Question

In 1978, sellers of a good Ford Pinto valued them at $1,111 and valued a lemon at $765, while buyers valued good ones at $1,331, and lemons at $780. If an uninformed buyer figured 50% are each type, then the maximum price the buyer would pay for a Pinto would be _____.  

Group of answer choices

$1,035.55

$1,055.50

$1,065.55

$1,095.50

Consider the Pinto market again, but this time assume that uninformed buyers figured that fraction 0.45 are good ones, and the rest are bad. In this case, the price the buyer is willing to pay is _____ and this will _____ an adverse selection problem.  

Group of answer choices

$1,033.44; avoid

$1,033.44; generate

$1,027.95; avoid

$1,027.95; generate

c

onsider the used Pinto market one last time. Under imperfect information, to avoid adverse selection, the minimum percentage of good types necessary to avoid adverse selection is?

Group of answer choices

51.25%

55.5%

57.6%

60.1%

Answer 1

a) Buyer value $1,330 for good cars and $780 for lemon and figured 50% of each type

Expected price they will be willing ot pay = Value of good car * Probability of getting good car + Value of lemon car * Probability of getting lemon car

Expected price they will be willing ot pay = 1,331 * 0.5 + 780 * 0.5 = 1,055.5

Option B is correct.

b) If there is 45% chance of getting good car.

Expected price they will be willing ot pay = Value of good car * Probability of getting good car + Value of lemon car * Probability of getting lemon car

Expected price they will be willing ot pay = 1,331 * 0.45 + 780 * 0.55 = 1,027.95Adverse selection occurs when sellers have more information than buyers. Thus, it actually generate adverse selection. Option D is correct

c) In the above example, buyer will not be able to get a good car with $1,027.95 because sellers expect atleast $1,111 for a good car. Buyer will always end up getting a lemon car from 1,027.95. Adverse selection can be removed if probability of getting a good car is X and getting a lemon car is (1 - X)

1,331 * X + 780 * (1 - X) = 1,111

1,331X + 780 - 780X = 1,111

551X = 331

X = 60.1%

Option D is correct.