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Unformatted text preview: xceeds the price the sellers are willing to accept (i.e. $2400 > $2000). This is due to the fact that the buyer and seller have asymmetric information about the quality of the cars. Let's think about the source of this market failure... The problem is that there's an externality between the sellers of good cars and the sellers of bad cars; when a seller decides to sell a bad car, he affects the buyer's perception of the quality of the average car on the market. 326 This lowers the price that the buyers are willing to pay for the average car, and thus hurts the people who are trying to sell good cars. It is this externality that results in the market failure. Let's demonstrate with another (similar) example... Suppose now that there are 100 sellers and 100 buyers, as before, but now there are 80 plums and only 20 lemons. The expected value of the average car to the buyers then becomes: 0.2 ($1200) + 0.8 ($2400) = $2160. With a lower proportion of bad cars on the market we have a situation where the average car is worth $2160 to the prospective buyers and plum cars will now be sold! The caveat is that the cars that are most likely to be offered for sale are the ones that people most want to get rid of. The very act of offering to sell something sends a signal to the prospective buyer about its quality level. If too many low quality items are offered for sale (as we see above) it makes it more and more difficult for the owners of high quality items to sell their products. The "Lemon's Problem" is the classic example of what is called adverse selection. The low quality items in the model served to "crowd-out" the high quality items because of the high cost of acquiring information. This adverse selection problem may become so severe that it can completely destroy the market. Another example might serve to clarify what we mean by adverse selection. Consider the insurance industry. Suppose that an insurance company wants to offer insurance for bicycle theft. They do a careful market survey and find that the incidence of theft varie...
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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