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 .

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) [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 $30, 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 ) 30, 000 + 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. (7 points)
2. If I could use a service (Carfax for example), and the price was $50how would we estimate the percentage of lemons on the market (if the average price of a used car was $10,000this is not the priceit is simply an example)? Note that this is a very challenging question and is only worth 2 points out of 20 on this section. (2 points)
3. What industry (other than cars and motorcyclesnon transportation) could use a Lemons tracking service (this is a think question). (7 points)
4. How does Gresham's Law relate to Akerlof's paper? (4 points)

Answer rating: 100% (QA)

1 If 50 of the used cars on the market are lemons a consumer would be willing to pay the expected value of a used car which is calculated as follows P... View the full answer