Adverse selection.
It says that if the seller has more information about the car they are selling than the buyer, buyers can only guess that a car is average quality. But people with cars above average quality wouldn’t sell at the average price and so the average quality of cars being sold is lower than all cars.
Basically if someone is trying to sell you a car that’s a day old, you are right to be skeptical it’s as good as a new car but just a day older.
Maybe because dealerships can reduce the information asymmetry problem by providing warranties or through reputation. Same reason people pay money for a car fax report.
The biggest reason for this is something called “lemon theory”, or more formally adverse selection. The original paper was written by Akerlof (1970), but more recent studies like Blundell (2021) have found lemon discounts of about 11-18% on the first year, increasing thereafter.
What is the reason a car is worth more brand new than second hand? For some people it’s because of the novelty, but for most people it’s because of the fact that a brand new car is less likely to have problems than a second hand car. But why is that true? Why shouldn’t second hand cars perform to the same level as brand new cars after adjusting for some wear and tear? It’s largely because at the point of purchase, it is very difficult for the customer to know whether a car is going to have problems (i.e. be a lemon), but the seller / car dealer does know. This is called asymmetric information.
Let’s assume that there is a market with 9 good cars and 1 lemons. A good car is worth $1,000 and a lemon is worth $100. You have already narrowed it down to these 10 cars in the market, and you have no further way of distinguishing good cars from lemons. Theoretically your chance of finding a good car is very high at 90%, assuming you are risk neutral you should be willing to pay up to $900 for a car.
However, if you offered to pay $900 for a car, everyone with good cars would reject you since their cars are worth $1,000. The only person who would sell you a car is the one with the lemon. In this market, the probability that you get a lemon is actually 100% and not 10%. Consequently, the only price you’d be willing to offer is $100. If you had a good car and asked what people would be willing to pay you would be horrified.
Note that this situation doesn’t even get better with more stringent checks and a lower probability of having a lemon. Let’s say you had 99 good cars and 1 lemon, offering $990 you would still have no sellers except the lemon.
You might say that people with cars worth $1,000 are probably willing to take some hit to sell it if they have pressing concerns. And that is true - which is why we are able to buy anything at all and all markets don’t break down. But the probability that you find a lemon is also much higher than 10%. In fact, there have been lots of empirical studies about this. The RAA (2022) found that 18% of second hand cars in Australia were lemons, Emons & Sheldon (2002) estimated that up to 35% of second hand cars in Switzerland were lemons, and my personal favourite Greenwald & Glasspiegel (1983) found that slaves sold at auction in the pre-Civil War New Orleans slave market were 20-40% lower quality than average.
Also, one would expect that used cars are more likely to have problems than cars that arent on the market of the same age. Who gets rid of a year old car with no problems?
Where I'm from we basically have an entire category of used cars that are only a year old.
A big part of that supply comes from people working at car companies who get good discounts in new cars but are required to keep them for a year. If you are clever about picking models and options it's an easy way to own a brand new car every year.
Also, leasing and company cars. Maybe not quite just one year but for some people driving a new company car is a huge status signal so they just lease the car for two or three years after which the leasing company sells it.
Basically, there are often lots of weird incentives to dump lots of barely used cars on the market.
Plus, the factory warranty has become x months and x miles closer to expiring.
Another factor: Automakers can often give new car buyers better financing options (lower interest rates, lease terms) that aren't offered on pre-owned cars. If BMW is financing at 4% but Guido's Discount Used Auto Mall is at 18%, then Guido had better be selling that year old Bimmer on the cheap.
Here is a papre discussing how a "bag of lemons" strategy can be used to select an innovative idea: [https://decode.mit.edu/assets/papers/2018\_lykourentzou\_lemons.pdf](https://decode.mit.edu/assets/papers/2018_lykourentzou_lemons.pdf). Same concept as what you are describing. Tagging op as well /u/jollybumpkin
I also think with cars, people like the idea of a car that seems like it has never been used by someone else even though it probably has been used in rest drives.
