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2. Adverse Selection and Signaling Consider a market with two types of goodshigh quality (H) and low quality (L). Everyone knows that 23% of the goods are high quality, and the rest are low quality. Potential buyers value high quality goods at 250, and low quality goods at 100. Potential sellers value high quality goods at 150, and low quality goods at 50. Assume that a good will always be sold for the buyers maximum willingness to pay.

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a. (2 points) If qualities were observable to potential buyers, what would their maximum willingness to pay for each type be? Which types will be traded?

b. (7 points) If sellers know their goods qualities, but buyers do not observe goods qualities, what will the buyers initial maximum willingness to pay be? Which type(s) of goods will be traded? Once buyers figure out which type(s) make it to the market, what will their maximum willingness to pay eventually be?

c. (2 points) Assume that an agency is willing to issue a quality certificate for any good that meets certain standards. For high quality goods to meet the standards, the owner must spend 90, but for low quality goods to meet the standards, the owner must spend 180. If potential buyers believe that a quality certificate is a signal of high quality, what will their maximum willingness to pay for a certified good be? What about an uncertified good?

d. (14 points) Would sellers of high quality goods get the certificate? What about sellers of low quality goods? Is this stable?

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