Question

Consider a market for a specific kind of used cars, say 2009 Honda Civic. Suppose that in use these cars have proved to be either trouble free and reliable (peach) or have many things go wrong (lemon). The buyers are willing to pay $8,000 for a peach and $4,000 for a lemon. Each seller, on the other hand, values his/her car at $6,000 if it is a peach, and $2,000 if it is a lemon. The information about quality of any given car is not symmetric between its owner and potential buyers. The owner of the car knows perfectly well whether it is a peach or a lemon, whereas potential buyers don’t. The buyers only know that 60% of the Civics are peaches and the remaining 40% are lemons.
Required:
a. What will be the market price for a Civic? Which cars will be traded? (For definiteness, suppose that there is a limited stock of used Civics and a larger number of potential buyers.) Assume that the example above takes place in month 0. Every month that passes, all sellers of Civics – regardless of type – are willing to accept $100 less than they were the month before. Also, with every passing month buyers are willing to pay $400 less for a peach than they were the previous month and $200 less for a lemon.

b. What will be the market price for a Civic in month 1? Which cars will be traded?
c. What will be the market price for a Civic in month 2? Which cars will be traded?

Answer 1

Answer:

a. What will be the market price for a Civic? Which cars will be traded?

• market price = $6,400
• all cars would be traded since the market price exceeds the selling price of peaches (and lemons).

b. What will be the market price for a Civic in month 1? Which cars will be traded?

• market price = $6,080
• all cars would be traded since the market price exceeds the selling price of peaches (and lemons).

c. What will be the market price for a Civic in month 2? Which cars will be traded?

• market price = $5,760
• only lemons would be traded since the market price exceeds the selling price of lemons but not peaches.

Explanation:

month 0

buyers expected cost:

peaches $8,000 x 60% = $4,800

lemons $4,000 x 40% = $1,600

total expected cost = $6,400

sellers expected price:

peaches $6,000

lemons $4,000

month 1

buyers expected cost:

peaches $7,600 x 60% = $4,560

lemons $3,800 x 40% = $1,520

total expected cost = $6,080

sellers expected price:

peaches $5,900

lemons $3,900

month 2

buyers expected cost:

peaches $7,200 x 60% = $4,320

lemons $3,600 x 40% = $1,440

total expected cost = $5,760

sellers expected price:

peaches $5,800

lemons $3,800