Suppose that you own a used car dealership. You want to sell a 2005 Honda Civic LX. You know that this car is of high quality, and it cost you $5000 to acquire it (so you will not sell it at a price below $5000). However, consumers cannot see the quality of the car at the time of purchase. They believe that 25% of the cars in the used car market are high-quality cars and 75% are low-quality cars or “lemons.” A typical lemon costs $2000 to acquire (so you will not sell it at a price below $2000). Consumers are eager to buy and are willing to pay up to $3000 for a lemon and $6000 for a high-quality car. From now on, suppose that only you (the seller) know the quality of the cars. (Buyers do not know the quality, but know the proportion of high- and low-quality cars in the market). Suppose that you could offer bumper-to-bumper warranties. You know that offering a warranty on a high-quality car costs, on average, $450 per year of warranty offered, while a warranty on a lemon is very costly and it costs $1600 per year. One of your economist friends suggests that you offer a two-year warranty to signal to consumers that your 2005 Honda Civic Accord LX is indeed a high-quality car. She says that this will enable you to sell. (f) Suppose now that, in addition to high- and low-quality cars, there are also medium-quality cars in the market. Consumers do not see the quality of the car at the time of purchase, but believe that half of the cars are of low quality, ¼ are of medium quality, and ¼ are of high quality. As before, if you own a high-quality car, you are willing to sell it at a price of $5000 or more. You are willing to sell a medium-quality car at $3000 or more, and a lemon at $2000 or more. Consumers are willing to pay up to $6000 for a high-quality car, $4000 for a medium-quality car, and $3000 for a lemon. If you had a medium-quality car, do you expect to be able to sell it? Justify your answer.
Suppose that you own a used car dealership. You want to sell a 2005 Honda Civic LX. You know that this car is of high quality, and it cost you $5000 to acquire it (so you will not sell it at a price below $5000). However, consumers cannot see the quality of the car at the time of purchase. They believe that 25% of the cars in the used car market are high-quality cars and 75% are low-quality cars or “lemons.” A typical lemon costs $2000 to acquire (so you will not sell it at a price below $2000).
Consumers are eager to buy and are willing to pay up to $3000 for a lemon and $6000 for a high-quality car.
From now on, suppose that only you (the seller) know the quality of the cars. (Buyers do not know the quality, but know the proportion of high- and low-quality cars in the market).
Suppose that you could offer bumper-to-bumper warranties. You know that offering a warranty on a high-quality car costs, on average, $450 per year of warranty offered, while a warranty on a lemon is very costly and it costs $1600 per year. One of your economist friends suggests that you offer a two-year warranty to signal to consumers that your 2005 Honda Civic Accord LX is indeed a high-quality car. She says that this will enable you to sell.
(f) Suppose now that, in addition to high- and low-quality cars, there are also medium-quality cars in the market. Consumers do not see the quality of the car at the time of purchase, but believe that half of the cars are of low quality, ¼ are of medium quality, and ¼ are of high quality. As before, if you own a high-quality car, you are willing to sell it at a price of $5000 or more. You are willing to sell a medium-quality car at $3000 or more, and a lemon at $2000 or more. Consumers are willing to pay up to $6000 for a high-quality car, $4000 for a medium-quality car, and $3000 for a lemon. If you had a medium-quality car, do you expect to be able to sell it? Justify your answer.
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