Economics questions - Assignment Example

new or used durable good, the importance of branding and quality in her decision, and her decision to purchase an item that has a warranty or guarantee . A risk-averse customer will trade savings for decreased risk; she will thus be less likely to buy used goods, good she perceives to be of an inferior quality or brand, and more likely to invest in a durable, expensive good which in its price includes a warranty or service guarantee for a period of time. . b. [10 marks] A refrigerator company includes a warranty that provides for free service and repairs during the first two years of ownership of any new refrigerator.

The number of reported repairs rises after the warranties are introduced. Explain why this has occurred, referring to both the concepts of moral hazard and adverse selection. This phenomenon can be understood using the concept of moral hazard, in that customers who perceive the warranty to be “free” or included in the price of the good, might have purchased a refrigerator with or without a warranty, experience the cost of using that warranty once they have purchased the good to be zero. Therefore, problems that might otherwise have been tolerated (such as cosmetic defects), or repaired at the cost of the consumer (such as small parts) are now reportable, warranty-covered repairs.

This phenomenon might also be explained by adverse selection, namely that under certain conditions customers and vendors may have differential access to information. Customers may be aware of conditions they intend to expose the refrigerator to (such as extreme heat) that will likely shorten its lifespan or durability, but which the vendor and guarantor of the warranty is unaware of. Customers with such undisclosed intentions may be more drawn to manufacturers offering warranties and thus become over-represented in population of customers once the warranty is introduced. c. [5 marks] In order to solve the problem of excessive repair requests in (b), the