Question

2. There are two courier firms in the market. Herme’s vans (50 in total) often break down, deadlines are missed and the average cost per vehicle delivery is $80. Athena’s vans (50 in total) are more reliable, they have an excellent record of delivering on time and the average cost per vehicle delivery is $120.

(a) With full information, customers are willing to pay $100 per vehicle delivery for Hermes’s service and $160 per vehicle delivery for Athena’s service. Calculate the profit each firm makes under a full information equilibrium. Illustrate the full information equilibrium. [10 marks]

b) Now assume that buyers are risk neutral and they don’t know the characteristics (that is, the “type”) of the courier company. All they know is that there is a 70% chance they will hire type = Hermes and 30% chance they will hire type = Athena. What is the market outcome with asymmetric information? Calculate the profit/loss for each firm. Illustrate the outcome using the diagram used in part (a) above. [10 marks]

Answer 1

Q2)

(a) Now, Under the full information equilibrium, 50 units of Herme's vans will be sold for the consumers' willingness to pay = 100 per unit and the 50 units of Athena's vans will be sold for the consumers willingness to pay = 160 per unit.

Profit for Herme = (Price - average cost)* total units sold

= (100 - 80)*50 = 20*50 = 1000

Profit for Athena = (160 - 120)*50

= 40*50 = 2000

(b) If buyers do not know the type, they would be willing to pay the expected value of the vans

= Pr(Herme)*Willingness to pay for Herme + Pr(Athena)*Willingness to pay for Athena

= 0.7*100 + 0.3*160 = 70 + 48 = 118

Now, since the cost of producing Athena vans is 120 and the consumers willingness to pay is only 118, in equilibrium no Athena will be sold. Athena will exit the market and the buyers will know that the only vans sold are Herme. Thus, they will be willing to pay 100. Herme will sold 50 units at 100 each and again make a profit of 1000. Athena will be out fo the market and make a profit of 0.