Situation 1

Robert wants to buy a certain type of used car. Paula owns this type of used car. Paula claims that her car is of excellent quality. She knows the real condition of her used car. In fact, her car is not in good condition. Robert does not have any knowledge in automobile mechanics and thus does not know whether Paula's car is in excellent condition or not. Robert is risk neutral. Robert is willing to buy a used car in a good condition at $17,000 and used car in less than a good condition at $8,000. Paula makes an offer to Robert for $12,000. Since her car is in less than a good condition, she would be willing to sell it to Robert or anybody else for $6,000.

• Will Robert accept her offer? Why? Why not?
• What is the maximum price at which Robert would buy Paula's car?

Situation 2

Compared to Situation 1, Situation 2 is characterized by full information. Robert knows what Paula knows and vice versa.

• What price would Robert be willing to pay for Paula's car?
• Why is Situation 1 an example of market failure?