Consider a market for used motor cycles. There are good quality and poor quality

Question

Consider a market for used motor cycles. There are good quality and poor quality used motor cycles on the market. Any seller of good quality used motor cycles will accept a price no lower than $500. Any seller of a poor quality motor cycle will sell for no lower than $100. Assume the market is perfectly competitive but buyers cannot determine quality. There are a total of 2,500 motor cycles on the market, 1,000 of which are poor quality motor cycles, for which buyers have no value. Suppose that market demand for good quality used motor cycles is given by: P = 2,000-0.5Q.

How many good quality motor cycles will be sold? How many poor quality motor cycles well be sold? Explain and illustrate this result graphically above.

Explanation / Answer

Answer

Since the buyers cannot determine the quality of the car, in equilibrium only poor quality motor cycles will be sold at an equilibrium price of 100. The average price for a buyer who cannot determine the quality of the car will be

(1000/2500)*100+(1500/2500)*500

=40+300

=340.

At this price no good quality car will be sold as sellers wont accept price below 500 for a good car. Hence at the price of 340 only bad cars will be put for sale, But at this price demand for bad cars is zero. Thus price falls to 100 and there will be no equilirium price above 100.

Hence the equilibrium price is 100 with all bad cars being sold in the market and 0 good cars will be sold at this price.

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