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Thank u sir!
vandita
On 26 Apr 2014 14:27, "Amit Goyal [via Discussion forum]" < [hidden email]> wrote:
Suppose that there are two types of cars, good and bad. The qualities of cars are not
observable but are known to the sellers. Risk-neutral buyers and sellers have their own
valuation of these two types of cars as follows :
Types of Cars Buyer's Valuation Seller's Valuation
Good (50% probability) 5,000 4,500
Bad (50% probability) 3,000 2,500
suppose that sellers value a good car at 4,500 and a bad car at 2,500, and quality is not
observed by the buyers. What is the highest price that risk-neutral buyers will offer for
a used car if they recognize adverse selection?
(a) 2,500
(b) 3,000
(c) 4,000
(d) 4,500
Buyer's valuation for a randomly selected car from the pool of used cars is 4,000 (=0.5*(5000)+0.5*(3000)) which is less than the seller's valuation for a good car. So at this price they will only get bad cars. Knowing this, the buyer's valuation for a used car will now be 3,000 and hence his maximum price (at which trade takes place) for a used car is 3,000.
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