Picture the used car market: Cars are either high, medium, or low quality. To bu
ID: 1204010 • Letter: P
Question
Picture the used car market: Cars are either high, medium, or low quality. To buyers, high quality cars (which never break down) are worth $8,000, medium quality cars (which sometimes break down) are worth $5,000, and low quality cars (which often break down) are worth $2,000. Buyers initially perceive the odds of any car being a given quality as equal - that is, there is a one-third chance a car is high, medium, or low quality. Sellers know with certainty the quality of their car. Describe the market process - who drops out of the market rst? When the market nally reaches equilibrium, what types of cars are being sold? What is the price?
Explanation / Answer
Initially when the buyers perceive all cars of same quality, they will determine an intermediate price i.e. $ 5,000 so the sellers with high quality cars will drop out as there will be no takers for $ 8000. With the high quality cars out of the market, buyers will start receiving equal number of low quality cars for $ 5000, so the price will again start to drop and medium quality cars will be outsed of the market, so finally only low quality cars will be left in the market and the price will be steadily stabilise at $ 2,000. So finally at equilibrium only low quality cars will be sold and at $ 2,000.