Question

Problem I-A: Consider the following situation. There are M sellers of used cellphones on the market and many potential buyers who compete in Bertrand fashion to buy these cellphones. Assume cellphones can either be of good quality or bad quality. The reservation seller prices are $150 for a good quality phone, and $20 for a bad quality phone. Buyers are willing to pay up to $200 for a good quality phone, and up to $50 for a bad quality phone. The ratio of good phones to bad phones among these M sellers is 1/2. That means that for every good phone there are two bad phones or that the probability of dealing with a good phone is 1/3 and the probability of dealing with a bad phone is 2/3.

a) What will happen if buyers can determine the exact quality of the phones before buying? What goods get traded, what are the prices, and what is the total market surplus in this full information case?

Answer: (TS = 110/3 M)

Please note that the answer is given to you, but I need help solving this problem in complete detail as I don't understand this subject too well. Thank you

Answer 1

The market outcomes can be very different with asymmetric information. The asymmetric information problem occurs when there is lack of information about the economic agents and the goods in the market. The Adverse selection problem arises when the asymmetric information about the quality of the goods being sold increases the quantity of low quality goods and drives the high quality goods out from the market.

The producers’ surplus is the difference between equilibrium price and cost of production of the good. This is given by the area above supply curve and below equilibrium price line up to equilibrium quantity.