Question
Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells high-quality cars that it carefully inspects and,
Two used car dealerships compete side by side on a main road. The first,
Harry's Cars, always sells high-quality cars that it carefully inspects and, if necessary,
services. On average, it costs Harry's $8000 to buy and service each car that it sells.
The second dealership, Lew's Motors, always sells lower-quality cars. On average, it
costs Lew's only $5000 for each car that it sells. If consumers knew the quality of the
used cars they were buying, they would pay $10,000 on average for Harry's cars and
only $7000 on average for Lew's cars.
Without more information, consumers do not know the quality of each dealership's
cars. In this case, they would figure that they have a 50-50 chance of ending up with a
high-quality car and are thus willing to pay $8500 for a car.
Harry has an idea: He will offer a bumper-to-bumper warranty for all cars that he sells.
He knows that a warranty lasting Y years will cost $500Y on average, and he also knows
that if Lew tries to offer the same warranty, it will cost Lew $1000Y on average.
a. Suppose Harry offers a one-year warranty on all of the cars he sells.
i. What is Lew's profit if he does not offer a one-year warranty? If he does
offer a one-year warranty?
ii. What is Harry's profit if Lew does not offer a one-year warranty? If he does
offer a one-year warranty?
iii. Will Lew's match Harry's one-year warranty?
iv. Is it a good idea for Harry to offer a one-year warranty?
b. What if Harry offers a two-year warranty? Will this offer generate a credible signal
of quality? What about a three-year warranty?
c. If you were advising Harry, how long a warranty would you urge him to offer?
Explain why.
Step by Step Solution
There are 3 Steps involved in it
Step: 1
![blur-text-image](https://dsd5zvtm8ll6.cloudfront.net/includes/images/document_product_info/blur-text-image.webp)
Get Instant Access with AI-Powered Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
![blur-text-image](https://dsd5zvtm8ll6.cloudfront.net/includes/images/document_product_info/blur-subtext-image.webp)
Step: 3
![blur-text-image](https://dsd5zvtm8ll6.cloudfront.net/includes/images/document_product_info/blur-subtext-image.webp)
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started