In the market for Rolexianish luxury watches, consumers cannot tell the difference between high-quality and low-quality movement watches. Even though the two types of watches look the exact same, the performance of low-quality movement watches is much worse than that of high-quality movement watches. Buyers value a high-quality movement watch at $10,000 and a low-quality movement watch at $8,000. Recently, the FBWI (Federal Bureau of Watch Investigators) conducted to study and determined that 40% of watches in the market are high-quality movement, while 60% are low-quality movement. Note: Assume there are no consumer protection laws or outside rating agencies. When buying a watch, there is no way to know if it is high or low quality.
A. What is a buyer’s expected value of a luxury watch?
B. If sellers of high-quality watches have a reservation price of $8,000 and sellers of low- quality watches have a reservation price of $6,500, what happens in this market? Are there any equity(fairnesss) implications? Explain.
C. If sellers of high-quality watches have a reservation price of $9,000 and sellers of low quality watches have a reservation price of $7,500, what happens in this market? Are there any equity(fairness) implications? Explain.
D. Screening is an important tool when asymmetric information is present. Assume you’re in the market for a high-quality watch and the sellers’ reservation prices are $6,000 for a low-quality watch and $10,000 for a high-quality watch (and you, as the buyer, know these reservation prices). Can you screen out the low-quality watches by offering $6,000 and when the owner turns you down, you know she’s selling a high-quality watch? Will that work? Explain.