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5) Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells high-quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry's $8,000 to buy and service each car that it sells. The second dealership, Lew's Motors, always sells lower-quality cars. On average, it costs Lew's only $5,000 for each car that it sells. If consumers knew the quality of the used cars they were buying, they would pay $10,000 on average for Harry's cars and only $7,000 on average for Lew's cars. Without more information, consumers do not know the quality of each dealership's cars. In this case, they would figure that they have a 50-50 chance of ending up with a high- quality car and are thus willing to pay $8,500 for a car. Harry has an idea: He will offer a bumper-to-bumper warranty for all cars that he sells. He knows that a warranty lasting Y years will cost $500Y on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew $1,000Y on average. a. Suppose Harry offers a one-year warranty on all of he cars he sells. i. What is Lew's profit if he does not offer a one-year warranty? If he does offer a one-year warranty? ii. What Harry's profit if Lew does not offer a one-year warranty? If he does offer a one-year warranty? iii. Will Lew's match Harry's one-year warranty? iv. Is it a good idea for Harry to offer a one-year warranty?

5) Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells high-quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry's $8,000 to buy and service each car that it sells. The second dealership, Lew's Motors, always sells lower-quality cars. On average, it costs Lew's only $5,000 for each car that it sells. If consumers knew the quality of the used cars they were buying, they would pay $10,000 on average for Harry's cars and only $7,000 on average for Lew's cars. Without more information, consumers do not know the quality of each dealership's cars. In this case, they would figure that they have a 50-50 chance of ending up with a high- quality car and are thus willing to pay $8,500 for a car. Harry has an idea: He will offer a bumper-to-bumper warranty for all cars that he sells. He knows that a warranty lasting Y years will cost $500Y on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew $1,000Y on average. a. Suppose Harry offers a one-year warranty on all of he cars he sells. i. What is Lew's profit if he does not offer a one-year warranty? If he does offer a one-year warranty? ii. What Harry's profit if Lew does not offer a one-year warranty? If he does offer a one-year warranty? iii. Will Lew's match Harry's one-year warranty? iv. Is it a good idea for Harry to offer a one-year warranty?

Exploring Economics
Exploring Economics
8th Edition
ISBN:9781544336329
Author:Robert L. Sexton
Publisher:Robert L. Sexton
Chapter8: Market Failure
Section: Chapter Questions
Problem 10P
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5) Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells high-quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry’s $8,000 to buy and service each car that it sells. The second dealership, Lew's Motors, always sells lower-quality cars. On average, it costs Lew's only $5,000 for each car that it sells. If consumers knew the quality of the used cars they were buying, they would pay $10,000 on average for Harry's cars and only $7,000 on average for Lew’s cars. Without more information, consumers do not know the quality of each dealership's cars. In this case, they would figure that they have a 50-50 chance of ending up with a high- quality car and are thus willing to pay $8,500 for a car. Harry has an idea: He will offer a bumper-to-bumper warranty for all cars that he sells. He knows that a warranty lasting Y years will cost $500Y on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew $1,000Y on average. a. Suppose Harry offers a one-year warranty on all of he cars he sells. i. What is Lew's profit if he does not offer a one-year warranty? If he does offer a one-year warranty? ii. What Harry's profit if Lew does not offer a one-year warranty? If he does offer a one-year warranty? iii. Will Lew's match Harry's one-year warranty? iv. Is it a good idea for Harry to offer a one-year warranty? b. What if Harry offers a two-year warranty? Will this offer generate a credible signal of quality? What about a three-year warranty? c. If you were advising Harry, how long a warranty would you urge him to offer? Explain why.
Transcribed Image Text:5) Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells high-quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry’s $8,000 to buy and service each car that it sells. The second dealership, Lew's Motors, always sells lower-quality cars. On average, it costs Lew's only $5,000 for each car that it sells. If consumers knew the quality of the used cars they were buying, they would pay $10,000 on average for Harry's cars and only $7,000 on average for Lew’s cars. Without more information, consumers do not know the quality of each dealership's cars. In this case, they would figure that they have a 50-50 chance of ending up with a high- quality car and are thus willing to pay $8,500 for a car. Harry has an idea: He will offer a bumper-to-bumper warranty for all cars that he sells. He knows that a warranty lasting Y years will cost $500Y on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew $1,000Y on average. a. Suppose Harry offers a one-year warranty on all of he cars he sells. i. What is Lew's profit if he does not offer a one-year warranty? If he does offer a one-year warranty? ii. What Harry's profit if Lew does not offer a one-year warranty? If he does offer a one-year warranty? iii. Will Lew's match Harry's one-year warranty? iv. Is it a good idea for Harry to offer a one-year warranty? b. What if Harry offers a two-year warranty? Will this offer generate a credible signal of quality? What about a three-year warranty? c. If you were advising Harry, how long a warranty would you urge him to offer? Explain why.
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