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 that the other party in the transaction. Imperfect information is a situation neither party has perfect information about the good/service being exchanged in a transaction. Such goods and services are sometime referred to an experience goods.

Background

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).

Assignment

1. Why was the manufacturer losing money on this program? Was this a problem of adverse selection or moral hazard?
2. What should the manufacturer do to stop losing money? Will rational actors use rule's of thumb?

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