Free Economics Dissertations - Adverse Selection In The Used Car Market a) Using No Diagram, Symbols Or
Adverse Selection in the Used Car Market
A) Using no diagram, symbols or equations explain how adverse selection may be a problem in the market for used cars. (max 300 words)
Adverse selection is a situation of market failure arising from imperfect information. It results in a situation in which the assumptions put forward by perfectly competitive markets theory cannot be fulfilled. Adverse selection occurs in a situation of asymmetric information, where a seller has greater knowledge of the product and its hidden problems than the buyer. In the context of used cars, the work undertaken by Akerlof (1970) in his assessment of the ‘market for lemons’ provides an explanation of the problems of adverse selection in this market. It assumes that the market for used cars consists of both good quality vehicles and poor quality vehicles, or ‘lemons’. The sellers of used cars know the actual quality of the vehicles they are selling, but the buyers do not. However, buyers do know that a percentage of used cars in the market are ‘lemons’, just not which ones.
Sellers are prepared to sell vehicles for different amounts depending on whether the car is of good quality or not, and will expect a higher value for the good car than for a lemon. Through the selling of ‘lemon’ cars, buyers’ perceptions of the average quality of cars in the market are affected. This leads to an average lower price that buyers are willing to pay, which ultimately has a damaging affect on the sellers of good used cars, who will be unable to reach the true value of their cars. As buyers have asymmetric information and do not know the true quality of the vehicle they are buying, they are only prepared to pay the ‘expected value’, after taking into account that the true quality of the vehicle will not known until after purchase.
B) Discuss the likely effects of warranty's in the context of the market for used cars (add diagrams/equations). (max 400 words)
The effects of warranties in the context of the market for used cars are as follows: an incentive mechanism (for both sides of the market); a risk sharing contract; a signal about product quality; a quality-assurance contract. (Corricelli and Luini, 2001)
The following diagram explains the use of warranties as a signalling mechanism, and includes the zero-profit lines of one seller of good used cars and one seller of ‘lemons’. The slope of these lines depends on the failure probability of the used cars, and the steep line, CL VL, represents a high probability of used car failure, and the flatter CH VH line represents a lower probability of breakdown.
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