Information Asymmetry. a. Adverse Selection: In the market for used airplanes, explain how adverse selection might...

Information Asymmetry.

a. Adverse Selection: In the market for used airplanes, explain how adverse selection might arise. What might the buyer or seller do to eliminate adverse selection?

b. Moral Hazard and the Principal-Agent problem. Suppose you own a real estate office that represents buyers and sellers of residential homes. You hire someone to manage the office for you. What moral hazard issues might you encounter? How does this illustrate the Principle-agent problem, and what could you do to partially eliminate the principle-agent problem?

Solutions

Expert Solution

A used airplane will have different technical issues and complexities that is only known to the person who have either used it or won it. It means that the seller of the airplane, will have better information about the functioning of the airplane and the issued faced by it. These information is not there with the buyer. So, there is a case of information asymmetry and adverse selection arises.
To eliminate the adverse selection problem, the airplane should be inspected for its functionality and other aspects by the third party quality agencies of high repute and accredited by these agencies regarding its functioning, any technical issues and overall quality of the product. A free maintenance & service of the airplane for a particular period and warranted by the reputed agency, will eliminate the adverse selection.

A moral hazard issue arises when the manager does not perform due diligence in evaluation of the real estate property and it causes harm to either the buyer or seller. It will cause harm to the reputation of the real estate office. In this case, the poor decision of the manager, will lead to damage caused to the buyers & sellers as well as the real estate office. So, moral hazard arises.
It also represents the principal-agent problem as the manager as agent, takes decisions that suits to his interests, and he does not think about the best interest of the owners. It is a case of agency problems. To eliminate it, there should be provision of incentive with the sale of each real estate property and it should be linked to the volume of the profit earned by the office. Due to this reason, the manager will try to maximize the profit so that his own incentives will be maximized. It will eliminate the agency problem.

Rahul Sunny answered 1 year ago

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