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Unformatted text preview: nd the Market Mechanism," The Quarterly Journal of Economics, 84, 1970, pp.488-500. 4 325 bad cars). The current owner (seller) of the car knows the quality but the prospective buyers don't know whether any given car is a plum or a lemon. Further, the owner of a lemon will be willing to part with it at a price of $1000 and the owner of a plum will be willing to part with it at a price of $2000. The buyers will be willing to pay $1200 for a lemon and $2400 for a plum. This market has no problems if it is easy to verify the quality type of each car. The lemons would sell for somewhere between $1000 and $1200 and the plums would sell for somewhere between $2000 and $2400. But what happens when the buyers can't observe the quality of the car? In this case, the buyer is at an informational disadvantage and must "guess" about how much a particular car is worth. We will make a simple assumption about the form of the buyer's guesses, that is, we will assume that if a car is equally likely to be a plum or a lemon then a typical buyer would be willing to pay the expected value of the car. Using the numbers from the example this means that the buyer would be wiling to pay: ($1200) + ($2400) = $1800. Wait a minute! Now who are the sellers that are willing to sell at such a price? The owners of lemons would, but the owners of plums would not want to sell their cars (they require at least $2000 by assumption). So the price the buyers are willing to pay for an "average" car is less than the price that the sellers of the plum cars want in order to part with their cars. At a price of $1800 only lemons would be offered for sale!! But if the buyer was certain that he would get a lemon then he wouldn't pay $1800 for it. In fact, the equilibrium price in this market would need to be somewhere between $1000 and $1200. For prices in this range we know only owners of lemons would offer their cars for sale, and buyers would expect (correctly) to get a lemon. In this market, none of the plums ever get sold even though the price that buyers are willing to pay e...
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This note was uploaded on 05/25/2010 for the course ECON 301 taught by Professor Sning during the Spring '10 term at University of Warsaw.
- Spring '10