Used Cars

Used Cars^[1]

Adverse selection should make you wary of used-car sellers as well as telemarketers. When buying a used car you should most want to attract sellers of very high quality automobiles. Alas, sellers would most want to part with pre-owned vehicles of low quality. Used-car buyers need to take adverse selection into account and question the motives of used car sellers.

To simplify matters, assume that you are considering buying a 1996 Honda Civic that will necessarily be of either excellent or low quality. The car’s quality determines its value to you.

Table 2

Car’s Quality	Car’s Value to You
Excellent	$10,000
Poor	$3,000

A mechanic who can determine the value of the car need not worry about adverse selection because he won’t care why the car is being sold. Hidden information about the car’s quality causes adverse selection. If you’re not a mechanic, then you should worry that the seller most wants to sell his car when its quality is poor. Consequently, you should be reluctant to pay more than $3,000 for it.

Iteration magnifies the power of adverse selection. Assume that 90 percent of all 1996 Honda Civics are of excellent quality. Further assume that current owners know their car’s quality, but prospective buyers don’t. You would err in thinking that if you bought a used 1996 Honda Civic, there would be a 90 percent chance of getting one in excellent condition, since owners of poor quality cars will most desire to sell you their automobile. If all buyers are aware of adverse selection, then the price of used cars will be far from $10,000. Of course, this low price for used cars will mean that owners of excellent cars will be even less willing to sell them. Adverse selection thus creates a vicious circle.

As adverse selection lowers the price of used cars, fewer used cars of excellent quality are sold, which by definition increases the strength of adverse selection, which further lowers the price of used cars, which causes even fewer used cars of excellent quality to be sold, which . . .

As a result, even though 90 percent of 1996 Honda Civics are of excellent quality, almost all of the used cars on the market will be of poor quality.

What if an owner of an excellent quality used car wants to sell his vehicle? An owner unwilling to accept a low payment needs to convince the buyer of the car’s high quality. The buyer or seller could pay for an independent mechanic to inspect the vehicle. An inspection removes the hidden information that causes adverse selection. The owner could also perhaps explain his reason for selling the car. For example, if the seller could prove that he had to sell the car because he was moving to a different continent, then the buyer might believe that adverse selection isn’t the reason the owner put his car on the market. The seller could also offer a warranty that covered some repair costs. The warranty would reduce the harm of hidden information because if the car was not of excellent quality and consequently broke down, the buyer would receive some compensation.

^[1]Akerlof (1970).