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Why Do Used Cars Sell For So Much Less Than New?

October 27, 2014

If Mr. Smith wants to SELL me his horse, do I really WANT to buy it? It’s a question as old as markets and horses have existed, but it was for many, many years, one of the unspoken questions of economics.

It is a question Groucho Marx once posed in a slightly different way, when he declared that he refused to join any club which was prepared to accept him as a member.

So how do we solve this paradox? The paradox of the horse that is, not the Groucho paradox.

For most of the history of economics, the answer was quite simple. Simply assume perfect markets and perfect information, so the horse buyer would know everything about the horse, and so would the seller, and in those cases where the horse is worth more to the buyer than the seller, both can strike a mutually beneficial deal. Gains from trade, it’s called.

In the real world, of course, life is not so straightforward, and the person selling the horse is likely to know rather more about it than the potential purchaser. This is called ‘asymmetric information’, and the buyer is facing what is called an ‘adverse selection’ problem, as he has adverse information relative to the seller.

This is a classic case of what economics professor George Akerlof sought to address in 1970, in a seminal paper called ‘The Market for Lemons’.

Akerlof had become intrigued by the limited tools that economists were using in the late 1960s. Unemployment, so went much of the general thinking, was caused by money wages adjusting too slowly to changes in the demand for labour. This was the so-called ‘neo-classical synthesis’ and it assumed classic markets, albeit they could be a bit slow to work.

At the same time, economists had come to doubt that changes in the availability of capital and labour could in themselves explain economic growth. The role of education was called upon as a sort of magic bullet to explain why an economy grew as fast as it did. But that posed a problem for Akerlof. How can we distinguish the impact on productivity of the education itself from the extent to which education simply helped grade people, he asked. The idea here is that more able people will tend on average to seek out more education. So how far does education in itself contribute to growth, and how far does it help simply as a signal and a screen for employers? In the real world, of course, these signals could be useful because employers are like the horse buyers – they know less about the potential employees than the employees know about themselves, the classic adverse selection problem.

Akerlof turned to the market for used cars for the answer, not least because at the time a major factor in the business cycle was the big fluctuation in sales of new cars. He quickly spotted the problem. Just like in the market for horses, the first thing a potential used car buyer is likely to ask is “Why should I WANT to buy that used car if he wants so much to SELL it to me”. The suspicion is that the car is what Americans call a ‘lemon’, a sub-standard pick of the crop. Owners of better quality used cars, called ‘plums’, are much less likely to want to sell.

Now let’s say you’re willing to spend £10,000 on a plum but only £5,000 on a lemon. In such a case, the best price you’d be willing to pay is about £7,500, and only then if you thought there was an equal chance of a lemon and a plum. At this price, though, sellers of the plums will tend to back out, but sellers of the troublesome lemons will be very happy to accept your offer. But as a buyer you know this, so will not be willing to pay £7,500 for what is very likely to be a lemon. The prices that will be offered in this scenario may well spiral down to £5,000 and only the worst used cars will be bought and sold. The bad lemons have effectively driven out the good plums, and buyers will start buying new cars instead of plums. Just as with horses, asymmetric and imperfect information in the used car market has the potential, therefore, to severely compromise its effective operation.

What can be done about this? For the answer we must go back to part of the reason why people seek education, which is to signal personal qualities which might otherwise be difficult to discern. This is part of the wider theory of signalling and screening, and it takes us to another place, on another day.

Further Reading and Links

Akerlof, G. (1970), The Market for Lemons: Quality, Uncertainty and the Market Mechanism. Quarterly Journal of Economics. 84:488-500.

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