Question

In: Economics

Why is Neha unable to sell Lorenzo the car seat? Check all that apply.

How asymmetric information prevents gains from trade

 

Lorenzo sees a classified ad from Neha offering a used car seat for $20. On the opposite page, he sees a big color ad from a national retail chain offering a new car seat for $250. Lorenzo values a car seat at $270 as long as it works, regardless of whether it is new or used.

 

For each of the scenarios listed, determine the principle illustrated by each person's reasoning.

 

 Scenario      Moral Adverse       Hazard Selection

 Suppose Lorenzo buys the new car seat from the national retail chain, thinking "Someone would ask $20 for a used car seat only if it didn't work well."

 Suppose Neha, the seller of the car seat, knows the seat is safe-she is only selling it because her child has outgrown it. She thinks about asking $45 and offering a guarantee: She will replace the car seat with a new $250 car seat if it turns out not to work. Then she thinks "That's not a good idea! Someone can just buy it, handle it carelessly, and, if it breaks, can pretend it didn't work and get a new car seat for $45-meanwhile, I'll be out $205!"


Why is Neha unable to sell Lorenzo the car seat? Check all that apply.

  • Adverse selection can cause buyers to avoid purchasing high-quality goods because of the uncertainty about their quality.

  • Moral hazard can prevent sellers from offering guarantees of quality because they can't be sure that buyers won't try to take advantage of the guarantees by filing false claims.

Solutions

Expert Solution

Adverse selection is a situation where the seller of a product has more knowledge about the product than the buyer. It occurs when there is an asymmetric information and the behavior of the one party changes after the deal is stuck.

Moral hazard is a situation where both the parties have incomplete information. The one party behaves in a careless manner knowing that the other party will bear the cost. It occurs when there is asymmetric information before the deal is stuck.

In the scenario 1, Neha has more information about the car seat than Lorenzo. The seller has more information than the buyer.

Therefore, scenario 1 is a situation of adverse selection.

In the scenario 2 , the Lorenzo will behave carelessly just because the cost of the damaged car seat is borne by Neha. The cost of the careless attitude of Lorenzo is borne by Neha.

Therefore, scenario 2 is a situation of moral hazard.

Neha has more information regarding the car seat than Lorenzo. Lorenzo does not have complete information about the quality of the car seat. Lorenzo under values the car seat offered by Neha and does not buy it. Therefore, adverse selection can lead buyers to avoid the purchasing the high quality goods because of the uncertainty of the quality.

Neha assumes that the provision of the guarantee will lead to the careless handling of the car seat. Since the damage cost is borne by Neha, Lorenzo can mishandle the car seat and claim for the new seat. Therefore, the moral hazard can prevent sellers from offering guarantees of quality because they can't be sure that the buyers won't try to take advantage of the guarantees by filing false claims.

Therefore, both the statements are applicable as a reason that Neha could not sell the car seat to Lorenzo.

Rahul Sunny answered 2 years ago
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