Question

ABC Appliance offers a warranty requiring an annual fee. The warranty may be purchased at the time of sale or at any time within the first year after the appliance was purchased. The warranty fee after the date of purchase is twice the time-of-purchase fee. When asked why the fee was higher after the date of purchase, ABC's president said, "Buying a warranty is voluntary. We've noted that those who buy the warranty after the purchase date have a greater need for service." Charging the same rate or a lower rate after the date of purchase would expose ABC to what problem that also impacts private insurers?

Answer 1

Answer: adverse selection

Explanation:

Adverse selection is a situation whereby the sellers possesses information that the buyers do not have. It may also be the other way round whereby the buyers have information which the sellers don't have regarding the quality of a product.

There is information failure between both parties; typically, it's usually the sellers who has more information. Therefore, base on the scenario above, charging same rate or lower rate after the date of the purchase would expose ABC to adverse selection problems.