Which of the following examples is an adverse-selection problem and which is an

Question

Which of the following examples is an adverse-selection problem and which is an incentive problem? Explain why. In each case, give one method that the restaurant might use to reduce the problem. (A) A restaurant decides to offer an all-you-can-eat buffet that is sold for a fixed price. The restaurant discovers that the customers for this buffet are not its usual clientele. Instead, the customers tend to have big appetites. The restaurant loses money on the buffet. (B) A restaurant owner hires a manager who promises to work long hours. When the owner is out of town, the manager goes home early. This action results in lost profits for the firm.

Explanation / Answer

A.

It is an adverse-selection problem.

It shows the information asymmetry to seller and buyer. Restaurant thinks that customers of “all-you-can-eat buffet” will be a selected clientele but people who come for this “all-you-can-eat buffet” are different. Thus, buyers and sellers both are thinking differently.

Screening method can be used to resolve adverse-selection problem. Restaurant can define the target customer on the basis of certain criteria such as family couple, income or choice of cuisine. Thus, only those people will be entertained who fulfil the mentioned criteria.

B.

It is an incentive problem.

It involve the promises of manager that commits to work for longer hours. But, commitment is not fulfilled when owner is out of town. Here, promise to work for long hours affect the wage of manager.

Collaboration of variable pay in total wage payment can be introduced as a solution. Here, variable pay is associated with profits earned by the company. Thus, company and the managers both work towards the same objective.

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