If you have ever thought of buying a new car, you are undoubtedly familiar with the claim that as soon as you drive the new car off the showroom floor its price falls dramatically. Recent popular books have asserted that simply driving a new car off the lot reduces the price by 25 percent.
Many economists explain this drop as occurring because the people who are trying to resell their cars quickly are typically doing so to get rid of “lemons.” Even if your virtually new car isn’t a lemon, people who want to buy your car can’t be sure, so they aren’t willing to pay as much as your virtually new non-lemon car is really worth. It is the classic story of “market failure.”
Nice story—except it’s wrong. In fact, the widespread perception that a new car loses substantial value as soon as a buyer drives it off the lot is really just a myth, as we shall see.
But when anomalies occur like the lemon problem, they inevitably create a financial incentive for someone to solve them. Suppose you buy a car for $20,000 and decide for whatever reason to resell it quickly. Assuming nothing is wrong with the car, you have a $20,000 car with just a few miles on it, but according to authors Steven Levitt and Stephen Dubner, you can only sell it for $15,000 because buyers believe that people only try to sell a new car so quickly when there’s something seriously wrong with it.
What do you do? Do you really sell the car for a $5,000 loss?
The real question is: can you convince someone for less than $5,000 that there is nothing wrong with your car? Could you hire your local mechanic or the car’s original manufacturer to inspect the car and certify that there is nothing wrong with it? If you could do this for $500 and tell potential buyers about the certification in your advertisements, you could likely sell the car for the full $20,000, earning for yourself $19,500—not $15,000.
In fact, there are many possible solutions. For example, a person worried about buying a lemon can buy a certified pre-owned car. Car manufacturers also allow warrantees to be transferred to new owners. Whether the warrantee is for three years/36,000 miles or five years/60,000 miles, a person who buys a lemon will not be stuck with it, even if he is the second owner.
Furthermore, some places allow you to return a used car for a full refund. For instance, CarSense, a certified used car dealer in the Philadelphia area, offers full refunds for cars returned within five days of purchase. And of course, these resale companies want to maintain a reputation for screening out any problematic cars.
Luckily for us, the lemon thesis can be easily tested. Last year I analyzed the prices of used cars—all 2006 models—in the Philadelphia area, comparing the manufacturers’ suggested retail price (MSRP) when new with the certified used price and the Kelly Bluebook price. The Kelly Bluebook price “reflects a vehicle’s actual selling price and is based on tens of thousands of recent real sales transactions from auto dealers across the United States.”
I looked at used cars that were less than a year old, all with about 15,000 miles. These were chosen to define what used cars sell for when they are about a year old. Additional used cars were looked at that had less than 5,000 miles on them, averaging 3,340 miles.
One thing immediately became clear: used cars with only a few thousand miles on them sell for almost the same price as when new. The certified used car price was on average just three percent less than the new car MSRP, and actually three percent higher than the new car Bluebook prices. The Kelly Bluebook further indicates that the private-transaction used car price was only four percent less than the new car Bluebook prices.
One explanation for such a small drop on private transactions—in which buyers can’t even rely on a brand name dealer’s certification—is that manufacturer warrantees still protect buyers.
I called Kelly Bluebook to check if the sample I had was representative and was told that a study of all the cars in their sample would have yielded a similar result; there is surely no large drop in a car’s price as soon as you drive it off the lot.
Even more damning, the price of these virtually new cars occasionally rises even above the MSRP. The Kelly Bluebook representatives claim that in order to maintain strong resale price values and prevent customers from feeling as if the dealer is taking advantage of them, manufacturers often ensure that dealers cannot sell their cars—even the most popular models—at more than the MSRP.
If the lemon thesis had been correct and the seller would do well to wait a year to sell it, then used cars that are about a year old should not sell for much less than those with only a few thousand miles on them. But, indeed, these older cars do sell for a lot less. The certified used car price for these older cars was 14 percent lower than the new car MSRP and eight percent lower than the new car Bluebook prices.
It is easy to claim “market failure,” that information isn’t perfect and that imperfect information prevents transactions from taking place. Of course, saying that markets fail because information is costly makes as much sense as saying that markets fail because steel is costly. But making trades possible also means profits, and markets are incredibly good at fixing “problems” when there are profits to be made.