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Market Failure — Asymmetric Information · Paper 1 — Free Economics HL Practice Questions
1FoundationSAQ-SDefinition and examples of asymmetric information8 marksPaper 1~12 min
A used car market contains both high-quality cars ("plums") and low-quality cars ("lemons"). Sellers know the true quality of their car, but buyers cannot distinguish between them before purchase.
(a)
Define asymmetric information as it applies to this used car market. [2 marks]
(b)
Explain how this information asymmetry leads to adverse selection in the used car market. [2 marks]
(c)
Evaluate the effectiveness of a government-mandated vehicle inspection and certification scheme as a solution to the adverse selection problem in this market. [4 marks]
Solutions
2MasterySAQ-SSolutions to asymmetric information4 marksPaper 1~6 min
In the market for pre-owned cars in Country X, sellers know the true condition of their vehicle, while buyers cannot distinguish between high-quality ("peaches") and low-quality ("lemons") cars. The average buyer is only willing to pay USD 6000 for a car of unknown quality. A government inspection scheme is introduced requiring all cars to pass a certified mechanical test before sale, costing USD 500 per car. Sellers of "peaches" welcome the scheme; sellers of "lemons" exit the market.
(a)
Using a demand supply for the pre-owned car market, explain how the inspection scheme affects equilibrium price and quantity. [2 marks]
(b)
Deduce whether the inspection scheme fully resolves the problem of asymmetric information in this market. [2 marks]
Solutions
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