HE3001 Tutorial 4

1) Consider the Akerlof’s model of lemons. Suppose there are 3 possible car qualities: high, medium and
low. Suppose also that the proportion of each type of car is 1/3. The values of buyers and sellers for
different car qualities are tabulated below.

Seller’s value Buyer’s value

Low quality car 5 8
Medium quality car 10 13
High quality car 15 18

(a) Is there an equilibrium in which all types of qualities are traded?

(b) Is there an equilibrium in which only low and medium qualities are traded?

(c) Is there an equilibrium in which only low qualities are traded?

d) Instead of equal proportion of cars, suppose the proportion of high-, medium-, and low-quality cars are
θ H ,θ M ,θ L respectively. Derive conditions on θ H ,θ M ,θ L under which there is an equilibrium in which all
cars are traded.
2) 1,000 people want to sell their used cars of varying quality in the market. Original owners know
exactly what their cars are worth. All used cars look the same to potential buyers until they have bought
them; then they find out the truth.

The quality of cars X is uniformly distributed between 0 and 2,000.

If a car is of quality X , its original owner will be willing to sell it for any price greater than X . If a buyer
knew that a car was of quality X , she would be willing to pay X +500 for it. If a buyer is not sure of the
quality of a car, she would be willing to pay its expected value, given their knowledge of the distribution
of qualities on the market.

(a) Suppose that everybody knows that all the used cars are for sale. What would used cars sell for?
Would every used car owner be willing to sell at this price?
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(b) Let X be some number between 0 and 2,000 and suppose that all cars of quality lower than X are
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sold, but all cars of quality higher than X are kept by original owners. What would buyers be willing to
pay for a used car? At this price, which used cars would be for sale?
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(c) Write an equation for the equilibrium value of X , at which the price that buyers are willing to pay is
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exactly enough to induce all cars of quality less than X into the market. Solve this equation for the
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equilibrium value of X .

(d) Comment on the efficiency of the market.

3) Each year, 1,000 citizens of Singapore sell their used cars and buy new cars. The original owners of the
old cars have no place to keep second cars and must sell them. These used cars vary a great deal in
quality. Their original owners know exactly what is good and what is bad about their cars, but potential
buyers do not. Lamentably, the used-car owners have no scruples about lying about their old cars.

The distribution of values of used cars on the market is given by a uniform distribution f ( V )=1/2000,
where 0 ≤ V ≤ 2000. I.e. there is an equal probability of getting a car of each V between 0 and $2,000.

There is a very large number of potential buyers, any one of which would be willing to pay $ V for a car
of value $ V . Potential used-car buyers are all risk-neutral. That is if they don’t know the value of a car
for certain, they value it at its expected value, given the information they have.

Lim’s Garage will test out any used car and find its true value V for a price of $200. Lim’s Garage is known
to be perfectly accurate and perfectly honest in its appraisals. Given the cost, people with terrible cars
are not going to want to pay $200 to have Lim tell the world how bad their cars are. But people with very
good cars will be willing to pay Rod the $200 to get their cars appraised, so they can sell them for their
true values.

Let’s try to figure out exactly how the equilibrium works, which cars get appraised, and what the
unappraised cars sell for.

(a) If nobody had their car appraised, what would the market price for used cars in Singapore be and
what would be the total revenue received by used-car owners for their cars?

(b) If all the cars that are worth more than $X are appraised and all the cars that are worth less than $X
are sold without appraisal, what will the market price of unappraised used cars be? (Hint: What is the
expected value of a random draw from the set of cars worth less than $X?)

(c) Suppose again that all the cars that are worth more than $X are appraised and all the cars that are
worth less than $X are sold without appraisal. Let us consider a decision of the marginal owner who has a
car worth $ X and is deciding whether to appraise his car. How much money will he get if he sold a car
without appraisal? How much money will he get if he sold a car with appraisal?

(d) If the above scenario is an “equilibrium”, we must have that owners with value less than $X choose
not to appraise while those with owners with value more than $X choose to appraise. What is the value
of $X in such an equilibrium?
(e) In equilibrium, on average, how many cars will be sold unappraised and what will they sell for?

