PArt 1:
Context
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.)
Also see the help provided in the discussion preparation.
Instructions
For your discussion post, address the following within the context of the above scenario:
Why was the manufacturer losing money on this program? Was this a problem of adverse selection or moral hazard?
What should the manufacturer do to stop losing money? Will rational actors use rules of thumb?
Part 2: Respond to this peer:
A moral hazard can be defined as a lack of incentive to guard against risk where one is protected from its consequences by insurance. In this case, I believe, we have the problem of adverse selection which means that sellers have information that buyers do not have. Adverse selection may be due to asymmetric information which occurs when one party in a business transaction has access to more information than the other party. The customer who leased the car has more information than the manufacturer who auctioned the returned car.
The manufacturer is losing money in this program because the residual value of the car is estimated to be 60% of the new car price. For example, if a brand-new car cost $25,000 when the customer returns it, it will be worth $15,000 (25,000 * 60%). Sometimes the manufacturer may auction the return car for less than $15,000, which is not beneficial to him. He will prefer that the customer purchase the car after leasing it instead of returning the car because the auction value reflects the true market value of the car, which is less than the company’s residual value.
The manufacturer may reduce its losses by gaining access to more information. He needs to hire an expert mechanic to screen, check all return cars, and sets the residual price at the true market value of the used car before auctioning the return car. This will help solve the asymmetric information and will help control the loss. The manufacturer can also increase the lease car price or modify the term of the contract to cover the cost of the damage return car.
The rational-actor paradigm assumes that people will act rationally, optimally, and according to their self-interests. Rules of thumb are commonly accepted and simplified that people follow and apply to different situations. Manufacturers need to think ahead and find better solutions before leasing any car. They need to review the term of the contract and the price to make sure that they make money instead of losing money.
