Question

Suppose that in the Akerlof example, there are only seven cars with quality levels 0.5; 0.75; 1; 1.25; 1.5; 1.75; 2 (i.e., there is no complete lemon). Assume sellers are fully informed about each car's quality and buyers only know the average quality of cars. If the sellers have a reservation price of $5000 per unit of quality, and the buyers value cars at $7500 per unit of quality. Determine whether the market disappears completely, and, if not, how many cars will be sold.

Answer 1

Akerlof Markets are markets where lemon (low quality) and plum (good quality) goods coexist and the lemon sellers have incentive to withold information regarding their quality, thus creating information asymmetry. This leads to adverse selection on behalf of the buyers who are unaware of the product quality.

In the given question, the sellers are in possession of all information regarding their quality and are willing to take $5,000 for every unit of quality. As a result, following is the schedule of prices that the sellers are willing to sell their products at.

Seller	Quality	Price
1	0.5	$2,500
2	0.75	$3,750
3	1	$5,000
4	1.25	$6,250
5	1.5	$7,500
6	1.75	$8,750
7	2	$10,000

The buyers however, are not aware of the quality of each car and know only the average car quality.

For each unit of quality, buyers are willing to pay $7,500, which means that each buyer will be willing to pay (7,500 X 1.25) = $9,375 for all cars irrespective of their quality. And from the schedule we can see that at $9,375, all cars except one will be sold. The last car which can be sold only at $10,000 will remain unsold as the reservation price of the seller exceeds the price that the buyer is willing to pay.

Thus, market for cars will not dissappear and 6 units will be sold.

Thanks!