Question

10. The market for lemons Consider a market in which there are many potential buyers and sellers of used cars.

Each potential seller has one car, which is either of high quality (a plum) or low quality (a lemon). A seller with a low-quality car is willing to sell it for $5,000, whereas a seller with a high-quality car is willing to sell it for $9,500. A buyer is willing to pay $6,000 for a low-quality car and $10,500 for a high-quality car. Of course, only the seller knows whether a car is of high or low quality, as illustrated in the accompanying image.

Suppose that 80% of sellers have low-quality cars. Assume buyers know that 80% of sellers have low-quality cars but are unable to determine the quality of individual cars. If all sellers offer their cars for sale and buyers have no way of determining whether a car is a high-quality plum or a low-quality lemon, the expected value of a car to a buyer is _____$ (Hint: The expected value of a car is the sum of the probability of getting a low-quality car multiplied by the value of a low-quality car and the probability of getting a high-quality car multiplied by the value of a high-quality car.) Suppose buyers are willing to pay only up to the expected value of a car that you found in the previous question.

Since sellers of low-quality cars are willing to sell for $5,000, while sellers of high-quality cars are willing to sell for $9,500, will be_________ willing to participate in this market at that price.

a. only high-quality sellers

b. only low-quality sellers

c. all types of sellers

d.no sellers

The dilemma in this problem is an example of which of the following economic concepts?

a. Adverse selection

b. Moral hazard

c. Screening

d. Signaling

Answer 1

Seller’s price for low quality car = $5,000

Buyer’s price for low quality car = $6,000

Percentage of sellers having low quality car = 80%

So the probability of low quality car = 80% = 0.8

Seller’s price for high quality car = $9,500

Buyer’s price for high quality car = $10,500

Percentage of sellers having high quality car = 100 - 80% = 20%

So the probability of high quality car = 20% = 0.2

The expected value of a car to a buyer = probability of getting a low-quality x Buyer’s Price of low quality car + the probability of getting a high-quality x Buyer’s Price of high quality Car

The expected value of a car to a buyer = 0.8 x $6,000 + 0.2 x $10,500 = 4,800 + 2,100 = $6,900

As the expected price of the Car is $6,900 then only low quality sellers will participate in this market. So the answer is

b) only low-quality sellers

The dilemma in this problem is an example of adverse selection, as per definition, adverse selection is a process of trade where, buyer and seller have the access to different information called as asymmetric information, and buyers having more private information about the quality of the product will buy the products selectively to get the maximum benefit.

So answer should be a) Adverse Selection.