In a second-hand goods market, sellers and know their own product's quality but buyers cannot. Valuations rise with quality: sells quality at price and sells quality at price , with and . This market will suffer from
Select all that apply.
2 marksMicroeconomicsAsymmetric informationAdverse selection and the market for lemonsModerateabout 2 min
IIT JAM 2021 Question 40: Asymmetric information
Answer and worked solution
Answer: (A) and (C)
Because buyers cannot observe quality, they will pay only an average price. That price is unattractive to the high-quality seller , who withdraws, leaving mostly low-quality goods: this is adverse selection, statement (A).
The unravelling of trade when good products exit is a form of market failure, statement (C). Moral hazard involves hidden actions after a contract, which is not the issue here, and there is no claim of excess supply, so (B) and (D) are wrong. The correct statements are (A) and (C).
The trap: (B) moral hazard
Hidden quality before trade is adverse selection, not moral hazard; moral hazard concerns hidden actions taken after an agreement.
Plain-text version
In a second-hand goods market, sellers H and L know their own product's quality but buyers cannot. Valuations rise with quality: H sells quality Q_H at price P_H and L sells quality Q_L at price P_L, with Q_H > Q_L and P_H > P_L. This market will suffer from (A) adverse selection (B) moral hazard (C) market failure (D) excess supply
Asymmetric information has come up 16 times in 5 exams since 2014.
What this question tests
This question is on Adverse selection and the market for lemons, part of Asymmetric information in Microeconomics.
How hidden quality can make good products or good risks leave a market.
TestStop has 8 past-paper questions on this subtopic.
Question from the IIT JAM 2021 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.