Adverse Selection

Adverse Selection - Adverse Selection Consider the market...

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Adverse Selection Consider the market for used cars. A potential buyer cannot tell whether a used car is a good car that will run well or is a lemon that will never run right. After one has owned a car for a while, one learns something about the quality of the automobile. So, the seller knows more about the quality of a used car than the buyer. Since the buyer cannot tell the difference between a good and a bad car, both good and bad cars must sell for the same price somewhere in between the low value of a lemon and the high value of a good car. Suppose that buyers know that 60% of used cars are lemons. A buyer is willing to pay $2000 for a good car and $1000 for a lemon. Sellers are willing to accept $1500 for a good car and $500 for a lemon. Since the price will reflect the average car quality, all used cars will sell for $1400. Sellers of lemons are more than happy to receive a price higher than the lemon's low quality, but sellers of good cars will be unwilling to sell at a price below its high value. Therefore, only
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This note was uploaded on 11/22/2011 for the course FIN FIN1100 taught by Professor Bradrifkin during the Fall '09 term at Broward College.

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