Suppose you work for the Trade Association for LCD screen manufacturers, who produce screens and sell them to Original Equipment Manufacturers (OEMs) like Dell, HP, Sharp, Sony, etc. Currently, your association policy is that all LCD screen manufacturers must bear the replacement cost of defective screens. That is, if an OEM purchases a screen and it is defective, the LCD screen manufacturer must replace it. Your estimate is that 5% of screens are defective, and the replacement cost is $200.

Your superior proposes a new policy where the manufacturer is not responsible for defective screens, i.e. where the OEMs would need to pay for screen replacements themselves. Suppose that you believe that there are no moral hazard issues, i.e., the proportion of defective screens remains at 5% with the new policy. Assume that the LCD screen manufacturers (the suppliers) arerisk neutraland the OEMs(those who demand the screens) arerisk averse.

Which of the following statements is true about the effects of the change from the old policy to the new policy?

1Price increases and output increases

2Price increases and output decreases

3Price decreases and output increases

4Price decreases and output decreases

5Price increases and output remains the same

6Price decreases and output remains the same