A new car loses substantial market value when it is purchased, even though the same new car can sit on the dealer’s lot for weeks, or even months, and retain its market value. One explanation of this paradox is that many people obtain considerable utility from owning new things and are willing to pay premiums to get them. But there is a second, complementary explanation that relates to asymmetric information. Used-car owners (potential sellers) have much better information about the mechanical condition of their cars than do potential buyers. Owners of defective cars—so-called "lemons"—have an incentive to sell them to unsuspecting buyers, whereas owners of perfectly operating cars have an incentive to retain their cars. Although both good and bad used cars are offered for sale, the average quality of the used cars offered on the market is poorer than the same makes and models that are not for sale. The typical consumer finds it difficult to identify the poorer quality used cars simply by looking at them or taking them for a test drive. Thus, the demand for used cars, and used-car prices in general, are lower than otherwise because of the risk of getting a poor-quality car. (1) So we have a solution to the paradox. When purchased, the market values of new cars drop quickly to the average market value established in the used-car market. This is true even though new cars may be in perfect operating condition. Their market value is depressed relative to cars still on the lot because (1) many people are willing to pay premiums for brand new cars and (2) buyers of used cars assume the risk of "buying someone else’s problem." Transferable new-car warranties reduce, but do not eliminate, the potential repair costs of used cars. Consumers lose time in arranging repairs and lose the use of the car while it is being repaired.

Photograph courtesy of: (c)Nance Trueworthy;