Free Economics Dissertations - The Tangency Point A Between The Zero-profit Line Vh And The Indifference
The tangency point A between the zero-profit line VH and the indifference curve EUH represents market equilibrium.
The point of intersection between lines CH VH and CL VL determines a warranty provision at which sellers of both good quality and lemon cars would be prepared to offer a partial warranty. Above this point, the cost of providing additional warranty increases by a larger degree for the seller of ‘lemon’ cars, than for the seller of good quality cars. However, risk adverse consumers prefer being fully insured against the monetary loss associated with a car’s breakdown; and hence prefer full warranty provision. Below the point of intersection, on the left hand side of the diagram, buyers will only be prepared to pay a lower price for cars as they are uninsured against buying a ‘lemon’.
EUL and EUH represent buyers’ indifference curves towards buying used cars at different warranty provisions. However, the indifference curve for those buying cars from providers of ‘lemon’ cars, under a situation of full warranty provision, becomes EUL’ EUH. This is because under a situation of full warranty, buyers do not care about the degree of potential breakdown for the cars, as they are fully insured against it. In this case the buyer becomes indifferent to either type of offers for used cars.
C) Consider one or more example of warranty that are used in practice (e.g.. find a warranty on the internet) consider what, if anything economic theory (particularly the theory of adverse selection) has to say on your example(s) and whether your example by any characteristics that you feel should be interpreted into economic theory. (max 300 words)
An example of a car company selling used cars with warranties is Volkswagen. Volkswagen offers a ‘comprehensive’ warranty for one year after the car is bought, with the level of cover available depending on the age of the car. If the car is less than four years old, the car in covered against any parts and labour costs arising from ‘sudden component failure’ (www.volkswagen.co.uk), whereas cars over four years old are only covered for a fixed list of component parts. The provision of a comprehensive warranty, especially on cars less that four years old, should signal to the market that Volkswagen sells quality used cars, and not ‘lemons’.
The effects of warranties are divided between full warranty and partial warranty, as shown in the above diagram. Volkswagen uses a combined system of full and partial warranty depending on the age of the car. This suggests, in economic terms, that those cars over four years old are more likely to be ‘lemons’ than those under fours years of age. In reality, this reflects that cars become increasingly prone to breakdown with age, a fact accepted by most consumers.
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