Question

Consider a market for used cars. Suppose that each car on the market is 1 of seven possible levels of quality x={1000,2000,…,7000}. There is an equal amount of cars at each quality level. Each current owner (and potential seller) knows the quality (x) of the car that they have. (Note: We did not do a problem like this explicitly in class, but it is a very simplified version of the “A” insurance example from the notes.)

a. Suppose that buyers cannot observe or verify the quality of the cars. Let p* be the equilibrium price of the cars which is equal to the average quality of the cars on the market. Suppose all the cars are on the market currently. What is p*, and is it sustainable as an equilibrium price?

b. Find the value of p* that can be sustained as an equilibrium price? Which cars are sold? (Hint: Think about adverse selection).

c. How can this adverse selection problem be mitigated?

Answer 1

Economics

Consider a market for used cars. Suppose that each car on the market is 1 of seven possible levels of quality x={1000,2000,…,7000}. There is an equal amount of cars at each quality level. Each current owner (and potential seller) knows the quality (x) of the car that they have. (Note: We did not do a problem like this explicitly in class, but it is a very simplified version of the “A” insurance example from the notes.)

a. Suppose that buyers cannot observe or verify the quality of the cars. Let p* be the equilibrium price of the cars which is equal to the average quality of the cars on the market. Suppose all the cars are on the market currently. What is p*, and is it sustainable as an equilibrium price?

b. Find the value of p* that can be sustained as an equilibrium price? Which cars are sold? (Hint: Think about adverse selection).

c. How can this adverse selection problem be mitigated?

Answer: as given in the question quality x =1000, 2000,3000,4000,5000,6000,7000

So P*= 1000+2000+3000+4000+5000+6000+7000/7

= 28000/7= 4000

Answer (b) : adverse selection occur when there is lack of symmetrical information to deal between buyers and sellers. Here quality is known only by sellers and not by buyers so there will be possibility of occurring adverse selection. Average price is 4000 if a buyer wants to pay 4000 but he doesn't know the quality it is possible that buyer will choose low quality good at higher price and this will leads to adverse selection. Here if there is no adverse selection that is only possible if seller tell buyer about the quality of car. This adverse selection mitigated iff seller tell quality of the cars.

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