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PAGE ONE economics
®
Why Is It So Difficult To Buy a
High-Quality Used Car?
Scott A. Wolla, Ph.D., Senior economic education Specialist
GLOSSARY
Adverse selection: The tendency of insurance
to be purchased by those most likely to
make claims.
Asymmetric information: A situation where
one party to a market transaction has
more information about a product or
service than the other. The result may be
an over- or under-allocation of resources.
Moral hazard: The risk that one party to a
transaction will engage in behavior that
is undesirable from the other party’s view.
Premium: The fee paid for insurance
protection.
“I discovered that the informational problems that exist in the used car market
were potentially present to some degree in all markets.”
—George A. Akerlof, Nobel Prize winner, 2001
Are you in the market for a vehicle? During the 2007-09 recession, newvehicle sales plunged to their lowest levels in nearly 30 years. They have
since fully recovered as people replace their aging vehicles with shiny new
cars, trucks, vans, and sport utility vehicles. Prices of new vehicles, however,
are at all-time highs, leading many buyers to look for used vehicles. It can
be a challenge, though, for buyers to figure out whether they are getting
a good deal. The seller generally knows far more about the vehicle. Even
with careful examination, the buyer still likely won’t know everything the
seller knows. When one party knows more about the product than the
other party, there is “asymmetric information.” In the case of a used car,
the seller has more information—and the advantage. The opposite can
also be true in a transaction—the buyer can have more information and
the advantage.
The Market for Lemons
The used-car market is often used to discuss the implications of asymmetric
information. In this market, sellers have greater knowledge about the condition and quality of their cars than buyers. For example, a seller is likely to
know about engine or transmission problems, the maintenance history,
and any defective equipment. In other words, the seller is likely to know
whether the car is a “lemon” (a car with defects). The buyer, however, is at
a disadvantage. Even with a careful visual inspection or a test drive, defects
can be missed or hidden. The seller is in the driver’s seat (so to speak) in
this market.
To better understand asymmetric information, consider a buyer looking
for a particular car make and model. Let’s call it the 2012 Econocar Utility
Maximizer. The buyer is willing to pay up to $14,000 for a high-quality
used car (a “cherry”) but only $10,000 for a low-quality used car (a lemon).
Imagine she visits two sellers advertising 2012 Utility Maximizers. One
September 2016
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Closing the Asymmetric Information Gap
!
2
NOTE: New-vehicle sales peaked at a post-recession high of 18.6 million
vehicles in November 2015 (blue line). Although prices of new vehicles fell
during the recession, they are now at all-time highs (red line).
SOURCE: FRED®, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/graph/?g=5qkM, August 8, 2015.
seller is selling a cherry; the other is selling a lemon. Each
seller knows the history of the car for sale—they have
good information and know whether it is a cherry or a
lemon. The buyer, however, doesn’t see much difference
between the two cars. She can’t tell whether either car is
a cherry or a lemon. In other words, there is asymmetric
information. As such, because she can’t know for sure,
the buyer assumes that neither car is of high quality. So,
she is willing to only offer a price below that of a highquality car: $12,000.
Now consider the larger used-car market. Other buyers
behave in similar ways. Because they cannot distinguish
between lemons and cherries, they offer prices somewhere in the middle. Some sellers who really do have
high-quality used cars aren’t willing to sell them below
their true value, so they keep the cars instead. Sellers of
low-quality cars, however, gladly sell their lemons. Low
prices, then, reduce the overall quality of used cars on
the market, leading to a market dominated by lemons.
With fewer cherries on the market, buyers offer even less,
further reducing the quantity of high-quality cars on the
market. This cycle leads to market inefficiency because
transactions that would have benefited both buyers and
sellers fail to take place. That is, although sellers are willing to sell high-quality used cars to buyers at a fair price,
the transactions do not occur because the buyers are
unsure about the condition of the cars.
Regulation has helped buyers receive better information.
The 1975 Magnuson-Moss Warranty Act (also known as
the Lemon Law) regulates warranties on vehicles (and
other consumer goods), and a variety of state laws (also
referred to as lemon laws) protect consumers from defective products, including vehicles.
To reassure used-car buyers—and to get them to pay a
higher price—some sellers provide warranties or “certify”
their highest-quality used cars. Generally, a car labeled
certified has been inspected and repaired (if necessary)
to meet high quality standards and may include a warranty. Buyers can also take several steps to help reduce
the asymmetric Information gap. First, research can help
steer them to a generally more-reliable car. Third-party
sources, such as Consumer Reports and J.D. Power, collect and analyze data to estimate the average reliability
and quality of certain car models.
Once a seller finds a car, various sources can provide
additional information about that car. For example, auto
mechanics can look for defects hidden or overlooked.
