An insurance market may fail to exist due to asymmetric information and adverse selection that results from it (buyers don’t know the repair risks associated with the seller’s car, just like insurers may not know the “repair” risks associated with the person who is requesting insurance from them). Suppose there are four cars for sale in a used car market. They have quality 0.25, 1, 1.5, and 2. The car seller values the car at $10Q (i.e. car of quality 0.25, 1, 1.5 and 2 are valued at $2.50, $10, $15 and $20). The car buyer values the car at $15Q (i.e. values the car of quality 0.25, 1, 1.5 and 2 at $3.75, $15, $22.50 and $30).
Now the state law changes and you are allowed to take the car for quality inspection from the exchange, and there is not just one unique price now at which transactions have to occur—instead, any car buyer and seller who meet at the exchange can negotiate a price after the independent mechanic verifies quality. What transactions are likely to occur now, and at what price ranges for each car?