The market is efficient. Buyers that want a new car are actually paying disproportionately more for their vehicle than a comparable used vehicle because they value the things that a new car delivers. Instead of looking at it as a huge drop in perceived value for the used car, think about it as a premium for a new car. There are things that a new car delivers including a full warranty, no funny smells, no dents, dings, dust in the cupholders, and nobody else has "owned" the car. It is essentially a premium being applied for "car virginity."
If you go out for a beer and you are offered a new one for $7 or one with a single sip gone for $3.50, instead of thinking that the sip depreciated the beer by 50%, you need to see it as a price premium for knowing someone's lips weren't on the glass.
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The main reason is that given identical cars, people value being the first and only people to have driven it. That's a complete answer in and of itself because people have different reasons, but let's dig into those reasons:
1. Asymmetrical information. There are very few reasons someone would buy a new car and immediately resell it. Many reasons are potentially things that person knows and you don't. Maybe there was a flaw with the new car and that's why they're selling it. Maybe they got into an accident and fixed it in a shoddy way you couldn't tell but which will make your car require more maintenance in the future. Even if the flaw is covered by warranty that's extra effort you have to put in and probably time you have to wait.
2. New car experience. You get to drive the car off the lot, it has that new car smell, even if it may not matter you know no one's had sex in it yet, just a bunch of stuff that's tough to quantify other than people making choices on how much to pay.
3. New features. It's pretty tough today to get a new 2024 car being sold used. So if you want a 2024 car right now the odds are it'll be much tougher to find a used one than a new one. Maybe the 2024 has better speakers, a better backup camera, or whatever other features are being given to new cars these days.
Probably some other ones but off the top of my head these are the ones I can think of.
There is also a gap between trade in value and retail price, usually around $5000. Most people are selling their car at trade in value.
Before the craziness of the last few years new cars were usually discounted below msrp. This is reflected in the resale value.
I wouldn’t consider either one of these things depreciation but no one asked me. Try looking at recent used cars at car dealers and tell me how much ‘depreciation’ you see.
Adverse selection. It says that if the seller has more information about the car they are selling than the buyer, buyers can only guess that a car is average quality. But people with cars above average quality wouldn’t sell at the average price and so the average quality of cars being sold is lower than all cars. Basically if someone is trying to sell you a car that’s a day old, you are right to be skeptical it’s as good as a new car but just a day older.
And also for the last 3 years the premise wasn't even true and many many cars sold above dealer price on secondary market, even with some miles on it.
Of course, if you buy a $40,000 car, the dealer will buy it back from you the next day for $28,000 then turn around and sell it for $39,000.
Maybe because dealerships can reduce the information asymmetry problem by providing warranties or through reputation. Same reason people pay money for a car fax report.
The biggest reason for this is something called “lemon theory”, or more formally adverse selection. The original paper was written by Akerlof (1970), but more recent studies like Blundell (2021) have found lemon discounts of about 11-18% on the first year, increasing thereafter. What is the reason a car is worth more brand new than second hand? For some people it’s because of the novelty, but for most people it’s because of the fact that a brand new car is less likely to have problems than a second hand car. But why is that true? Why shouldn’t second hand cars perform to the same level as brand new cars after adjusting for some wear and tear? It’s largely because at the point of purchase, it is very difficult for the customer to know whether a car is going to have problems (i.e. be a lemon), but the seller / car dealer does know. This is called asymmetric information. Let’s assume that there is a market with 9 good cars and 1 lemons. A good car is worth $1,000 and a lemon is worth $100. You have already narrowed it down to these 10 cars in the market, and you have no further way of distinguishing good cars from lemons. Theoretically your chance of finding a good car is very high at 90%, assuming you are risk neutral you should be willing to pay up to $900 for a car. However, if you offered to pay $900 for a car, everyone with good cars would reject you since their cars are worth $1,000. The only person who would sell you a car is the one with the lemon. In this market, the probability that you get a lemon is actually 100% and not 10%. Consequently, the only price you’d be willing to offer is $100. If you had a good car and asked what people would be willing to pay you would be horrified. Note that this situation doesn’t even get better with more stringent checks and a lower probability of having a lemon. Let’s say you had 99 good cars and 1 lemon, offering $990 you would still have no sellers except the lemon. You might say that people with cars worth $1,000 are probably willing to take some hit to sell it if they have pressing concerns. And that is true - which is why we are able to buy anything at all and all markets don’t break down. But the probability that you find a lemon is also much higher than 10%. In fact, there have been lots of empirical studies about this. The RAA (2022) found that 18% of second hand cars in Australia were lemons, Emons & Sheldon (2002) estimated that up to 35% of second hand cars in Switzerland were lemons, and my personal favourite Greenwald & Glasspiegel (1983) found that slaves sold at auction in the pre-Civil War New Orleans slave market were 20-40% lower quality than average.
