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Homework answers / question archive / Jonas would like to buy a used banjo, but he is not an expert on instruments and, thus, cannot assess the quality of the banjo directly without playing it for an extended period
Jonas would like to buy a used banjo, but he is not an expert on instruments and, thus, cannot assess the quality of the banjo directly without playing it for an extended period. Jonas believes that owner who have not taken proper care of their banjos are more willing to sell than owners who have maintained their banjos well. Because of this, Jonas believes that banjos up for sale are probably lower quality.
1.
Which of the following economic problems is characterized in the story?
a) Moral hazard.
b) Government failure.
c) Adverse selection.
d) The free-rider problem.
The correct answer is c) adverse selection.
Adverse selection occurs in a situation where there's incomplete information on the side of the buyer, that he or she either can't verify or can verify but only after the sale takes place.
A famous example is George Akerlof's description of the "lemon" market. The typical setting is also a market with used cars, where the buyers can verify the quality only ex post. If the buyers can't distinguish between good and bad quality used cars, then they would only be willing to pay a price, which would be the average between the price of a good quality car and a bad quality car. The problem arises because for this price, only the sellers with bad quality cars are willing to sell, so only bad quality cars will be sold in this market, even though both buyers and sellers would have been willing to trade the good quality cars as well.
