ECON501HW6soln

ECON501HW6soln - Economics 501.01 Microeconomic Theory...

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Economics 501.01 Microeconomic Theory Professor Patricia Reagan Autumn 2007 Homework #6 Solutions 1. Many consumers view a well-known brand name as a signal of quality and will pay more for a brand-name product (e.g., Bayer aspirin instead of generic aspirin, or Birds Eye frozen vegetables instead of the supermarket’s own brand). Can a brand name provide a useful signal of quality? Why or why not? A firm sends a signal regarding the quality of its product to entice some customers to purchase the product. Signals like advertising that promote consumer recognition of a brand name are costly; a firm would only spend the money on promoting its brand if it felt that consumers would try its product, deem the quality of the product to be good, and purchase the product again. Otherwise, the expenditures on advertising would be wasted, since consumers would try a product and decide never to purchase it again. Thus, only producers with high-quality goods should spend money promoting their brand name. Recognizing this, consumers can reliably assume that any brand name product is of reasonably high quality. 2. Faced with a reputation for producing automobiles with poor repair records, a number of American companies have offered extensive guarantees to car purchasers (e.g., a seven-year warranty on all parts and labor associated with mechanical problems). a. In light of your knowledge of the lemons problem, why is this a reasonable policy? In the recent past, American automobiles appeared to customers to be of low quality. To reverse this trend, American companies invested in quality control, improving the potential repair records of their products. They signaled the improved quality of their products through improved warranties. b. Is the policy likely to create a moral hazard problem? Explain. Moral hazard occurs when the party to be insured (the owner of an American automobile with an extensive warranty) can influence the probability or the magnitude of the event that triggers payments (the repair of the automobile). Covering all parts and labor associated with mechanical problems reduces the
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ECON501HW6soln - Economics 501.01 Microeconomic Theory...

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