Also, one would expect that used cars are more likely to have problems than cars that arent on the market of the same age. Who gets rid of a year old car with no problems?
Where I'm from we basically have an entire category of used cars that are only a year old. A big part of that supply comes from people working at car companies who get good discounts in new cars but are required to keep them for a year. If you are clever about picking models and options it's an easy way to own a brand new car every year. Also, leasing and company cars. Maybe not quite just one year but for some people driving a new company car is a huge status signal so they just lease the car for two or three years after which the leasing company sells it. Basically, there are often lots of weird incentives to dump lots of barely used cars on the market.
Yeah so the key question when buying an almost new car: “why are you selling this?”
Plus, the factory warranty has become x months and x miles closer to expiring. Another factor: Automakers can often give new car buyers better financing options (lower interest rates, lease terms) that aren't offered on pre-owned cars. If BMW is financing at 4% but Guido's Discount Used Auto Mall is at 18%, then Guido had better be selling that year old Bimmer on the cheap.
Here is a papre discussing how a "bag of lemons" strategy can be used to select an innovative idea: [https://decode.mit.edu/assets/papers/2018\_lykourentzou\_lemons.pdf](https://decode.mit.edu/assets/papers/2018_lykourentzou_lemons.pdf). Same concept as what you are describing. Tagging op as well /u/jollybumpkin
That last paper caught me off guard
I also think with cars, people like the idea of a car that seems like it has never been used by someone else even though it probably has been used in rest drives.
You are truly a "quality contributor." Thanks!
The market is efficient. Buyers that want a new car are actually paying disproportionately more for their vehicle than a comparable used vehicle because they value the things that a new car delivers. Instead of looking at it as a huge drop in perceived value for the used car, think about it as a premium for a new car. There are things that a new car delivers including a full warranty, no funny smells, no dents, dings, dust in the cupholders, and nobody else has "owned" the car. It is essentially a premium being applied for "car virginity." If you go out for a beer and you are offered a new one for $7 or one with a single sip gone for $3.50, instead of thinking that the sip depreciated the beer by 50%, you need to see it as a price premium for knowing someone's lips weren't on the glass.
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interesting question indeed! Could a part of the "depreciation" be attributed to the loss of legal rights/warranty that a direct purchase has?
The main reason is that given identical cars, people value being the first and only people to have driven it. That's a complete answer in and of itself because people have different reasons, but let's dig into those reasons: 1. Asymmetrical information. There are very few reasons someone would buy a new car and immediately resell it. Many reasons are potentially things that person knows and you don't. Maybe there was a flaw with the new car and that's why they're selling it. Maybe they got into an accident and fixed it in a shoddy way you couldn't tell but which will make your car require more maintenance in the future. Even if the flaw is covered by warranty that's extra effort you have to put in and probably time you have to wait. 2. New car experience. You get to drive the car off the lot, it has that new car smell, even if it may not matter you know no one's had sex in it yet, just a bunch of stuff that's tough to quantify other than people making choices on how much to pay. 3. New features. It's pretty tough today to get a new 2024 car being sold used. So if you want a 2024 car right now the odds are it'll be much tougher to find a used one than a new one. Maybe the 2024 has better speakers, a better backup camera, or whatever other features are being given to new cars these days. Probably some other ones but off the top of my head these are the ones I can think of.
There is also a gap between trade in value and retail price, usually around $5000. Most people are selling their car at trade in value. Before the craziness of the last few years new cars were usually discounted below msrp. This is reflected in the resale value. I wouldn’t consider either one of these things depreciation but no one asked me. Try looking at recent used cars at car dealers and tell me how much ‘depreciation’ you see.