Suppose we are in a used car market and 50% of the cars are good quality cars but buyers do not know which seller in the market owns the good quality cars. Suppose also that signaling the quality of the car is possible via providing warranties for a certain number of years. The annual cost of warranties and the prices of the good and bad quality cars are given by the matrix below:
|
|
Good Quality Car
|
Bad Quality Car
|
|
Cost of A............. I Warranty
|
E150
|
E300
|
|
Price of the Car
|
£1500
|
£300
|
a. How many years of warranty would good quality car owners have to offer to credibly differentiate (separate) themselves from bad quality. i.e. credibly signal their quality?
b. Is signaling profitable for the owners of good quality cars in this case or are the owners of good quality cars better off without signaling? Show numerically and explain why.
c. What if only 20% of the cars in the market were good quality cars, would signaling be profitable for the owners of good quality cars?