Question

Julia sees a classified as from Bob offering a used lawn mower for $30. On the opposite page, she sees a big color as from a national home improvement chain offering a new lawn mower for $250. Julia values a lawn mower at $300 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 Hazard Adverse Selection

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Supposed Julia buys the new lawn mower from the national home improvement chain,

thinking "Someone would ask $30 for a used lawn mower only if it didn't work well."

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Suppose Peter, the seller of the lawn mower, knows the mower is in good condition-

he is selling it only because he has decided to replace his lawn with a new deck.

He thinks about asking $45 and offering a guarantee: He will replace

the lawn mower with a new $250 lawn mower if it turns out not to work.

Then he 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 lawn mower for $45 meanwhile, i'll be out $205!"

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Why is Peter unable to sell Julia the lawn mower? (Check all that apply)

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

B. 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.

(Please Check the correct answers for the chart above and check the answer/answers that apply for the last question. Please respond in a clear way that is easy to follow and understand.)

Answer 1

Julia is uncertain because of the quality of lawn mower which is sold at low price.

This is the situation of adverse selection which occurs when there is asymmetric information between buyer and seller before the transaction occurs. Here Julia is also doubtful because of adverse selection.

Peter is having the problem of moral hazard which occurs after the transaction has taken place. Given this way, Peter is not certain that the buyer would not take advantage of the guarantee and hence doesn't want to guarantee.

Peter is unable to sell the good to Julia because of moral hazard wherein the sellers prevent from giving guarantees, because of false claim by buyer.

When the good is sold at low price , like it was to Julia, then there are doubts about the quality.

Only second option is correct.