Many wineries in the Napa Valley region of California enjoy strong reputations for producing high quality wines and want to protect those reputations. Fred T. Franzia, the owner of Bronco Wine Co., sold Napa-brand wines that do not contain Napa grapes (Flynn, Julia, "In Napa Valley, Winemaker's Brands Divide an Industry," Wall Street Journal, February 22, 2005, A1). Other Napa wineries sued Mr. Franzia, contending that his wines, made from lower-quality grapes, damaged the reputation of the Napa wines. Suppose that the wine market has 2,000 wineries, and each sells one bottle of wine. Half, 1,000, have Napa grapes that they can turn into wine, and half have Central Valley grapes. The marginal opportunity cost of selling a Napa wine is $20, and the marginal opportunity cost of selling a Central Valley wine is $5. A large number of risk-neutral consumers with identical tastes are willing to buy an unlimited number of bottles at their expected valuations. Each consumer values a wine made from Napa grapes at $25 and a wine made from Central Valley grapes at $10. By looking at the bottles, consumers cannot distinguish between the Napa and the Central Valley wines.
a. If all of the wineries choose to sell wine, what is a consumer's expected value of the wine? If only the wineries with Central Valley grapes sell wine, what is a consumer's expected value of the wine?
b. What is the market equilibrium price? In the market equilibrium, which wineries choose to sell wine?
c. Suppose that wine bottles clearly label where the grapes are grown. What are the equilibrium price and quantity of Napa wine? What are the equilibrium price and quantity of wine made from Central Valley grapes?
d. Does the market equilibrium exhibit a lemons problem? If so, does clearly labeling the origin of the grapes solve the lemons problem?