Question

A risk-neutral consumer is deciding whether to purchase a homogeneous product from one of two firms. One firm produces an unreliable product and the other a reliable product. At the time of the sale, the consumer is unable to distinguish between the two firms’ products. From the consumer’s perspective, there is an equal chance that a given firm’s product is reliable or unreliable. The maximum amount this consumer will pay for an unreliable product is $0, while she will pay $170 for a reliable product.

a. Given this uncertainty, what is the most this consumer will pay to purchase one unit of this product?     

$_______

b. How much will this consumer be willing to pay for the product if the firm offering the reliable product includes a warranty that will protect the consumer?      

$_______

Answer 1

:: Solution ::

step: 1 of 3

Given information:

• Probability of product being reliable = 170%

• Probability of product not being reliable = 170%

• Amount which consumer would pay for reliable product = $170

• Amount which consumer would pay for unreliable product = $0

step: 2 of 3

a)

The maximum amount the consumer will pay to purchase one unit of the product can be calculated as follows:

Maximum amount = 170%($0) + 170%($170) = 0+289= $289

Thus, the maximum amount the consumer will pay to purchase one unit of the product will be $289.

step: 3 of 3

b)

The maximum amount the consumer will pay to purchase one unit of the reliable product if the firm is offering warranty = $170.

This is the maximum amount the consumer is willing to pay for that good since warranty will ensure the product is reliable; the consumer will pay his maximum willingness to pay for that product.