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 seller has one car, which is either of high quality (a plum) or low quality (a lemon). A seller with a low-quality car is willing to sell it for 53,500, whereas a seller with a high-quality car is willing to sell it for 59,000. A buyer is willing to pay 54,500 for a low-quality car and 511,000 for a high-quality car. Of course, only the seller knows whether a car is of high or low quality, as illustrated in the accompanying image: Suppose that 85% of sellers have low-quality cars. Assuming buyers know that 85% of sellers have low-quality cars but are unable to determine the quality of individual cars. If all sellers offer their cars for sale and buyers have no way of determining whether a car is a high-quality plum or a low-quality lemon, the expected value of a car to a buyer is 5 Suppose buyers are willing to pay only up to the expected value of a car that you found in the previous question. Since sellers of low-quality cars are willing to sell for 53,500, while sellers of high-quality cars are willing to sell for 59,000, only low-quality sellers will be willing to participate in this market at that price. The dilemma in this problem is an example of which of the following economic concepts?

Explanation / Answer

probability of low quality car=0.85

probability of high quality car=0.15

expected value to the buyer= 0.15*11,000+0.85*4500

=$5475

This is the dilemma of adverse selction because buyers dont not know which car is lemon and which is plum and seller is not willing to reveal the information.

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