## (Solution Download) 1 Fashion and Prices You are in the market for

1. Fashion and Prices. You are in the market for a used car and have narrowed your options to two types of cars, type F and type P. According to Consumer Reports, the two types of cars have roughly the same frequency of lemons (50 percent). Like other consumers, you are willing to pay \$1,000 for a lemon and \$7,000 for a plum. The people who buy new F cars are fashion conscious and purchase a new car every three years. The people who buy new P cars are insensitive to the whims of fashion. Predict the equilibrium prices of the two types of cars and defend your answer with two graphs, one for each type of car.
2. Double Ignorance. Suppose both buyers and sellers of used cars are ignorant: No one can distinguish between lemons and plums. Would you expect the market to be dominated by lemons? Illustrate with a completely labeled graph.
3. Groucho Club. Consider a classic quip from Groucho Marx: I won t join any club that is willing to accept me as a member. Suppose Groucho wants to associate with high-income people (the higher the income the better) and everyone else has the same preferences as Groucho.
a. Use the notion of adverse selection to explain this quip.
b. Relate the quip to the adverse-selection problem.
4. Purchasing a Fleet of Used Cars. You are responsible for buying a fleet of 10 used cars for your employees and must pick either brand B or brand C. For your purposes, the two brands are identical except for one difference: Based on your experience with the two brands, you figure that 50 percent of B cars in the market are lemons and only 20 percent of C cars in the market are lemons. You are willing to pay \$1,000 for a known lemon and \$3,000 for a known plum. If the price of B cars is \$1,800 and the price of C cars is \$2,200, which brand of car should you pick?
5. Adverse Selection of MP3 Players. Consider the market for used MP3 players, with knowledgeable sellers and ignorant buyers. Half the MP3 players in existence are plums and half are lemons. Each buyer is willing to pay \$50 for a plum or \$20 for a lemon. The minimum supply price for a plum is \$10 and the minimum supply price for a lemon is \$2.
a. In equilibrium, will the market be thin or will all the used MP3 players in the market belemons? Explain and illustrate your answer with a complete graph.
b. Suppose that at a price of \$26, the quantity of plums is 20 and the quantity of lemons is 80. Is this an equilibrium? Explain and illustrate your answer with a completegraph.

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