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?

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Quizplus · Accepted Answer

Risk-neutral buyers will offer the expected value of the car, which is the average of the value of good and bad cars. However, since the buyers cannot observe the quality of the car, they will base their offer on the average value of all cars in the market, which is $3,500. This means that if a seller offers a car for more than $3,500, the buyer will assume that it is a good car, which is not necessarily the case. Therefore, the highest price that a risk-neutral buyer will offer for a used car in the face of adverse selection is $3,000, which is between the value of good and bad cars, to account for the probability that the car being sold is either good or bad.

Suppose That Sellers Value a Good Car at $4,500 and a Bad