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 problem? Explain.

Short answer

1. This is a reasonable policy since it will signal the good quality cars which might be sighted as lemons (bad quality cars) by the buyers.
2. This policy will create a problem of moral hazards since after receiving extensive guarantees, the buyers of cars will get easy about taking care of their car, which will increase the number of repairs

Step-by-step solution

Extensive guarantees policy of American companies 

With a growing number of foreign car manufacturers that assured good quality to the customers, the American companies faced tough competition from the outside world in the past. People became unwilling to pay higher prices for not-so-assured quality American-manufactured cars. Buyers considered them lemons when compared with foreign-manufactured cars.

To counter this, the American companies tried improving their repair records, invested in quality control, and later added extensive warranty policies as a market signal of good quality to the customers.Therefore, this move by the American companies helped them gain back the lost customer as the extensive guarantees would signal a good quality of American cars.

Extensive guarantees will create the problem of moral hazards

These extensive guarantees would end up creating a problem of moral hazards. Moral hazards occur when one of the parties acts against the agreement after entering into it.The customers who have these extensive guarantees will become less careful about their cars. This negligence on the part of customers might result in more repairs, increasing the cost of the manufacturing firm. Hence, the firm faces the problem of moral hazard.