Suppose there is a used car market with 500 cars for sale. Buyers know that 250 of the used cars are of poor quality and are worth only $1,000, while the other 250 used cars are of good quality and are worth $3,000. However, buyers do not know which individual cars are of poor quality or good quality. The seller of a car knows the worth of the car. Which of the following statements is true?The equilibrium price of a used car will be $2,000.We expect moral hazard to occur in this market.In equilibrium, only poor quality cars will be sold.

Question

Quizplus · Accepted Answer

In this scenario, the market is likely to experience a phenomenon known as "adverse selection," not moral hazard. Adverse selection occurs when buyers cannot distinguish between high-quality and low-quality goods, leading to the market price reflecting an average value of the goods. However, because sellers know the quality of their cars, those with good quality cars will not be willing to sell at the average price ($2,000 in this case), leading to a market where only poor quality cars are sold at or below the average price. This is different from moral hazard, which involves changes in behavior after a transaction occurs.

Suppose There Is a Used Car Market with 500 Cars