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Market Failure — Asymmetric Information · Paper 3 — Free Economics HL Practice Questions
1ChallengeSAQ-LDefinition and examples of asymmetric information7 marksPaper 3~11 min
In the market for pre-owned luxury cars in a European city, sellers know the exact condition of their vehicles, but buyers cannot distinguish between high-quality cars ("plums") and low-quality cars ("lemons") before purchase. The market initially contains 1000 cars: 400 plums and 600 lemons. Buyers are risk-neutral.
Buyer's maximum willingness to pay — USD 50,000 — USD 20,000
Seller's minimum acceptable price — USD 40,000 — USD 15,000
(a)
Calculate the single equilibrium price and quantity that emerge under asymmetric information. Show all working. [2 marks]
(b)
Explain why this equilibrium represents a market failure, using the concept of adverse selection. [2 marks]
(c)
A government mandates a certified pre-owned inspection programme that fully reveals car quality to buyers before purchase. Each inspection costs USD 3,000, paid by the seller. Evaluate the effectiveness of this policy in correcting the market failure. [3 marks]
Solutions
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