Question

1. Suppose there are two kinds of used cars, good cars and lemons. A good car is worth $10,000, and a lemon is worth $2,000. Owners of used cars know where the car is good or bad, but potential buyers do not.

(a) Supposing half of all cars are good and half are lemons, what is the expected value of a used car of unknown quality?

(b) Based on your answer to part (a), do you expect owners of used cars to offer them for sale on the m used car market?

(c) If you see a car for sale on the used car market, what price do you value it at?

(d) What potential issue in the health insurance industry does this resemble?

Answer 1

TUESDAY - SEPTEMBER AUGUST WK 39 267-098 9 2 6000 d of al 10 of Car 11 not willing he 24 Cost of good cay = $10,000 Cost of lemon (bad cax) = $2,000 @ Expected realue of a used car of unknown quality is & ( 10,000) + (2,000) 5,000 + 1000 need are not willing to sell $6ood because they place a Theouth on good car, At $ 6000 only will be sold and this onener of case, lemon will drive out good huge profit. In such a from the market. (C) Since am not of the quality of i would take the expected cars and then would like to to purchase at the expected value. 12 6 Qunurs at 10,000 lemon lemon cars will get 1 be 2. bi d 3 amare car, value of th b both 4 at 5 ho (& The above ven problem relates to adverse selection iw nbich bulfer unable to sexeen out belucen good and bad cars. in the health insurance in industry, sick persons are the ones who buys um insurance. This companies raises the emiume due to nehich Similarly manin- bre ch which healthy consumers also I suffer 2013