Which of the following two examples illustrates adverse selection and which illu

Question

Which of the following two examples illustrates adverse selection and which illustrates an incentive problem? Explain your answer. In each case, give one method that the restaurant might use to reduce the problem.

a. A restaurant offers an all-you-can-eat buffet sold at a fixed price. The customers for the buffet are not the restaurant’s usual clientele, but new customers who have big appetites. The restaurant discovers it is losing money on the buffet.

b. The restaurant owner hired a new manager who promised to work at least 8 hours per day. If the owner is not on site, the manager leaves work early, reducing restaurant profits.

Explanation / Answer

a. It is the case of adverse selection. In this case resturant can restrict quantity of items to be served per person in the menu or introduce the new limited buffet at this price and increase the price of all you can eat buffet.

b. This is the case of incentive problem. In this case, resturant can change the salary structure of the manager, instead of paying a fixed salary, resturant can fix some percentage of the salary on the bases of the sales of the resturant, and hence can create an incentive for the manager to stay in the resturant.

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