Economics of Used Cars Pricing

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Questions and Answers

What is the outcome for Amy if she works extra hard under an efficient contract?

She earns $200 per day. (correct)

She earns $100 per day.

Her earnings are dependent on weather conditions.

She bears the risk of losing her job.

What problem arises when Paul cannot observe Amy's effort?

There is perfect information.

Amy bears all the risk.

Profit is maximized.

Moral hazard occurs. (correct)

What is the value of Amy's extra effort per day?

$100

$160

$40 (correct)

$200

Under an inefficient contract, what does Amy earn regardless of her effort?

$100 Signup and view all the answers

How does the risk-neutral principal, Paul, manage his earnings from multiple stores?

He pulls earnings across all stores. Signup and view all the answers

What is one key characteristic of an inefficient contract in this scenario?

It does not align interests between principal and agent. Signup and view all the answers

What does an efficient contract guarantee for a risk-averse agent like Amy?

No risk exposure. Signup and view all the answers

Which of the following represents the primary incentive for Amy to exert extra effort?

The fear of being fired. Signup and view all the answers

In a risk-neutral transaction between a buyer and a seller, what price does the market establish for lemons?

$6,000 Signup and view all the answers

Which condition suggests that asymmetric information does not lead to an efficiency problem in the car market?

Buyers consider expected value (EV) at $6,000 while sellers value good cars at $5,000. Signup and view all the answers

What happens when sellers value good cars at $7,000 while buyers consider the expected value to be $6,000?

Sellers will refuse to sell good cars at the buyers' expected value. Signup and view all the answers

Which of the following is a characteristic of the market described as efficient?

Goods are allocated to those who value them the most. Signup and view all the answers

What is one of the key implications of asymmetric information in the car market?

Sellers have better knowledge of car quality than buyers. Signup and view all the answers

When considering expected values in a market with asymmetric information, what is the benefit to buyers?

They can estimate the average quality of cars based on market trends. Signup and view all the answers

In the context of adverse selection, what does it mean when goods go to those who value them the most?

Prices reflect the actual value of the goods sold. Signup and view all the answers

What is the primary reason why sellers may choose not to sell a good car at a price of $6,000?

They believe the quality of their car justifies a higher price. Signup and view all the answers

What is the expected value (EV) for Paul when he bears all risk with a fixed wage according to the given scenario?

$100 Signup and view all the answers

Which type of contract allows the agent to earn profits based on the state of nature?

State-contingent contracts Signup and view all the answers

In a scenario where Amy is highly risk-averse, which type of payment structure would she likely prefer?

Fixed wage Signup and view all the answers

What is the main advantage of using a skillfully designed contract to address moral hazard?

It ensures the agent always acts efficiently. Signup and view all the answers

What does Amy achieve by paying a fixed license fee to Paul under a fixed-fee contract?

Paul bears all the risk. Signup and view all the answers

How does working hard affect Amy's potential earnings under the state-contingent contract structure?

It allows her to keep all extra earnings. Signup and view all the answers

In a profit-sharing contract, what determines the payoffs for each party?

Observable total profit. Signup and view all the answers

What happens to Amy's incentives when she operates under a fixed-fee contract?

She has less incentive to work hard. Signup and view all the answers

What is one method used to bond agents to ensure their good behavior?

Requiring a performance bond Signup and view all the answers

What problem arises with bonding if an employee fears repeated opportunistic behavior from the employer?

The employee may refuse to deposit the bond Signup and view all the answers

What happens to the supply curve for good cars when the reservation price is $5,000?

It is horizontal up to 1,000 cars and then vertical. Signup and view all the answers

What is the estimated value of cars (EV) when the information is incomplete and symmetric?

$6,000 Signup and view all the answers

How do deferred payments help reduce the need for monitoring?

By rewarding only those who remain with the firm long-term Signup and view all the answers

At which price does the supply curve, S2, for good cars become vertical?

$7,000 Signup and view all the answers

What is an efficiency wage?

A high wage above the worker's opportunity cost Signup and view all the answers

What is a potential issue with deferred payments and good employees?

