The used-car market is one of the hidden characteristic problems for which the market system has not developed a completely satisfactory solution. Many used cars on the market are "lemons"—cars that frequently require expensive repairs. Individuals who purchase new cars often try to sell them when they are discovered to be lemons, and hence the used-car market contains a disproportionately high number of low-quality cars. This depresses the price of used cars because the buyer can't tell which are lemons. There is asymmetric information. Many car owners who would otherwise put their good cars up for sale find that the selling price of their cars is too low. They are better off continuing to drive their high-quality automobiles than selling them for a low price that reflects the low average quality in the used-car market. This further lowers the average quality of used cars at equilibrium, resulting in an even lower equilibrium price. And so on. In terms of the economist's jargon, many car owners find that the reservation value of their cars is higher than the price that the car will fetch on the market.
definition: Reservation value
The car owner's reservation value is the minimum that he of she would be willing to accept to part with the car. The buyer's reservation value is the maximum that he or she would be willing to pay.
Sellers' utility will increase if and only if they sell their cars for more than their reservation values. Buyers' utility will increase if and only if they buy their cars for less than their reservation values. These observations follow from the definition of "willing." (Read the definition of reservation value again.)
The used-car market exhibits a degree of market failure: There are owners of high-quality automobiles who would be willing to sell their cars at prices that buyers would be prepared to pay if they could be certain of the quality. However, one cannot distinguish high-quality cars from lemons before purchasing, so the price of high-quality used cars reflects the large fraction of lemons in the market. Consequently, there are buyers and sellers of the high-quality cars who are not able to strike a deal. The highest price that the seller could obtain is often below the seller's reservation price. The outcome is not efficient. To drive this point home—pun intended—consider what happens the day after you accept delivery of your new car. The car's value on the used-car market is already well below the price you paid on the previous day and is thus below your reservation value. (Why has the car's market price fallen so much in one day? This question has already been answered.)
The difference between the job-market example (Section 6) and the present model of the used-car market is that signaling occurs in the former and this can ensure that high-quality goods or services are credibly identified. (The outcome is not fully efficient in the job-market scenario because signaling consumes resources.) When it is possible for high-quality sellers to signal at a relatively low cost, the market can force low-quality sellers to reveal themselves.
We conclude with a numerical illustration of market failure when there is no signaling. Assume that there are many more buyers in the used-car market than sellers;competition among the latter will result in all sellers charging the same price if there is no possibility of signaling (no warranties, etc.).
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