Asymmetric Or Imperfect Information Can Cause

Asymmetric Information Andor Imperfect Information Can Cause Two Form

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 than the other party in the transaction. Imperfect information is a situation in which neither party has perfect information about the good/service being exchanged in a transaction. Such goods and services are sometimes referred to as "experience goods." 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.)

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The scenario presented highlights a significant problem faced by car manufacturers engaged in leasing programs, primarily driven by the concepts of asymmetric and imperfect information, leading to market failures such as moral hazard. The core issue revolves around the manufacturer's financial losses stemming from the residual value of leased cars, which was substantially lower than anticipated, resulting in average losses of $480 per vehicle in 1999.

To understand why the manufacturer was losing money, it is crucial to analyze the roles of adverse selection and moral hazard in this context. Adverse selection occurs prior to a transaction when one party possesses more information about the quality or condition of the good than the other. In this case, the manufacturer may have lacked sufficient insight into the actual driving behavior or vehicle condition of lessees, which influences the residual value at the end of the lease term. If lessees are aware that their driving behaviors—such as aggressive driving, poor maintenance, or neglect—significantly reduce the car's residual value, they may be less incentivized to take care of the vehicle, thus exacerbating depreciation and leading to higher losses at resale.

On the other hand, moral hazard manifests after the contract is signed, where the lessee's behavior may change because they do not bear the full cost of their actions. Lessees might use the vehicle more intensively or negligently, knowing that the residual value will be paid by the manufacturer or that they will not retain the vehicle afterward. This increased or reckless use directly impacts the car’s condition at return, further lowering its auction price and contributing to the financial losses observed.

Given the scenario, it appears that moral hazard is the dominant problem. The lessees, motivated by the knowledge that they are not accountable for the decrease in residual value, might not exercise proper care during their lease tenure. Consequently, the residual values decline, and the manufacturer’s expected returns are undermined.

To mitigate these issues and prevent ongoing losses, the manufacturer can implement several strategies. First, they could enhance the monitoring of vehicle usage through telematics, tracking driving behavior to encourage safe and moderate use. Second, they could introduce higher residual value charges or penalties for excessive wear and tear, incentivizing lessees to maintain the vehicle’s condition. Third, the manufacturer might require higher security deposits, which can be forfeited if the vehicle’s condition deteriorates beyond agreed limits, aligning incentives to preserve vehicle condition.

Additionally, employing strict return conditions and thorough inspections can help the manufacturer identify excessive wear or misuse early, allowing for targeted remedies. Offering insurance or maintenance packages might also reduce the likelihood of negligent use, as lessees would be more aware of the costs associated with poor vehicle care.

Regarding the behavior of rational actors, they are likely to rely on heuristics or rules of thumb when making decisions under uncertainty, especially when complete information is unavailable or costly to obtain. For example, lessees might assume that the manufacturer's inspections are not exhaustive, or they may believe that minor damages won't significantly impact their deposit or future obligations. Consequently, to effectively enforce the desired standards, the manufacturer must create clear, enforceable rules and communicate them effectively to influence lessees’ behavior. This could include transparent policies on wear and tear, penalties for violations, and emphasizing the benefits of proper vehicle care.

In conclusion, the manufacturer’s losses are primarily driven by moral hazard, with lessees engaging in behaviors that diminish the residual value of vehicles at auction. Addressing this issue requires strategic adjustments—such as monitoring, incentivizing proper use, and implementing penalties—to align the lessee's incentives with the manufacturer’s financial interests. Recognizing that rational actors tend to follow heuristics, the manufacturer must also employ clear, enforceable policies to mitigate moral hazard and sustain profitability in their leasing programs.

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