Prior to the 2008 financial crisis, General Motors typically offered unusually l

Question

Prior to the 2008 financial crisis, General Motors typically offered unusually large rebates and favorable financial conditions on its cars. After the company’s emergence from its brief 2009 bankruptcy, General Motors switched its strategy to offer long-term warranties comparable to those offered by Hyundai-Kia. Assume that the effect of the two strategies on GM’s average and marginal cost curves are identical. Using some of the reasoning involved in the theories of adverse selection (and/or behavioral economics) distinguish between the two strategies’ effects on the demand for GM models.

Explanation / Answer

Prior to the 2008 financial crisis, the company offered unusually large rebates and favors to buyers of cars in order to increase their sales, not looking into the fact that it might allow poor quality buyers too to buy the cars, since they are getting relaxed conditions to make the purchase.

As a result of this, the company unknowingly sold the cars to bad and poor quality buyers who defaulted on their payments later on or did not take care of the car in order to make use of its relaxed warranties, thereby leading to losses for the company. Such a situation where the company is unable to find out the difference between its good-quality and poor-quality buyers is known as adverse selection.

However, post 2008, the company made its policy rules strict by offering only long-term warranties, wherein only the good-quality buyers came forward to buy the cars, since the poor-quality ones knew that they wouldn’t be able to take proper care of the car and thus won’t be able to get benefits out of it.

Hence, the demand for the GM models declined post 2008 policy change and only the good quality ones sought to buy it.

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