2. The market for lemons Consider a market in which there are many potential buy

Question

2. The market for lemons 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 $3,500, whereas a seller with a high-quality car is willing to sell it for $9,000. A buyer is willing to pay $4,500 for a low- quality car and $11,000 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: SA Suppose that 85% of sellers have low-quality cars. Assume 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 $ the value of a low-quality car and the probability of getting a high-quality car multiplied by the value of a high-quality car.) (Hint: The expected value of a car is the sum of the probability of getting a low-quality car multiplied by

Explanation / Answer

2. Expected value for buyer = 85% x $ 4500 + 15% x 11000 = 3825 + 1650 = $ 5475

Only low quality sellers are willing to sell their car at this price.

Problem of adverse selection.

Adverse selection: This implies taking the advantage of asymmetric information before transaction. For example, a person may be more eager to purchase life insurance due to health problems than, someone who is healthy.

3.

i) Moral hazard

Moral hazards: This implies taking the advantage of asymmetric information after transaction. For example, if someone has car insurance he may commit theft by getting his car stolen to reap the benefits of the insurance.

ii) Adverse selection.

Adverse selection: This implies taking the advantage of asymmetric information before transaction. For example, a person may be more eager to purchase life insurance due to health problems than, someone who is healthy.

iii) Both statements are correct.

Related Questions

Navigate

• Browse (All)
• Browse 2
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.