How the used car market is like health insurance

Ugh, over and over again people say, Don’t buy a new car!  It’s like throwing your money away.

It isn’t!  New cars are less likely to break down than the used cars on the used car market.  They cost less because you’re getting compensated for that additional probability of hassle.

Oh, but you say, cars lose some huge % of their value right off the lot.  Their probability of breaking down doesn’t change just because you signed some papers and drove a few feet.

All righty kids, this is where it gets complicated.

First off, before I start, there’s a brilliant and wonderful paper on this topic.  It’s the most cited paper in economics period.  It also got rejected twice (once for being obvious, once for being untrue) before landing in a third journal.

Ok, so back to the question: you’ve probably heard that a new car drops dramatically in value as soon as you sign the papers and drive if off the lot.

Have you ever thought about why?  It doesn’t lose that much rubber from the tires…

After a month or so, you tend to have an idea about whether the car you bought was a great car or had problems.  You know if the a/c leaks water into the passenger side or if it makes funny noises when it hits 65 mph or if it just doesn’t go.  If you could, you’d sell the car to some unsuspecting buyer or back to the dealership and use that money to get a better car.  But you can’t.  Why can’t you?

Well, anybody trying to sell a month old car, unless they suddenly find they have to move to Antarctica, probably got a lemon.  You don’t sell an almost new car unless there’s something wrong with it.  That means that people are going to assume that it’s a lemon and aren’t going to offer you much, if anything, for the headache you’re trying to unload.  If it’s a really bad lemon, then the faults should be apparent once you drive off the lot.  So the reason your car drops in value is because you’re only going to sell it back right away if there is something wrong with it and you’re going to keep it otherwise.

Ok, but what about 2 or 3 or 5 year old cars?  Well, say you have that month old lemon.  You think… well, everybody knows that month old cars on the market are lemons.  Maybe if I hold onto it another week, people will think it’s a good car.  So they hold onto it another week, which means people now think that month + week old cars are lemons, and so on.

It gets even worse.  Say someone wants a newer model car after 5 years and has a perfectly good car to sell.  He or she cannot get a fair price for it because there are so many lemons on the market, and only lemons, that if (s)he puts the nice car on the market people will assume it’s a bad car too.  So this person keeps the good car a little longer and waits to buy a new one.  That means that the ratio of lemons to peaches is even higher, further driving down the prices of used cars.

We can even take this argument a bit further and prove that used car markets can’t exist.  Once the ratio of lemons to peaches increases, the next best car will be unable to get a fair price, and the person will choose not to put it on the market, driving down the prices even more.   Eventually even the only sort-of lemons cannot get a fair price for themselves and only the worst of the worst cars that nobody wants to buy will be able to be on the market.  And nobody will be willing to buy them.

Of course, I just “proved” to you that a market for used cars cannot exist, but there IS a market for used cars… how is that?

A bunch of reasons:

Lemon laws not only protect consumers, but they’re good for producers– folks are more likely to take a chance on a car if they know they can return the car without question if it turns out to be bad.  This also helps the used car market have more peaches because there isn’t so much of a downward death spiral.

Producers can also certify used cars as being peaches.  You’ve probably noticed that certified used cars are more expensive than non-certified.  This isn’t just the cost of certification, but that there’s a lower probability of lemon-hood.

Similarly, producers can offer warranties and charge more if people know they can return their lemons should something go wrong.  This also keeps lemons off the market and peaches on.

In some instances, trust can help.  Ads saying that the “owner is leaving for Europe, cannot take car with him,” can convince buyers there’s nothing wrong with the car.  Additionally, if you have repeated games with same dealership, you may be more likely to get a peach so that you’ll be willing to work with them the next time you buy a car.  Similarly, if people talk about dealerships in social networks, then a dealer may be concerned about its reputation and be willing to take lemons out of the market.

If some people do not understand the additional risk, they may be willing to pay more for a used car, which can in turn put more peaches on the market since the going price will be higher.

Additionally, the market for luxury cars may be different if the people in this market put a premium on “newness.”  They may not care that they can’t get a fair price for their old car.

