9 The market for lemons Consider a market in which there are

9. 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 $5,000, whereas a seller with a high-quality car is willing to sell it for $9,500. A buyer is willing to pay $6,000 for a low-quality car and $10,500 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 SAL Suppose that 80% of sellers have low-quality cars. Assume buyers know that 80% 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 iss getting a low-quality car multiplied by 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 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 5,000, while sellers of high-quality cars are willing to sell for $9,500 will be willing to participate in this market at that price in this problem is an example of which of the following Adverse selection Signaling Screening Moral hazard

Solution

Ans:

1) $6900

Expected Value of car = (80% * $6000) + (20% * $10,500)

                                    = $4800 + $2100

                                    = $6900

2) Sellers of low quality cars

if buyers are will to pay only up to the expected value of the car, only sellers of low quality cars will be willing to participate in this market at that price.

3) Adverse selection

Adverse selection means situation where sellers have information that buyers do not have.