Question

1. A common complaint is that a new car will depreciate by 25% as soon as the new owner drives it off the lot. This information comes from resale price data from cars sold just months after the initial purchase. How does adverse selection imply that most cars depreciate much less?
2. Most pizza restaurants charge by the pie or by the slice. Cici's has found a niche by charging a flat rate for the meal and allowing as many visits to the pizza buffet as the customer desires. How does this affect the make-up of its clientele?

Answer 1

Solution

Cici's is charging a flat rate for the meal and allowing as many visits to the pizza buffet as the customer desires.Due to this,there will be a considerable change in it's clientele.Now it's clientele will consist of only those people who are willing to eat the minimum number of pies that will collectively amount to the flat rate that Cici's is charging.The customers will consider the cost of single pie as that of charged by the other Pizza restaurants.

Due to this the average consumption per customer visiting the Cici's restaurant will increase as the total quantity of pizza consumed will increase.

Adverse selection is nothing but information asymmetry - When the sellers have more information that of the buyers.

Here it is being assumed that the new car will depreciate by 25% immediately after the purchase just because of the adverse selection from the resale data (The sellers have gathered the re-sale data which is unavailable to the buyers)

Firstly,this resale data does not represent the true sample size / size of the entire car market i.e., Most % of the cars bought are used for more than at least 1 year or more but here the resale data is only pertaining to the cars that re-sold in just few months after purchase.So,keeping in mind this data and applying it and arriving at the above assumption that the new cars will depreciate by 25% is a kind of exaggerating.So,if there is no adverse selection by means of this re-sale price data,the percentage by which the cars depreciate would be lesser.

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