Question

Consider that oil can have 10 levels of quality v. Assume that there are the 10 oil producers that produce at each level and can produce the same amount of oil. The cost of producing oil at level v is 2 3 v. Also assume that oils are sold at the international markets and buyers cannot examine the oil quality directly. Assume that there are a lot of consumers, and that their willingness to pay for oil of quality v is v. i.e., if the consumers knew which type of oil they buy, they were willing to pay $v for it. As consumers cannot tell the difference, when buying, between the different quality of oil, they are willing to pay for the average quality oil. For example, if there were only producers of oil at quality 4 and 6 in the market, then the price the consumers were willing to pay is 0.5 × 4 + 0.5 × 6 = 5.

Which producers would be willing to sell in that price?

Answer 1

If oil can have 10 levels of quality v. Assume that there are the 10 oil producers that produce at each level and can produce the same amount of oil. The cost of producing oil at level v is 2 3 v. Also assume that oils are sold at the international markets and buyers cannot examine the oil quality directly. Assume that there are a lot of consumers, and that their willingness to pay for oil of quality v is v. i.e., if the consumers knew which type of oil they buy, they were willing to pay $v for it. As consumers cannot tell the difference, when buying, between the different quality of oil, they are willing to pay for the average quality oil.

For example, if there were only producers of oil at quality 4 and 6 in the market, then the price the consumers were willing to pay is 0.5 × 4 + 0.5 × 6 = 5. So at this price only the producers of quality v< 5 would be willing to sell.

This is because since the consumers are willing to pay only an average price so the producers who have the cost of production more than the average price will incur loss if they sell at this price. So only those producers whose cost is below the average price will be willing to sell at this average price.