GRA6031 Microeconomics
Problem Set 11: Hidden Characteristics I
1. Market for Lemons (very important for the exam)
Consider the market for a specific used car, say a 2017 Citrus. Suppose that in use, these cars
have either proved to be largely trouble free and reliable or have had many things go wrong.
The usual slang name for the latter type of car is ‘lemon’ (L), so for contrast, let us call the
former type ‘orange’ (O).
Suppose that the owner of an orange Citrus values it at €12,500. Similarly, each owner of a
lemon Citrus values it at €3,000. A buyer is willing to pay €16,000 for an orange Citrus, while
a lemon Citrus is valued at only €6,000. Suppose that oranges are a fraction f of used Citruses.
The market is such that the seller chooses the price of a used car and a buyer responds with
either accepting or rejecting the proposal.
A. Present the extensive form of this used car market when there is complete information.
B. Determine the subgame perfect equilibrium.
C. Is the equilibrium efficient? Explain your answer.
Information about the quality of any specific car is asymmetric between the two parties in the
transaction. The owner of a citrus knows perfectly well whether it is an orange or a lemon.
Potential buyers don’t.
D. What is the expected value of a used car for the buyer?
E. For which values of fraction f is the market efficient, i.e. for which values of the
fraction f can a price be determined such that all buyers and sellers want to
exchange all cars? Explain your answer by specifying the price requirement for the
buyers and the sellers.
F. Present the extensive form of the used car market with asymmetric information.
G. Determine the Nash equilibrium price when the market is efficient?
H. Determine the Nash equilibrium when the market is inefficient.
I. Explain why the equilibrium outcome in (H) is characterized as adverse selection.
2. Real estate bargaining
This exercise shows the importance of the sequence of decisions and incomplete information
in bargaining.
A real estate company sells houses in a market where the respective shares of buyers 3/10,
1/2, and 1/5 of the buyers are willing to respectively pay 5, 6, or 7 for a house. The real estate
agent knows the type of the buyer. The cost of the house is 4 for the real estate company. The
seller proposes a price, and subsequently the buyer accepts or rejects the proposal. If a buyer
rejects the proposal of the real estate agent, then the real estate agent as well as the buyer earn
0.
A. Present the extensive form.
B. Provide an example of a strategy of the real estate agent.
C. Determine the subgame perfect equilibrium.
D. Is the subgame perfect equilibrium efficient? Explain your answer.
E. What is the equilibrium payoff of each player?
Now consider the setting where the real estate agent does not know the type of the buyer.
F. Present the extensive form.
G. Provide an example of a strategy of the real estate agent.
H. Determine the expected payoff of the real estate agent for each of the
following choices: the real estate agent chooses the price of the house to be 5,
6, and 7.
I. Determine the subgame perfect equilibrium.
J. Is the subgame perfect equilibrium efficient? Explain your answer
K. What is the equilibrium payoff of each player?
L. Specify for each player whether the player gains or loses compared to the situation
when there is complete information. Explain your answer.
3 Education and job assignment (see also education signaling, discussed in lecture)
(Strategic form in a setting with incomplete information)
Consider a setting where an employee considers taking a part-time MBA education. The
motivation for taking the education is that it may have an impact on a future job assignment,
i.e. being a manager or a blue-collar worker. The market wage for a manager is higher than
that for a blue-collar worker. Assume in particular that these wages are 10 and 6 respectively.
The details of the strategic setting are as follows. Nature chooses player 1’s skill (productivity
at work), which can be high (H) or Low (L), and only player 1 knows his skill. The
probability that player 1’s type is H is p>0. After player 1 learns his type, he can choose
whether to be content with his undergraduate degree (U) or to get an MBA degree (D).
Getting an MBA degree requires some effort that is type dependent. Assume that high-skilled
types find it easier to study. In particular, assume that the cost of studying is 2 for the high-
skilled type, and 5 for the low-skilled type. Player 1 incurs thus a private cost if he gets an
MBA, and a cost of 0 if he does not.
Player 2 is an employer, who can assign player 1 to one of two jobs. Specifically player 2
can assign player 1 to be either a manager (M) or a blue-collar worker (B). Player 2 does not
know the type of player 1. Player 2’s payoff (the employer’s profit) is determined by the
combination of skill and job assignments. A high-skilled worker is relatively better at
managing, while a low-skilled worker is relatively better at blue-collar work. The employer’s
net profits, i.e. the revenues minus the market wage paid to the employee, from the possible
skill-assignment matches are given in the following table:
Assignment M B
Skill
H 10 5
L 0 3
A. Present the extensive form.
B. Determine the expected payoff of each player when player 1 chooses (U, D), i.e. player 1
chooses U(D) when his skill is H(L), and player 2 chooses (M, B), i.e. the Employer
chooses M(B) when U(D) is observed, and p=1/4. Show your calculation.
C. Present the strategic form when p=1/4.
D. Find the two Nash equilibria.
E. Which of these is a pooling equilibrium?
F. Specify the separating equilibrium.