Reasons and Possible Solutions for Adverse - Selection Problem and Incentive Problem

Reasons and possible solutions for adverse-selection problem and incentive problem

First problem involves a restaurant who offer all-you-can-eat buffet at a fixed price. The restaurant discovers that they are losing money because the source of customers changes to unusual customers who tend to have big appetites. This is an adverse-selection problem which customers are withholding the information that they have big appetites and their reasons to come to all-you-can-eat buffet. An adverse-selection problem can be reduced by correcting the design of the contracts and changing the prices of the buffet that would motivate the customers to self-select based on their private information. The possible solution is to give out different time limit and charge different time limit with various prices accordingly. Customers can choose their need for the time before starting to eat. For example, the restaurant can charge customers who eat between 30 minutes to one hour and customers who eat more than one hour differently. This solution can reduce the time for the customers to digest the food when people with big appetites tend to need more time to digest and charge customers based on their appetites indirectly.

The second case involves a restaurant who hires a manager who promises to work long hours yet leaves early when the owner is out of town, which causes the restaurant to loss profit. This is an incentive problem which in the case, the manager does not act in the restaurant owner’s best interest automatically in this agency relationship. The possible solution for this problem is to increase the expenditures on monitoring which to install security cameras in the restaurant and notify the manager about it. Although this action will increase the residual loss, the manager will not leave early since the owner can notice it.

If you require any further information, feel free to contact me.

Yours sincerely,

Yan Chi Lee

Yandy0420@gmail.com