The Market For Lemons

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1 The Market for Lemons A classic illustration of the e¤ects of asymmetric information is the market for used cars. It seems natural in this setting to assume buyers have limited information 2 about the quality of the various cars being o¤ered for sale, while sellers have a good idea as to whether the car is a .plum.(a good deal) or a .lemon.(a bad deal). We will consider a speci.c example. Assume 100 people want to sell their used cars and 100 people want to buy a used car. Everyone knows that 50 of the cars being o¤ered for sale are lemons and 50 are plums. The current owner of each car knows its quality, but the prospective purchasers do not. The owner of a lemon is willing to sell for $1,000; the owner of a plum for $2,000. Buyers have a WTP of $2,400 for plums and $1,200 for lemons. If quality is easy to verify (lemons have lots of rust; plums still have good-looking paint jobs), then this market works smoothly. Lemons sell for a price between $1,000 and $1,200 while plums sell for a price between $2,000 and $2,400. But what happens if potential buyers cannot observe quality? Then buyers have to make a guess about how much each car is worth. Say they assume each car has a 50% chance of being a plum and a 50% chance of being a lemon (note that this equals the true probability in the marketplace given the assumptions above). And, assume each buyer.s WTP equals the expected WTP across the two types. Given the assumptions above, this equals $1,800. The question is: which car owners would want to sell at that price? Answer: only the owners of lemons. The owners of plums will prefer to hold on to their used cars at a price of $1,800. Thus, buyers might rationally assume that, if they .nd a buyer willing to part with a car for $1,800, the car must be a lemon. Buyers, however, are not willing to pay $1,800 for a lemon; under our

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