Home cleaning services and general contractors often advertise that they are bon
ID: 1107262 • Letter: H
Question
Home cleaning services and general contractors often advertise that they are bonded. What this means is that the seller of the service has put up money with a third party that is available to the buyer if, for example, the cleaners damage or steal property or if the general contractor fails to complete the project or completes it in a substandard way. What is the purpose of bonding?
The following situations represent problems caused by asymmetric information. Determine whether they represent problems of moral hazard or adverse selection.
I. Karol is halfway to work before he realizes that he forgot to lock the back door. Because he has renter's insurance, he decides it is not worth being late to work just to go home to lock the door.
II. Joanne applies for a job as a part-time manager at a fast-food restaurant. Her MBA makes her incredibly overqualified for the job, yet the position goes to someone else who doesn't even have a college degree.
III. The potential costs of long-term care (such as a nursing home stay) can be very high and are also very uncertain. Because of this, the private market for long-term care in the United States has remained fairly small.
I. Unrest in the Middle East causes oil speculators to buy up oil futures, driving gasoline prices higher.
II Frances lives in an apartment above a restaurant, and her apartment always smells like burgers and fries. She has tried unsuccessfully to get the restaurant owner to remedy the problem. Situation I and II are caused by asymmetric information. Only situation I is caused by asymmetric information. Only situation II is caused by asymmetric information. Neither situation I nor II is caused by asymmetric information.
Explanation / Answer
Answer 1.
In my opinion, both these situations mentioned in the first question represent problems caused by information asymmetry. An unrest in the Middle East causes oil speculators to buy up oil futures, driving gasoline prices higher which leads to situation of moral hazard for normal population. Similarly, in case of Frances (who is living in an apartment above a restaurant), the apartment owner/seller must have been aware of the smell problem, however this might not have been disclosed to Frances at the time of sale. This can be considered as a case of adverse selection for buyer. The answer would be Situation I and II are caused by asymmetric information.
Answer 2.
Bailing out financial institutions can lead to moral hazard. According to Paul Krugman, moral hazard is "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly". In this situation, Federal Reserve announcing to bail out loss-making AIG can encourage the bank to take greater risks. If the higher risk lead to higher profit AIG will benefit, else if case goes against the bank it can avail a bailout.
Answer 3.
I feel that Bonding provides a good incentive for the contractor to not engage in the moral hazard of theft or failing to complete the project. This is also because if the contractor does not complete the work as per terms of contract, it will have a monetary implication along with a loss of credibility.
Answer 4.
In this question, Situation I represents moral hazard and situation II and III represent adverse selection. In situation 1, Karol is taking a risk of unlocked door since he has renter's insurance. If there is a break in/robbery then the insurance company will have to bear the loss, which is a classic case of moral hazard conduct on part of Karol. In situation 2, Joanne did not get the job since the fast food restaurant owner has made an adverse selection and chosen a wrong candidate (might be due to low salary offer for a less qualified candidate). Similarly, in situation 3, adverse selection has led to small marketplace, since sellers do not find it profitable to sell the long term care services.
Answer 5.
According to George Akerlof's model of the used car market, since buyer of used car has less information than seller about the product quality, the buyer will offer a low-to-average price for any used card. This will lead to lesser demand for premium quality used car and hence might reduce the overall market for good quality used card. Having said that, Akerlof has also suggested solutions to this adverse selection problem of used cars in form of offering warranties and ensuring robust quality controls for the used cars. Hence, in my opinion, Akerlof's model is not wrong, because his model shows that adverse selection has the potential to eliminate markets.
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