Critical Mass Problems

Lemons

It is well known that as soon as a new car is bought and driven off the lot, its value drops significantly. Walrasian economics cannot explain this phenomena.

The Model:

Cars can be divided into two categories and two subcategories:

• First, a car is new or used
• Second, a car is good or bad (a "lemon" or not)

The purchaser of a new car soon finds out whether or not his car is a lemon but, importantly, he is the only one who knows this.

Someone in the market for a used car knows that the market is comprised of both lemons and non-lemons. Knowing this, the used car purchaser seeks to bid no more than a weighted average of the price they'd pay for a lemon and the price they'd pay for a non-lemon using their best estimate of the populations for each.

Let: q_L=the estimated population of lemons p_L=price willing to pay for a lemon p_NL'=price willing to pay for non-lemon

Then,

Bid=q*p_L+(1-q)*p_NL

The important part to note is that the bid price will be lower than p_NL