Employers may fire good workers to avoid higher payouts Signup and view all the answers

In a situation with asymmetric information, what challenge do buyers and sellers face?

Sellers have more information about the car's quality. Signup and view all the answers

What is the role of reservation price in determining the market for used cars?

It sets the minimum price sellers can accept. Signup and view all the answers

Which type of monitoring focuses on undesirable actions after they occur?

After-the-fact monitoring Signup and view all the answers

Which supply curve corresponds to a reservation price of $7,000?

S2 Signup and view all the answers

What is a critical condition for a firm to benefit from efficiency wages?

The saving from reduced shirking must exceed higher wage costs Signup and view all the answers

In a market where information is asymmetric, how does it affect pricing?

Prices fluctuate widely based on perceptions. Signup and view all the answers

What can enhance the effectiveness of bonding for ensuring employee behavior?

Creating a strong firm reputation and independent verification Signup and view all the answers

At a price of $6,000, how many good cars are supplied in the market?

0 to 500 cars Signup and view all the answers

What is implied by symmetric information in a used car market?

Buyers and sellers both possess complete knowledge of car quality. Signup and view all the answers

How many cars does the supply curve become vertical at a price of $8,000?

No cars supplied Signup and view all the answers

Study Notes

Asymmetric Information - Adverse Selection

Reservation price for owners of high-quality used cars is $8,000.
Two scenarios for the value (v):
- If (v = $5,000), supply curve (S1) is horizontal at this price for up to 1,000 cars, then becomes vertical.
- If (v = $7,000), the supply curve is (S2).

Equilibrium with Symmetric and Asymmetric Information

Symmetric Information: All information is available to both buyers and sellers, resulting in a balanced market.
Asymmetric Information: Sellers know car quality, while buyers do not, leading to potential efficiency issues and equity implications.

Equilibrium Concepts

Equilibrium under symmetric information leads to an expected value (EV) of $6,000, calculated as:
- (EV = 0.5 \times 8000 + 0.5 \times 4000)
In asymmetric scenarios:
- If sellers value good cars at $5,000 and buyers have an EV of $6,000, cars sell at $6,000, but sellers appear to lose equity despite market efficiency.
- If good cars are valued at $7,000 but buyers still perceive them as worth only $6,000, sellers won't sell, creating market inefficiencies.

Moral Hazard in Contracts

Paul, a principal with multiple ice cream parlors, contracts Amy to manage one shop, dependent on local demand and her work effort.
Two information scenarios affect the efficiency of contracts:
- Symmetric Information: Paul can supervise Amy effectively.
- Asymmetric Information: Paul cannot monitor Amy’s effort directly.

Efficient vs. Inefficient Contracts

Efficient Contract:
- Offers Amy $200 for extra effort, and she bears no risk. Incentive to work is high since she would otherwise risk job loss.
Inefficient Contract:
- Fixed fee of $100 regardless of effort leads to reduced motivation for Amy, impacting overall profitability.

Contract Structures

Fixed-Fee Contracts:
- Amy pays a fixed license fee, ensuring she bears risk while Paul receives stable income.
Contingent Contracts:
- Payoffs depend on external conditions (e.g., weather affecting demand). Amy's income tied to demand encourages hard work while managing risk distribution.

Profit-sharing contracts link party payouts to total observable profit.
Bonding requires agents to guarantee good behavior with performance bonds, ensuring responsibility and commitment to tasks.

Deferred Payments & Efficiency Wages

Deferred payment strategies incentivize long-term employee retention by rewarding those who perform well over time.
Efficiency wages are set above market rates to deter shirking, motivating workers as losing their job means accepting lower-paying positions elsewhere.

Monitoring Strategies

After-the-fact monitoring enables employers to detect undesirable behavior by assessing outcomes rather than constant oversight.

These concepts showcase the interplay of information asymmetry in markets and contract theory, emphasizing the importance of effective monitoring and incentives.

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Description

This quiz explores the economic concepts surrounding the pricing of used cars, focusing on reservation prices and supply curves. It highlights different scenarios for values of v and their impact on the market for high-quality vehicles. Test your understanding of these important economic principles!