Thursday, September 02, 2010

Cherry Picking: An Economist’s Guide to Used Cars

After recently moving, I needed a used car that was both well maintained and reasonably priced. However, there was a problem: I am not a car expert. The prospect of finding a cherry, or a used car that’s worth its price, among the thousands of available cars in my area seemed a little daunting. Fortunately, by turning my search into an economic exercise, I was able to demystify the process and ease my nerves about making such a significant investment choice.

Used cars have been a popular topic in economics since George Akerlof (who eventually won the Noble Prize in Economics for his work on the subject) described how the market for used cars can be affected by imperfect information. A key premise in Dr. Akerlof’s work is the idea of asymmetric information: a scenario where one party has access to information that the other party does not. In his most famous paper on the subject, “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Akerlof argues that in any market where rational people are met with asymmetric information, eventually the only goods for sale will be those that are not worth buying. Economists use the term adverse selection to describe this idea. When a market suffers from adverse selection, skepticism affects the prices that buyers are willing to pay. The downward pressure on prices drives out the high-quality sellers. Ultimately, the only sellers left at a given price level will be those of low quality. When buyers eventually realize that the only cars available are of low quality, they will decide not to buy any cars at all. Now you can understand why I was feeling a little overwhelmed about the whole process of buying a used car.

Thankfully, the research didn’t end there. Joseph Stiglitz (who shared in Dr. Akerlof’s Noble Prize) developed the notion of screening as a method to get around the difficulties of asymmetric information. Screening is a way for both sides of a deal to use what they already know to learn about hidden information. By reducing the level of asymmetric information, Stiglitz argued that you could avoid situations of adverse selection. Knowing this, I started to put together some tools that would help me to screen my potential sellers.

I first used car-pricing guides to give me a general sense of when a seller was giving a fair price. If I couldn’t trust a seller to give an honest price, I certainly couldn’t trust the seller to be honest about other aspects of the car. I also requested reports that outlined what work had been done on the cars. In addition, I asked my car-savvy uncle to help me spot work that may have gone unreported. When requesting these reports, I judged the sellers’ reactions. Those with high-quality cars had nothing to fear from the increased inspection, while nervous sellers made me nervous. One desperate seller attempted to drop his price by nearly 20% when I told him I’d be back in a day with my uncle. Needless to say, we didn’t make it back to look at that car!

With patience, I found a nice prospect at a dealership that didn’t typically sell used cars. As it turned out, the previous owner had traded in her commuter car for a discount on something a bit more…luxurious. Before it was accepted as a viable trade-in, the car had to pass an inspection by the dealership, in addition to the standard state inspection. The dealer was also happy to meet my uncle and answer any questions he had about the vehicle. By exhibiting a willingness to provide as much information as possible on the car’s history, the dealer was using a technique called signaling. Michael Spence (who also shared in Dr. Akerlof’s Noble Prize) developed an explanation of how signaling is used by the person with more information in a particular deal to inform the other side about quality. In his willingness to let me explore the potential problems of the car, the dealer was trying to signal that he was confident about its quality and that it was worth my investment.

The inspections checked out, and the asking price was right on target with what my pricing guide suggested—I had found myself a car! By using my head and applying a little economic theory, a seemingly impossible task turned out to be fairly easy and nearly fun. Spread over about a week and a half, the process took about 15 hours. Only time will tell if it was worth the temporal and monetary investment, but, after a month of driving the car pretty vigorously, I’m confident that I found a cherry.

Discussion Questions:

1. How could car sellers that are really confident about the quality of their cars guarantee value? Why are used car sellers hard-pressed to offer such guarantees?

2. Signaling is a helpful tool when a transaction suffers from asymmetric information. Can you think of how signaling is used in the job market? What are some ways that prospective employees can use signaling to their advantage?

3. How do markets for products besides cars (like books or classes offered) suffer from asymmetric information? What tools have you have used to make more informed choices?

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