Consider a market in which there are many potential buyers and sellers of used c

Question

Consider a market in which there are many potential buyers and sellers of used cars. Each potential setler has one car which is either of high quality (a plum) or low quality (a lemon), à seller with a tow-quality car is willing to sell it for $4,500, whereas a seler with a high-quality car is willing to sell in for $8,500. A buver is wling to pay $5,500 for a low- quality car and $10,500 for a high-qually car. Of course, only the seller knows whether a car is of high or law quality as iustrated in the accompanying image that 85% of sellers have low-ou tr cars. Assume buvers know thof 89% of sellers have low oualtv cars but "" unable to -me quality of individual cars Mint. Tbe expected valse d byn value of a car to a buyer is vah e lo*qudity car and tho probabiitr of getting a high-gaalk, csr multiplied by the value ofhigeuity ear.) ar is the sur, of the probabilty of geting . ·" car Suepose-s are willing to try Only upto e expected value of .ht voufand in thernmicus ondon. Snce-s of bs-qualty cars are "ming to set tar .soo. whale seles of 'bhaallty tars are wang te for sasoa will be wding ts participate ", thia manet ee that poe nma in. this problem is exanieofwhich of the no economk Signaling Adverse selection Screening 0

Explanation / Answer

The expected value of a car to a buyer = 85% x 5500 + 15% x 10500 = $6250

Since sellers of low quality cars are willing to sell for $4500, while sellers of high quality cars are willing to sell for $8500, the low quality car sellers will be willing to participate in this market at that price. ($4500 < $6250)

The dilemma in this problem: Adverse selection (poor quality car sellers supply the market)

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