Question

Arisk-neutral consumer is deciding whether to purchase a homogeneousproduct from one of two firms. One firm produces an unreliable product andthe other a reliable product. At the time of the sale, the consumer is unable todistinguish between the two firmsîproducts. From the consumerîs perspec-tive, there is an equal chance that a given firmîs product is reliable or unreli-able. The maximum amount this consumer will pay for an unreliable productis $0, while she will pay $50 for a reliable product.

a. Given this uncertainty, what is the most this consumer will pay to purchaseone unit of this product?
b. How much will this consumer be willing to pay for the product if the firmoffering the reliable product includes a warranty that will protect the con-sumer? Explain

Answer 1

Uncertainty over Reliable and Unreliable Product

a. Given this uncertainty, the most this consumer will pay to purchase one unit of this product is $25

b. The amount that this consumer will be willing to pay for the product if the firm offering the reliable product includes a warranty that will protect the consumer is $50.

c. This is because the stated maximum amount that the consumer is willing to pay for the reliable product is $50. She is not prepared to spend more than this amount on the reliable product.

Step-by-step explanation:

a) Data and Calculations:

Unreliable Reliable

Maximum amount the consumer will pay $0 $50

Probability of reliability 0.5 0.5

Expected amount to pay for either product $0 $25 ($50 * 0.5)

a. Given this uncertainty, the most this consumer will pay to purchase one unit of this product is $25 ($0 + $25)