Question

ECO 226- Week 10  Assignment: The Lemon Market

As we have been learning that a  lemons’  market is a market in which adverse selection occurs.   Adverse selection occurs when unobservable qualities are mis-valued because of a lack of information. This is often called a lemons market.

How much is a consumer willing to pay for a used car that could be either a lemon or a plum? To determine a consumer’s willingness to pay in a mixed market with both lemons and plums, you must answer these questions: (50 points- 10 points each)

1. What is a lemons market? Why is it called this?

       2.  How much is the consumer willing to pay for a plum?

      3.   How much is the consumer willing to pay for a lemon?

      4.   What is the chance that a used car purchased in the mixed market will be of low quality?

      5.      In a market with asymmetric information, there are strong incentives for buyers and sellers to    solve the lemons problem. Discuss.

Answer 1

1)Lemon Maket is a market with quality uncertaininty.ie, how the quality of goods traded in a market can degrade in the presence of  asymmetric information between buyers and sellers, leaving only "lemons" behind.To obtain accurate information about quality is a problem also in the markets for consumer goods. When a consumer buys a used car, it may be very difficult for him to determine whether it is a good car, called a “plum” car or a bad car, i.e., a “lemon”.Especially a market of used car is called Lemon Market.

2) Let us consider a market where 100 people want to sell their used cars and 100 people want to buy used cars.Let us suppose that everyone in the market knows that 50 cars are “plums” and 50 are “lemons”. The present owner of each car knows its quality, but the people who want to buy the car, do not know whether any given car is a plum or a lemon.Let us now suppose that the owner of a lemon is willing to sell his car at $1000 and the owner of a plum is willing to sell his car at $2000. On the other hand, the buyers of the car are willing to pay $2400 for a plum and $ 1200 for a lemon.So the ideal equilibirium price for the customers willing to pay for plums would be between $2000-2400.

3) Similaly the ideal equilibirium price for the customers willing to pay for lemons would be between $ 1000-1200.

4) if it is easy to verify the quality of the used cars, there will be no problems in the market.But, if the buyers have no way to know the quality of the car, then they have to just guess about the quality and about how much should be paid for the car, then there is a chance of getting low quality cars.

5) if a buyer to assume that thre will be an equal probability of getting either a pum or lemon, then he woul be willing to pay the average price of a lemon or a plum, in this example $ 1800 = 1/2(1200)+1/2(2400).

But, obviously, only the owner of a lemon will be willing to sell his car at the price of $1800. Because, he offers his car at a price of $1000 and the buyer is willing to pay much higher an amount which is $1800.However, the owner of a plum will not be willing to sell his car at the price that the buyer is willing to pay.Because he wants considerably more, $2000, than what the buyer is offering to pay, which is only $1800. Although the good for sale is divisible, in equilibrium the seller ends up trading his whole endowment or not trading at all. Then the trades take place at a price equal to the expected quality of the good, conditional on the seller being ready to trade at that price with good incentives either from the part of seller or buyer.