Question

There are two sellers, $H$ and $L$, in a second-hand goods market where product quality varies. The sellers know the quality of their own product but the buyers cannot distinguish the product quality without further information. Sellers’ valuation of their own product is based on the quality. $H$ is willing to sell his product with quality $Q_H$ at a price $P_H$ per unit and $L$ is willing to sell the product with quality $Q_L$ at a price $P_L$ per unit such that \[ Q_H>Q_L \quad \text{and} \quad P_H>P_L. \] This market will suffer from

• A. adverse selection
• B. moral hazard
• C. market failure
• D. excess supply

Hint:

Adverse selection arises when one party has more information before a transaction (e.g., quality of goods), whereas moral hazard arises when one party’s actions after the transaction cannot be observed.

Answer 1

The Correct Option is A, C

Step 1: Understand the situation.
Buyers cannot observe product quality before purchase, while sellers have full information. This is a case of information asymmetry — sellers know more than buyers.
Step 2: Apply the concept.
Because buyers cannot distinguish between high-quality and low-quality goods, they are only willing to pay an average price. At this price, sellers of high-quality goods ($H$) exit the market, leaving only low-quality goods ($L$). This is known as adverse selection — bad quality drives out good quality.
Step 3: Conclusion.
Therefore, the market suffers from adverse selection.