Question

Consider a used car market in which half the cars are good and half are bad (lemons). If buyers are rational, the prices being offered for used cars will result in: a) an equal proportion of good cars and lemons being sold in an inefficient market. b) a larger proportion of good cars being sold and consequently, consumer surplus is increased. c) a larger proportion of lemons being sold and consequently, producer surplus is increased. d) an equal proportion of a good cars and lemons being sold in an efficient market.

Answer 1

The correct answer is option c.

Step-by-step explanation:

The market for lemons refers to the market for second-hand cars. In such a market a consumer can find both goods cars or peaches as well as bad cars or lemons.

A buyer is not aware whether the car he is buying is a lemon or a peach. So the buyers generally are willing to pay a lower price. A lower price motivates the seller to sell lemon instead of peaches or good cars.

So asymmetrical information regarding the condition of the car leads to adverse selection.

If buyers try to be rational and offer a lower price for a used car in order to reduce their risk, this will cause a larger portion of lemons to be sold n the market. This will increase the producer surplus.