Solutions to Practice Problem Set 9
Perloff Chapter 18
The state of California set up its own earthquake insurance program for homeowners in
1997. The rates vary by ZIP code, depending on the proximity of the nearest fault line. However,
critics claim that the people who set the rates ignored soil type. Some houses rest on bedrock;
others sit on unstable soil. What are the implications of such rate setting?
Solution is in the back of the book.
If you buy a new car and try to sell it in the first year—indeed, in the first few days after you
buy it—the price that you get is substantially less than the original price. Use Akerlof’s lemons model
to give one explanation for this much-lower price.
There are few reasons why someone would sell a recently purchased car. One reason is that
the car has already had reliability problems and the owners believe it is a “lemon”, a term for
a poorly assembled car that will chronically break down. Potential buyers can’t tell lemons
apart from reliable cars being sold for other reasons. A risk neutral buyer would only pay the
average value of a reliable car and a lemon (actually, the expected value of a car based on the
percentage of all cars that are lemons) for a recently purchased used car. But, this is less than
the value of a reliable car, so no reliable car owners will be willing to sell at this price. If the
seller will accept this price, the car must be a lemon, so the buyer should not pay more than
the lemon price. So, unless sellers can verify their car is not a lemon (by including a
warranty, etc.) buyers will not pay more than the value of a lemon.
Use Akerlof’s lemons model to explain why restaurants that cater to tourists are likely to
serve low-quality meals. Tourists will not return to the area, and they have no information about the
relative quality of the food at various restaurants, but they can determine the relative price by
looking at menus posted outside each restaurant.
Before eating, consumers can only gain information about the price of the meal and
its general characteristics, such as the type of cuisine. They are generally unable to
tell the quality of a restaurant meal until after it has been consumed. In a tourist
environment where no consumers are likely to return to the restaurant anyway, if the
restaurant owner can save money (increase profits) by serving low quality meals, the
owner has the incentive to do so. A low quality restaurant can post the same price for
meals as a high quality restaurant, but since tourists are equally likely to go to either
and will only go once, all owners make more money by saving on quality.
Use the analysis in Section 18.3 to answer the following questions: The wine market in this
problem has 2,000 wineries, in which each chooses to sell one bottle of wine. One thousand of the
wineries have high quality grapes and can choose to turn the grapes into wine, and 1,000 wineries
have low quality grapes and can turn those grapes into wine. The marginal opportunity cost of