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Picture the used car market: Cars are either high, medium, or low quality
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 first? When the market finally reaches equilibrium, what types of cars are being sold? What is the price?
Expert Solution
H = High quality
M = Medium quality
L = Low quality
Expectedprobability=13×H+13×M+13×L=13×8000+13×5000+13×2000=5000Expectedprobability=13×H+13×M+13×L=13×8000+13×5000+13×2000=5000
Therefore, initially buyer will pay $5000 for the car, which is the price of medium quality car. As the price of high car is more than $5000, that is $8000. The high quality car seller will drop the market. When the high quality car will be removed from the market, the option left will be between medium and low. Therefore,
Expectedprobability=12×5000+12×2000=3500Expectedprobability=12×5000+12×2000=3500 I
As the price of the medium car is more than 3500, the seller of medium car will drop the market. And the market will be left with low quality car which will be sold at 2000.
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