Question

You are in the market for a used car and decide to visit a used car dealership. You know that the Blue Book value of the car you are looking at is between $14, 000 and $26, 000.

A. If you believe that the dealer knows as much about the car as you do, how much are you willing to pay? Assume that you care only about the expected value of the car you will buy and that the car values are symmetrically distributed.

B. Now that believe that the dealer knows more about the car than you do. How much are you willing to pay?

C. How can this asymmetric information problem be solved in a competitive market?

Answer 1

a) You are willing to pay the average price.If the distribution of car values is symmetric,you are willing to pay $20000 for a randomly selected car.

b) You are willing to pay the average price unfront- $20000.However,the dealer will know this and only sell you a car worth between $14000 and $20000.But,you know this,so, you will only pay $17000 and so on.This ends with yo paying $14000 and the car being worth $14000.

c)This is OK for you but the dealer can never sell cars worth more than $14000.The resolution,of course is to get more information.This may include a test drive,mechanical inspection,warranty etc.