Question

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

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

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.

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.

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.

Key concepts

Asymmetric Information

In the marketplace, asymmetric information refers to a situation where one party in a transaction—typically the seller—has more information about the product than the other party, which is usually the buyer. This imbalance creates uncertainty for the buyer about the true quality of the product and can lead to a phenomenon known as the 'lemons market'. Buyers, being unsure of a product's quality, might assume the worst and offer only low prices, which in turn discourages sellers of high-quality products from entering the market. Consequently, the market becomes flooded with low-quality products, also known as 'lemons'.

Warranties act as a signal to counter this issue. When a company offers a warranty, it implies that the seller is confident enough in the product's quality to cover future repairs. This warranty helps to align the buyer's perception with the actual quality of the car, reducing the asymmetric information problem. When buyers see extensive warranties, it builds trust and can lead to an increase in perceived product quality.

Warranties

Warranties serve an important function in markets plagued by asymmetric information. They are promises made by sellers to handle any future repairs or defects. When car manufacturers provide extensive warranties, such as a seven-year coverage on parts and labor, it can greatly influence consumer confidence. Buyers interpret these warranties as signals of high product quality because a company wouldn't offer lengthy protections if they expected frequent failures.

The presence of a warranty offers more than just repair assurance. For buyers, it means peace of mind, knowing they won't incur unexpected repair costs in the future. For manufacturers, warranties are a tool to differentiate from low-quality competitors, thus attracting customers by demonstrating their own confidence in the product.

In essence, warranties mitigate the lemons problem by directly addressing the buyer's uncertainty about product quality and serving as a commitment by the seller to stand by their product.

Moral Hazard

Moral hazard arises when a party protected from risk behaves differently than they would without that protection. In the context of car warranties, when a consumer knows that any mechanical issues will be covered by the warranty, they might care less for the car, potentially skipping regular maintenance or taking more risks.

This problem can be exacerbated if the warranty is too extensive. Knowing that all parts and labor are covered for a long period might lead owners to push their vehicles harder than they normally would. The underlying issue is that the costs of any reckless behavior are not directly borne by the car owner, leading to a potential increase in warranty claims.

Therefore, while warranties help address asymmetric information and signal product quality, they simultaneously introduce moral hazard, requiring companies to balance warranty terms to minimize such risky behavior by consumers.