Market Failure — Asymmetric Information · Paper 2 — Free Economics HL Practice Questions

In the market for pre-owned cars in Country X, sellers know the true condition of their vehicles, while buyers do not. The market contains $50\%$ high-quality cars ("plums") and $50\%$ low-quality cars ("lemons"). Plums are worth $\text{USD }20{,}000$ to sellers and $\text{USD }28{,}000$ to buyers. Lemons are worth $\text{USD }8{,}000$ to sellers and $\text{USD }12{,}000$ to buyers. Buyers, unable to distinguish between the two types, are willing to pay only the expected value of a randomly chosen car.

A health insurance market in Country Y has two types of customers: low-risk individuals, who have a $10\%$ probability of incurring USD 50,000 in medical costs per year, and high-risk individuals, who have a $90\%$ probability of incurring USD 50,000 in medical costs per year. The population is $50\%$ low-risk and $50\%$ high-risk. Insurance companies cannot distinguish between the two types and must offer a single pooled premium. The market is perfectly competitive, so firms earn zero economic profit.