Reference no: EM133276691

Question - A simple example: The market for used cars. There are 2 types of used cars available at dealerships: good cars and lemons (which break down often).

The fraction of lemons at a dealership is λ.

Note that Dealers do not publicly distinguish good cars versus lemons; they sell what's on the lot at the sticker price.

Buyers cannot tell apart good cars and lemons. But they know that some fraction (percentage) λ ∈ [0, 1] of cars are lemons. - After buyers have owned the car for any period of time, they also can tell whether or not they have bought a lemon. -

Assume that good cars are worth $20,000 to buyers

Assume that lemons are worth $10,000 to buyers.

For simplicity (and without loss of generality), assume that cars do not deteriorate and that buyers are risk neutral.

As a Result, the Pcars = (1 - λ) • 20,000 + λ • 10,000

1. If 50% of the Used Cars on the market are lemons, how much would a consumer be willing to pay for a used car, if there was no method to separate the lemons from the good cars.

2. If I could use a service (Carfax for example), and the price was $50-how would we estimate the percentage of lemons on the market (if the average price of a used car was $10,000)? Note that this is a challenging question and is only worth 4 points out of 25 on this section.

3. What industry (other than cars and motorcycles, etc.-basically non-transportation) could use a Lemons tracking service (this is a thinking question).

4. How does Gresham's Law relate to Akerlof's paper?