Question

Two firms, Gord and FM, sell cars. Suppose 50% of the new cars in the market are made by Gord and 50% are made by FM. Gord has superior technology so it produces higher quality cars, and the cost of producing a car is $90 for Gord. FM produces low quality cars at a unit cost of $50. Consumers value high quality cars at $120 and low quality cars at $80 Suppose consumers are willing to pay any price at or below their values. Sellers can either accept or reject offers depending on whether an offered price is above or below the car's cost.

Assume there is imperfect information such that consumers know one company produces high quality cars and the other produces low quality cars, but they do not know which company produces high quality cars. What is the equilibrium price of cars?

Answer 1

The equilibrium price of cars in a market with two firms, Gord and FM, and imperfect information will likely fall above Gord's production cost of $90 and FM's valuation of $80, but below the consumer's high valuation of $120. It will be a single market price reflecting the average consumer valuation and accounting for the risk of buying lower quality at a higher price.

Step-by-step explanation:

A student has asked about the equilibrium price of cars in a market where two firms, Gord and FM, sell cars of different quality, and where there is imperfect information meaning consumers cannot distinguish which firm produces the high-quality cars. In such a market, solving for the equilibrium price requires understanding consumer behavior and the consequences of asymmetric information on price and quality perception.

Gord, producing high-quality cars, incurs a cost of $90 per unit and consumers value this quality at $120. FM produces low-quality cars and incurs a cost of $50 per unit with consumers valuing this quality at $80. Under perfect information, the market would stratify, with Gord's cars selling at or near consumer valuation of $120 and FM's at $80. However, imperfect information leads to a single market price, a blend of the high and low valuations, because consumers risk paying a high price for low quality.

The equilibrium price in this scenario would likely settle where consumers are willing to pay above the cost of production for both firms but are not willing to risk paying the full high-quality price without certainty on quality. Thus, the equilibrium price is likely to be above $90, Gord's cost, and below $120, the consumer's high valuation. Due to the imperfect information about quality, it will also be at or slightly above FM's valuation of $80, necessitating that FM's cars provide some consumer surplus to compensate for the perceived risk. Therefore, equilibrium price could be moderately above $90, balancing these factors and leaving both types of cars demanded in the market.