Reference no: EM132328733

Suppose there are two kinds of used cars which exist, good cars worth $20,000 to the seller and $30,000 to the buyer, and bad cars (lemons) worth only $10,000 to the seller and 15,000 to the buyer. There are q ∈ (0, 1) regular cars and 1 - q lemons. Also suppose that only the owner truly knows the type of car that it is, both agents are risk neutral, and that cars can only be sold for one price p.

1. If all cars of both kinds are sold, what is your expected value from buying a used car? Let μ denote the probability of buying a good car for the car that are actually sold (i.e., μ only equals q if all cars are sold). What is the expected value of the cars that are actually sold for the buyer? What is the price, p, the buyer is willing to pay in terms of her valuation of the cars and μ?
2. For which μ will the seller want to sell lemons? For which μ will the seller want to sell good cars? What does this imply about whether lemons, good cars, or both are sold in the market?