Thursday, June 15, 2006

Market for lemons

Used cars are the prototypical example given in information asymmetry arguments. Information asymmetry states that markets can collapse when sellers know more about the product than buyers, so if someone is trying to sell a car they know whether or not it's a lemon, but buyers do not. Therefore, buyers will be less likely to pay the price of a quality car and the only people willing to sell at their price will be those trying to unload lemons. As good cars exit the market, and only lemons remain, the prices buyers are willing to pay drop further, making more good cars exit and increasing the concentration of lemons further. This downward spiral results in no market at all.

Carmax tries to improve the used car experience by offering no haggle pricing, competitive financing, 12 point inspections, and good deals. I guess that they charge some premium for this quality insurance.

I'm in the market for a new car, and have had good experiences with Carmax in the past, so am thinking of buying from them again. I went to used car aggregator AutoBaron and pulled down data for the model of car I was looking at for four years, along with prices and miles. I then ran a regression on this with price being the output variable, and age and miles being the parameters. For my car, the price began at $24K and it lost about $1.5K/year in depreciation, and $50 per thousand miles (I am sure my regression was lousy as age and miles are correlated, but I did have some low mileage old cars and some high mileage new cars, so maybe it's not so bad. My standard errors were within 10%. Eh).

I then took these figures and punched in the cars listed on Carmax -- is Carmax offering a better or worse deal than the aggregate. I found to my surprise, that every car listed on Carmax was actually selling for less than the price predicted by my simple model. So, people on Craigslist are listing their cars for more than Carmax is, instead of Carmax charging a quality premium, the offer the quality and charge less for it.

Not what I expected.

It may be that the listers on Craigslist have hiked up their prices so they can reduce them through haggling later and the actual (spot) price is much lower than the listed price, but I don't know how much of a factor that is.


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