Question

Give an explanatory (numerical) example that illustrates a market failure in the market for used cars. Please includes an overlap in prices for each quality type and market failure.

Answer 1

- Maket failure is term that define situation where consumer demands does not equal the amount of service supply.

The market for used cars-

For example-

- If there are 2 types of car available in dealerships:good cars and break down cars.

-The fraction of break down cars at a dealership is x.

- Dealer's do not publicly distinguish good cars vs break down cars,they sell what's on the lot at the sticker price.

- Buyers cannot tell apart good cars and break down cars.But they konw that some fraction x €[0,1] of cars are break down cars.

- After buyer's have owned the car for any period of time ,they also can tell wheather or not they have bought a break down cars.

- Assume that good cars are worth Y1=$10,000 to buyers and break down cars are worth Y2=$20,000 to buyers.

Then,

- Equilibriumprice for new cars (P1)

P1=(1-x).20,000 + x.10,000.

- Now,consider the used car market.Assume that used cars sell at a 20 percent below their new value.So good used cars and break down cars sell for

X1=$16,000 and X2 =$8,000.

- Since car don't deteriorate,used cars buyers will be willing to pay Y11=$20,000 and Y22=$10,000 respectively for used cars and break down cars.There the buyer and seller together gain a surplus of $4,000 or $2,000 from each sale.

Equilibrium price of used car(P2)

P2=(1-x).16,000 + x.8,000.

- If the share of break down cars in the overall car population is high enough ,the bad cars will drive out the good ones.Although buyers would be willing to pay $ 20,000for a good used cars,their inability to distinguish good cars from break down cars means that they will not willing to pay more than $15,000 for any used cars.

- With x high enough ,no goods cars are sold ,and the equilibrium price must fall to exclusively reflect the value of break down cars.