Question

A risk-neutral consumer is deciding whether to purchase a homogeneous product from one of two firms. One firm produces an unreliable product and the other a reliable product. At the time of the sale, the consumer is unable to distinguish between the two firms’ products. From the consumer’s perspective, there is an equal chance that a given firm’s product is reliable or unreliable. The maximum amount this consumer will pay for an unreliable product is $0, while she will pay $100 for a reliable product.

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

$

b. How much will this consumer be willing to pay for the product if the firm offering the reliable product includes a warranty that will protect the consumer?      

Answer 1

Solution:-.

Hope its helps you...

a) Price = 0.5x100 + 0.5x0 = 50
This is due to adverse selection.

b) If the firm offers warranty, then she expects that 100% she will get reliable product. So she will be wililng to pay 100.