Question

Suppose that, to deal with adverse selection problems, a new federal lemons law requires all used car dealerships to provide a one-year warranty for each car they sell. Explain how this new law, designed to reduce adverse selection, might increase the problem of moral hazard.

Answer 1

Both moral hazard and adverse selection shows the situation were disadvantage of one party which due to the behaviour of another party. Moral hazard occurred due to the asymmetric information between two parties, where a change in behaviour of one party after signing the agreement. Adverse selection occurred where the sellers have more information than buyers about product quality.
There is a new law federal law imposed where there is one year warranty for every car sellers. This new law should be known by the buyers also. Otherwise the sellers exploit the rights of buyers. By giving warranty, there is a reduction of the problem of moral hazard. There is an insurance given to the car through this. Here the sellers know more about the defects and features of the used car. There is asymmetry of information in both moral hazard and adverse selection. Giving proper information about the car to the buyer will increase the customers and also avoid these problems. Like imposing this new law will manage the risk emerge buyers and sellers. And this law also avoid the problem of asymmetry.