Question

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 $3,500, whereas a seller with a high-quality car is willing to SALE sell it for $9,000. A buyer is willing to pay $4,500 for a low- quality car and $11,000 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:

Drop down options

only low-quality sellers

no sellers

all types of sellers

only high quality sellers

Answer 1

If all sellers offer their cars for sale and buyers have no way determining whether a car is a high-quality plum or a low-quality lemon, the expected value of a car to a buyer is 0.85*$4500+0.15*$11000 =$5475.( It is because 85% probability that car will be low quality and 15% probability that car will be high quality. )

Suppose buyers are willing to pay upto the expected value of a car that I found i.e $5475.

Since sellers of low quality cars are willing to sell for $3500, while sellers of high-quality cars are willing to sell for $9000, only low-quality sellers will be willing to participate in this market at that price. At this price only low-quality sellers will sell the car because high-quality car sellers will loose from here. The high-quality car sellers willing to sell it at price $9000 and selling price is greater than expected price i.e $5475. So they will not sell.

The dilemma in this problem is an example of economic concept adverse selection.

The problem is adverse selection because the condition of adverse selection arises from asymmetric information. The sellers know which car is specifically high quality and which car is low quality but buyers can not distinguish them. Only sellers of low-quality cars will remain in the market.