co-payment of a certain dollar amount (for example, \(\$ 10\) ) each time they visit a health care provider. All insurees are risk-averse. c. When airlines sell tickets, they do not know whether a buyer is a business traveler (who is willing to pay a lot for a seat) or a leisure traveler (who has a low willingness to pay). A solution for a profit-maximizing airline is to offer an expensive ticket that is very flexible (it allows date and route changes) and a cheap ticket that is very inflexible (it has to be booked in advance and cannot be changed). d. A company does not know whether workers on an assembly line work hard or whether they slack off. A solution is to pay the workers "piece rates," that is, pay them according to how much they have produced each day. All workers are risk-averse, but the company is not risk-neutral. e. When making a decision about hiring you, prospective employers do not know whether you are a productive or unproductive worker. A solution is for productive workers to provide potential employers with references from previous employers.

Short answer

Question: Identify whether the following situations involve moral hazard or adverse selection, explain the inefficiency that can arise, and briefly describe the proposed solution: a) Second-hand car warranty b) Healthcare co-payment c) Flexible and inflexible airline tickets d) Piece-rate pay for assembly line workers e) References for job candidates Answer: a) Adverse selection; inefficiency arises due to buyers' hesitancy to buy cars or offering low prices, fearing low-quality cars. The warranty helps assure buyers and builds trust. b) Moral hazard; inefficiency arises as healthcare providers can't discern the urgency level of patients, leading to overuse of services. Co-payment discourages unnecessary visits. c) Adverse selection; inefficiency arises when travelers refuse to buy expensive tickets or prefer lower-priced ones. Offering flexible and inflexible tickets targets both types of customers. d) Moral hazard; inefficiency arises if workers slack off, reducing productivity. Piece-rate pay incentivizes harder work and increases productivity. e) Adverse selection; inefficiency arises when employers end up hiring unproductive workers, wasting resources. References provide more applicant information, enabling better hiring decisions.

Step-by-step solution

a. Second-hand car warranty

This situation represents adverse selection since buyers don't have the information about the car's quality but sellers do. The inefficiency arises because buyers may be hesitant to buy a car or offer a low price, fearing a low-quality car. Offering a warranty on the car will reduce the inefficiency as it assures that repair costs will be covered, and the buyer can trust the seller more.

b. Healthcare co-payment

This situation is an example of moral hazard since people might take advantage of the system and use healthcare services more frequently than necessary. The inefficiency arises because healthcare providers can't discern the urgency level of each patient. The co-payment solution reduces inefficiency by discouraging unnecessary visits, thus helping healthcare resources to be allocated more effectively.

c. Flexible and inflexible airline tickets

This situation represents adverse selection since airlines don't know whether a buyer is a business or leisure traveler. The inefficiency arises when leisure travelers would refuse to buy expensive tickets, and business travelers would also prefer lower-priced tickets. By offering both flexible and inflexible tickets, airlines can target both types of customers, reduce inefficiency, and increase profit.

d. Piece-rate pay for assembly line workers

This is a case of moral hazard as the company doesn't know whether workers will put in the effort or slack off. The inefficiency arises if workers choose to slack off, reducing productivity. Paying workers according to their production levels (piece-rate) incentivizes harder work, reducing inefficiency and increasing productivity.

e. References for job candidates

This situation demonstrates adverse selection since employers don't know the productivity level of potential hires. The inefficiency arises when employers might end up hiring unproductive workers, causing resources to be wasted. By having productive workers provide references, employers receive more information about applicants, allowing them to make better hiring decisions and reducing inefficiencies.