Two types of existing houses are for sale: ones with a cracked foundation and ones without.In all other respects,they are identical.Houses without cracked foundations are worth $200,000 while those with cracked foundations are worth $200,000 minus the $20,000 to fix the crack or $180,000.The frequency of solid foundations is 80%.Sellers know which type of house they have but buyers cannot detect a crack.No seller "must" sell his house in order to move and thus no one accepts anything less than its value.
Suppose that consumers are unsophisticated and assume that houses with cracked and solid foundations are offered for sale in their true proportion.The consumer's reservation price is thus

Question

Quizplus · Accepted Answer

The reservation price for unsophisticated consumers will be based on the average value of the two types of houses, weighted by their frequency in the market. Therefore, the reservation price will be:

($200,000 x 0.8) + ($180,000 x 0.2) = $196,000

So, the best choice for the unsophisticated buyers would be to offer a maximum of $196,000 for any house, whether they suspect the foundation to be cracked or not. Any offer above this amount would result in overpaying for the house.

Two Types of Existing Houses Are for Sale: Ones with a Cracked