PROBLEM 3. In Torp, there are 200 people who want to sell their used cars. Everybody...

PROBLEM 3.

In Torp, there are 200 people who want to sell their used cars. Everybody knows that 100 of these cars are "lemons" and 100 of these cars are "good." The problem is that nobody except the original owners know which are which. Owners of lemons will be happy to get rid of their cars for any price greater than $200. Owners of good used cars will be willing to sell them for any price greater than $1,500, but will keep them if they can't get $1,500. There are a large number of buyers who would be willing to pay $2,500 for a good used car but would pay only $300 for a lemon. When these buyers are not sure of the quality of the car they buy, they are willing to pay the expected value of the car, given the knowledge they have.

A. If all 200 used cars in Torp were for sale, how much would buyers be willing to pay for a used car? Would owners of good used cars be willing to sell their used cars at this price? Would there be an equilibrium in which all used cars are sold? Describe the equilibrium that would take place in Torp.

B. Suppose that instead of there being 100 cars of each kind, everyone in town is aware that there are 120 good cars and 80 lemons. How much would buyers be willing to pay for a used car? Would owners of good used cars be willing to sell their used cars at this price? Would there be an equilibrium in which all used cars are sold? Would there be an equilibrium in which only the lemons were sold? Describe the possible equilibrium or equilibria that would take place in Torp.

Expert Solution

Rahul Sunny answered 1 year ago

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