Question

Auto dealers can purchase and fix up good used cars for $8000. Consumers are willing to pay $10000 for good used cars. Lemons can be obtained by dealers at a cost of $4000 per car and are worth $5000 to buyers. There are 100 good cars and 100 lemons and many potential buyers in the market. Buyers are unable to distinguish between good used cars and lemons when the car is being purchased.

a) In the absence of warranties or regulation in this market, what would be the total profit for sellers from selling good used cars?

b)

Continuing with the previous question, suppose dealers offer a warranty with an expected cost per warranty of $500 for good used cars.  If a seller of lemons offers a warranty the expected cost is $X per car. Consumers believe a car sold with a warranty is a good used car.

What is the minimum value of X for which a warranty offered by the dealer would be a solution to the adverse selection problem?

Answer 1

Thus in part b the solution is $2,500