[Adverse Selection] Two firms, Gord and FM, sell cars. Suppose 50% of the new cars in the market are made by Gord and 50% are made by FM. Gord has superior technology so it produces higher quality cars, and the cost of producing a car is $90 for Gord. FM produces low quality cars at a unit cost of $50. Consumers value high quality cars at $120 and low quality cars at $80. Suppose consumers are willing to pay any price at or below their values. Sellers can either accept or reject offers depending on whether an offered price is above or below the car’s cost. a. Assume there is imperfect information such that consumers know one company produces high quality cars and the other produces low quality cars, but they do not know which company produces high quality cars. What is the equilibrium price of cars? b. How does your answer in part (a) change when the cost of producing a car for Gord is $105 (instead of $90)? c. Back to the setting in part (a). Suppose we have the following dynamic game. First, each firm can choose to advertise (A) on TV, or not to advertise (NA). Advertising adds an extra $5 to the cost of the car for Gord and $50 for FM. Then, a consumer first sees if a car is advertised, then decides whether to offer $120 or $80 for a car. This is a signaling game in which the senders are the car companies and the signal is whether they advertise. Explain why Gord playing A and FM playing NA is a separating equilibrium.
[Adverse Selection] Two firms, Gord and FM, sell cars. Suppose 50% of the
new cars in the market are made by Gord and 50% are made by FM. Gord has superior
technology so it produces higher quality cars, and the cost of producing a car is $90 for Gord.
FM produces low quality cars at a unit cost of $50. Consumers value high quality cars at $120
and low quality cars at $80. Suppose consumers are willing to pay any
values. Sellers can either accept or reject offers depending on whether an offered price is
above or below the car’s cost.
a. Assume there is imperfect information such that consumers know one company
produces high quality cars and the other produces low quality cars, but they do not
know which company produces high quality cars. What is the
b. How does your answer in part (a) change when the cost of producing a car for
Gord is $105 (instead of $90)?
c. Back to the setting in part (a). Suppose we have the following dynamic
game. First, each firm can choose to advertise (A) on TV, or not to advertise (NA).
Advertising adds an extra $5 to the cost of the car for Gord and $50 for FM. Then, a
consumer first sees if a car is advertised, then decides whether to offer $120 or $80 for
a car. This is a signaling game in which the senders are the car companies and the
signal is whether they advertise. Explain why Gord playing A and FM playing NA is a
separating equilibrium.
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