3. (10 pts. total) This problem is based on a Market for Lemons experiment that

Question

3. (10 pts. total) This problem is based on a Market for Lemons experiment that was conducted in a class. Used car sellers and buyers tried to agree on a price for cars. Sellers knew the true value of each car (seller value), but buyers did not know the value of a particular car, only the distribution of values in the used car market. The below table is based on almost 400 pairings that occurred in the experiment. n some pairings, a transaction occurred (used car was sold), and in some pairings no transaction occurred. Based on the table below, showing the average seller value in each case, is there evidence of adverse selection? Explain in 2-4 sentences. Average Seller Value (No Transaction) 3,022.42 Average Seller Value (Transaction) 2,511.89

Explanation / Answer

In adverse selection, only the seller knows the true value of the care they are selling. So they have an incentive to pass off low quality cars as high quality and sell for a higher price. Consumers however know of this tactic and are wary of the cars which are priced high. They are more likely to buy average quality cars.

From the above table we see that cars which are not sold have a higher seller value where as cars which are sold have a lower seller value. Therefore we can see that even though the average seller value of a car is high, consumers are less willing to buy it because of the probability that they might buy a low value car at a higher price. Lower priced cars are sold more because its more likely that their price reflects its value. Hence this table could an evidence of adverse selection.

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