For a fee, they will look “under the hood” and run diagnostic tests. Additional information (such as maintenance,
odometer, and accident history) is available by researching the car’s VIN (vehicle identification number). Various
companies will provide a VIN report for a fee.
In the future, buyers may be able to easily obtain even
more information about a car’s history from the car’s
event data recorder (EDR), which is similar to the “black
box” on an airplane. Today, nearly all new cars have an
EDR. These microcomputers collect data related to safety
and accidents, including speed, braking, seatbelt use,
and airbag deployment.1 EDRs are likely to become more
powerful and collect more data over time.
Consider the Cost
In the rush to close the asymmetric information gap, it is
important to realize that obtaining information can be
costly. Some information may have explicit costs (fees or
subscriptions), while others have implicit, or opportunity,
costs. Any time you spend researching a product is time
you could have spent doing something else. Therefore,
the more expensive a transaction is, the more beneficial
your research may be. So it’s wise to seek out information
PAGE ONE economics®
before buying a house or car or choosing a college but
less important for choosing a frying pan or a stapler.
Other Markets with Asymmetric Information
Other markets also have the challenge of asymmetric
information. In the insurance market, for example, buyers
usually have more information than sellers (insurance
companies). The person wanting health insurance has
more information about his or her current health than
the insurance company. This imbalance can lead to two
potential problems in the health insurance market. The
first is adverse selection: People with health problems
are more likely to buy health insurance than healthy people, who might decide they don’t need health insurance.
This imbalance can create a pool of insured people with
more health problems than the general population. If this
is the case, health insurance companies will likely pay
more claims and charge higher premiums. The Patient
Protection and Affordable Care Act has attempted to
reduce adverse selection by creating financial incentives
to encourage all people (even the young and healthy)
to buy insurance.
The second potential pitfall is moral hazard: People with
insurance tend to take on more risk (knowing insurance
will pay some of the cost if anything bad happens) than
they would otherwise. This increase in risky behavior
could increase the number of claims insurance companies must pay and result in higher premiums. Insurance
companies attempt to learn about a potential customer’s
health and other habits before granting medical or life
insurance to reduce the risk to the company and ensure
an appropriate monthly premium is charged.
Credit markets also notably feature asymmetric information problems. A potential borrower has better information about his or her own ability and willingness to repay
a loan than the lender. Lenders attempt to learn about
potential borrowers’ credit and financial history from
credit reports. This information improves the ability of
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lenders to choose whom they should lend to and what
interest rate they should charge.
Finally, asymmetric information problems also plague
labor markets. Job seekers know more about their own
job skills and work ethic than potential employers.
Employers generally conduct interviews and check references but may also give assessments and seek additional
information online, including on social media. In addition,
some employers review credit reports,2 require drug testing, and/or perform a criminal background check.
Conclusion
When one party to a transaction has more information
than the other, the party with more information has the
advantage. This circumstance is a problem not only for
the party with less information, but also for the market
itself as transactions that would have benefited both buyers and sellers fail to occur. For example, even though
some people are willing to sell high-quality cars for a
suitable price, buyers won’t pay top dollar because they
are unable to assess a car’s true condition. So, the car
owners won’t sell, and the beneficial transactions never
occur. However, the growing availability of information—
if you seek it out—may help close the asymmetric information gap. n
Notes
1
Rafter, Michelle V. “Decoding What’s In Your Car’s Black Box.” edmunds.com,
July 22, 2014; http://www.edmunds.com/car-technology/car-black-boxrecorders-capture-crash-data.html.
2
eleven states have banned the use of credit checks in employment decisions
(Traub, Amy and Mcelwee, Sean. “Bad Credit Shouldn't Block employment: How
to Make State Bans On employment Credit Checks More effective.” Dēmos,
February 25, 2016; http://www.demos.org/publication/bad-credit-shouldntblock-employment-how-make-state-bans-employment-credit-checks-more-e).
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Name___________________________________ Period_______
Federal Reserve Bank of St. Louis Page One Economics ®:
“Why Is It So Difficult To Buy a High-Quality Used Car?”
After reading the article, complete the following:
1. Explain how the seller has an advantage in the used-car market.
2. How does asymmetric information in the used-car market influence the price and quality of used cars available
for purchase?
3. How can asymmetric information lead to inefficient markets?
4. How can buyers in the used-car market try to reduce the asymmetric information gap?
5. For each of the following, circle which market participant (buyer or seller) has the information disadvantage
and then identify strategies the disadvantaged participant uses to close the asymmetric information gap.
a. Health insurance market
•
Information disadvantage: Buyer / Seller
•
Method(s) used to fill the information gap:
(circle one)
b. Credit market
•
Information disadvantage: Buyer / Seller
•
Method(s) used to fill the information gap:
(circle one)
c. Labor market
•
Information disadvantage: Buyer (potential employer) / Seller (job seeker)
•
Method(s) used to fill the information gap
(circle one)
@FedFRASER