(f) In equilibrium, on average, what will be the total net revenue of all owners of used cars, after Lim’s
Garage has been paid for its appraisals?
4) Consider the labour market signalling model in the lecture where in the labour market, there is a
proportion h of high ability workers with marginal product a h and 1−h of low ability workers with
marginal product a l. a l< ah.

Workers only choose how much education to undertake: high ability type: e h, low ability type: e l. Each
unit of education costs c h for high ability workers and c l for low ability workers. c l >c h.

Firms decide a wage for each possible education level w ( e ) . In particular, they pay workers their
expected marginal product according to their beliefs about their productivity given the education level.

Beliefs are determined as follows in equilibrium:

 At any education level which is actually chosen, firms correctly anticipate the proportion of each
type of worker. For example,
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o If both types choose the same education level e h=e l=e , the firm believes that a
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worker with education level e is high ability with probability h .
o If both types choose different education levels e h ≠ e l , the firm believes that a worker
with education level e h is high ability, while a worker with education level e l is low
ability.
 At any education level which is not chosen, firms can have any beliefs.

Consider a potential separating equilibrium where low and high ability workers choose different
education levels e l and e h respectively.

a) What would firms pay for a worker with education level i) e h, ii) e l ?

b) Write down the condition which needs to be satisfied if a high ability worker does not want to choose
e l instead of e h.
c) Write down the condition which needs to be satisfied if a low ability worker does not want to choose
e h instead of e l.

d) Using b) and c), provide an argument for why e h must be more than e l.

e) For any other education level e ≠ e h , el (i.e. off the equilibrium path), write down the lowest and
highest possible wage that firms will pay.

f) Provide an argument for why e l=0 in any separating equilibrium.

Hint: can the low ability worker find a different education level (off the equilibrium path) which gives him
a higher payoff if e l >0 ?

5) There are exactly two kinds of workers who always have to stay on in the labour market. One kind has
a (constant) marginal product worth $10 and the other kind has a (constant) marginal product worth $15.
There are equal numbers of workers of each kind. A firm cannot directly tell the difference between
the two kinds of workers.

(a) If the labor market is competitive, how much will each kind of worker be paid?

Consider a simplified version of the labour market signalling model in the lecture.
Instead of choosing any e >0, workers can only choose two different levels of education in the below
scenario.

Suppose Prof X offers an online microeconomics course. The high productivity workers think that taking
this course is just as bad as a $3 wage cut, and the low-productivity workers think it is just as bad as a $6
wage cut. Firms can observe whether or not an individual takes the course.

(b) Suppose that the high-productivity workers all choose to take the microeconomics course and the
low-productivity workers all choose not to. In this (potential) separating equilibrium, if the labor market is
competitive, how much will each kind of worker be paid?

(c) In the above potential separating equilibrium, what will be the net benefit of taking the
microeconomics course for each kind of worker? Is this a valid separating equilibrium?

Suppose that now Prof Y replaces Prof X as the lecturer of the online course. As Prof Y is more interesting
than Prof X, high-productivity workers think that taking Prof Y’s course is as bad as a $1 wage cut, and
low-productivity workers think that taking Prof Y’s course is as bad as a $4 wage cut.
(d) Suppose that the high-productivity workers all choose to take the microeconomics course and the
low-productivity workers all choose not to. In this (potential) separating equilibrium, if the labor market is
competitive, how much will each kind of worker be paid?

(e) In the above potential separating equilibrium, what will be the net benefit of taking the
microeconomics course for each kind of worker? Is this a valid separating equilibrium?

Conceptual Question

6) Consider a used car market with n-types, V 1 <V 2 <…<V n all in equal proportion in the market.
Assuming all buyers are risk neutral,

a) Come up with conditions for valuations of buyers such that the used car market has a “pooling
equilibrium”

b) Come up with conditions for valuations of buyers such that the used car market has a “partial pooling
equilibrium”