Part 1: Reserve Prices
A reserve price is a minimum price set by the auctioneer. If no bidder is willing to pay the reserve price, the item is unsold at a profit of $0 for the auctioneer. I f only one bidder values the item at or above the reserve price, that bidder pays the reserve price. An auctioneer faces two bidders, each with a value of either $30.00 or $80.00, with both values equally probable. What reserve price should the auctioneer set, and what is the expected revenue from auctioning the item with and without a reserve price?
Part 2: Extended Warranties
Your product fails about 20% of the time, on average some customers purchase the extended warranty you offer on which you will replace the products if it fails. Would you want to price the extended warranty at 2% of the product price? Discuss both moral hazard and adverse selection issues.