Question

It costs $10 to produce a low-quality wallet and 420 to produce a high-quality wallet. Consumers...

It costs $10 to produce a low-quality wallet and 420 to produce a high-quality wallet. Consumers cannot distinguish between the products before purchase, they do not make repeat purchases, and they value the wallets at the cost of production. The five firms in the market produce 100 wallets each. Each firm produces only high-quality or only low-quality wallets. Consumers pay the expected value of a wallet. If all five firms initially produce low-quality wallets, could any one firm increase its profit by producing high-quality wallets instead?

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Answer #1

Cost to produce a low-quality wallet = $10

Cost to produce a high-quality wallet = $20

Five firms produce 100 wallets each

When all the firms produce low-quality wallets except one then the chance of buying a high-quality wallet = 1/5

And chance of buying a low-quality wallet = 1-1/5 = 4/5

Expected value of a wallet to a consumer = 10*4/5+20*1/5 = 8+4 = $12

Therefore if the fifth company produces wallet $20 it would bear loss of 20-12 =$8 per wallet whereas the profit of other four firms producing low-quality wallets will rise by $12-$10=$2 so all the firms would be happy to produce low-quality wallets.

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