Consider a market for used cars in which buyers would pay up to $18,000 for an orange (good used car) and $8,000 for a lemon. The owners of oranges will accept no less than $12,500 while owners of lemons will accept no less than $3,000. Assume that buyers always end up paying their full willingness to pay and that the fraction of oranges in the population is known to be f. If sellers can observe the type of car but buyers can’t, what is the minimum value of f such that the market for oranges does not collapse?

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Asked Dec 7, 2019
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Consider a market for used cars in which buyers would pay up to $18,000 for an orange (good used car) and $8,000 for a lemon. The owners of oranges will accept no less than $12,500 while owners of lemons will accept no less than $3,000. Assume that buyers always end up paying their full willingness to pay and that the fraction of oranges in the population is known to be f. If sellers can observe the type of car but buyers can’t, what is the minimum value of f such that the market for oranges does not collapse?

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Expert Answer

Step 1

The information asymmetry occurs in the economy when the sellers or the buyers have more information about the product in the market than the others. This means that either party will have more knowledge about the quality, quantity as well as the configuration of the product. Mostly, the sellers will have more information about the product than the consumers which leads to the information asymmetry.

Step 2

The potential consumer is willing to pay $18,000 for the good quality cars whereas they are willing to pay $8,000 for the bad quality cars in the market. The sellers of the good cars will accept a minimum of $3,000 whereas the sellers of the good cars will accept a minimum of $12,500 for their cars in the market. If the fraction of oranges is 0.5, the average value of a used car can be calculated as follows:

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Average Value of Used car = Average value Good used car +Average Value, Bad used car -[(0.5x18,000)+(0.5×9,000)] = 9,000+4,500 =13,500

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Step 3

Since the expected value of the used car is above the minimum accepted price for the good used car, the market for the good used cars will not collapse. The expe...

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Average Value of Used car = Average value, Bad used car °Good used car +Average Value, =[(0.45x18,000)+(0.6×9,000)] = 8,100+4,950 =13,050

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