Q1 A) suppose a \"lemons\" car is valued at $2500 and a good car is valued at $5

Question

Q1

A) suppose a "lemons" car is valued at $2500 and a good car is valued at $5000. If you know that there is a 50% chance of getting each, what is the expected value of the car.

B) what will happen in the market if the price is based on the expected value. Explain.

Q2)

Suppose you have hired a new worker, unfortunately you do not know if the worker is a shirker or a hard worker. Suppose working hard raises the probability of making a sale from 40% to 80% (thus raises the probability of making a commission C by the same percentage). If the cost of working harder is $200, what commission C should you offer the worker to provide an incentive to work hard.

Explanation / Answer

Expected value of the car. =0.5*2500+0.5*5000 = 3750

If price is based on the expected value the lemons will be sold at a higher price and a good car will not get its deserved price of 5000. This will drive the good cars out of the market till there are only lemons left in the market.

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