Suppose that there are two types of cars,good and bad.The qualities of cars are not observable but are known to the sellers.Risk-neutral buyers and sellers have their own valuation of these two types of cars as follows:
$$\begin{array} { | l | l | l | }
\hline \text { Types of Cars } & \text { Buyer's Valuation } & \text { Beller's Valuation } \
\hline \text { Good } & & \
\text { (50\% probability) } & 5,000 & 4,500 \
\hline \text { Bad } & & \
\text { (50\% probability) } & 3,000 & 2,500 \
\hline
\end{array}$$ When buyers do not observe the quality,what happens in the market?

Question

Suppose that there are two types of cars,good and bad.The qualities of cars are not observable but are known to the sellers.Risk-neutral buyers and sellers have their own valuation of these two types of cars as follows:
$$\begin{array} {  | l | l | l | } 
\hline \text { Types of Cars } & \text { Buyer's Valuation } & \text { Beller's Valuation } \
\hline \text { Good } & & \
\text { (50\% probability) } & 5,000 & 4,500 \
\hline \text { Bad } & & \
\text { (50\% probability) } & 3,000 & 2,500 \
\hline
\end{array}$$ When buyers do not observe the quality,what happens in the market?

Quizplus · Accepted Answer

Given the information asymmetry where buyers cannot observe the quality of cars, the market experiences a phenomenon known as "adverse selection." Buyers will be willing to pay a price based on the average value of the cars, which is (5,000 + 3,000) / 2 = 4,000. Sellers of good cars, valued at 4,500 by them, will not sell at this price, leading only bad cars, valued at 2,500 by sellers, to be sold in the market.

Suppose That There Are Two Types of Cars,good and Bad