But that underlying problem isn’t completely gotten rid of.  The bad still drives out the good in the used car market, so the average used car isn’t as good as it would be without asymmetric information causing adverse selection problems.

“What does this have to do with health insurance?” you ask, having been tantalized by the title.  Well, with health insurance, we are the car owners and the insurance companies are the potential car buyers.  We know what our health is better than the insurance company does.  Sicker people are more likely to buy health insurance and super healthy folks are less likely which drives up the price, meaning that mostly healthy folks are less likely, which drives up the price, which means that somewhat healthy folks are less likely… and onward until nobody can afford health insurance and the market fails.

That leads us to the need for group insurance, which is beyond the scope of this post.

38 Responses to “How the used car market is like health insurance”

  1. Everyday Tips Says:

    Ironically, we just bought a used car! :)

    Regarding health insurance, many insurers will not cover preexisting conditions. When we took out short term insurance for a couple months, we had to fill out huge forms stating every illness we ever had. I cannot bring myself to lie, so I wonder if I had an asthma hospitalization, would it have been covered?

    I can’t wait until preexisting condition clauses are removed from health insurance.

  2. nicoleandmaggie Says:

    Buying a used car isn’t a bad decision. It’s really a wash– you’re paying less because there’s more risk of hassle. Buying new or used is a good decision, especially if you weight hassle vs price differently than the average person.

    Insurers will also be happy when the preexisting condition clauses are removed– it’s a situation where they don’t want to be the only firm that offers insurance to preexisting conditions (because then all the people with those conditions will flock to them and drive prices up so that nobody but the sickest will buy the insurance), but they can make more money if ALL firms offer that insurance.

  3. frugalscholar Says:

    The cars we are interested in–low-maintenance, good mileage, etc–do NOT lose that much once “off the lot.” We ran the math and discovered that it was better to buy these new. Hence our 1998 Camry and 2002 Accord Hybrid. Both have-we hope-many more years in them/

    • nicoleandmaggie Says:

      The idea is that the market functions better for those vehicles… the Toyota and the Honda have good reputations for high quality (except for the recent Toyota problems) and consumer reports testimonials to boot. So people think there’s more peaches and fewer lemons, which drives the price up and keeps people willing to buy and sell the used cars. It all evens out magically.

  4. Molly On Money Says:

    Last week I ran the numbers on how much we spent on our cars last year. It was over 20% of our expenses (this SHOCKS me!). I’m thinking of getting rid of all of them and buying a bunch of bicycles for the family. It may not be practical (I live in the country and we work in the city) but I’m living in a fantasy this week!
    I have a 15yr old Toyota truck with over 270,000 mile on it. I love that truck and got a fair price for it used. It’s kept it’s value compared to the new PT Cruiser we bought and sold.
    And thanks for including the link to define asymmetric information and adverse selection!

  5. Debbie M Says:

    Other strategies:

    1) Buy cars ten years old. Even people with perfect cars sell them because they’re approaching 100,000 miles and they think they’re about to implode. (Only buy durable reliable cars at this age, of course.) I’ve done this twice and did fine once and great once.

    2) Buy cars five years old–people are paying off their loans then and tired of the same old car, so they get a new one even if their old one is perfectly good. Of course they’re more likely to be tired of their car if it’s a lemon, but this is the strategy I want to try next.

    3) Buy cars that were previously rental cars that are two years old–they always sell them after two years no matter how good they are and the maintenance is very thorough. Of course the drivers have treated the cars horribly, and rental car places usually get unreliable models. I used this strategy once and had extremely mediocre luck.

    • nicoleandmaggie Says:

      Yup, when people do things for irrational reasons (like buying a new car when the loan finishes regardless of how the car is doing and with no regard to resale value) the market equilibrium can change.

    • Leah Says:

      I did buy a rental car that was a year old. There were a few cosmetic interior issues from people not being nice to the car (like a cigarette burn on one seat) . . . but the car itself has been solid for 6 years now. Only the regular, expected maintenance has been required. Of course, it is important to have the car checked out before buying.

    • Leah Says:

      Checking back in. We’ve now bought two previous rental cars. My 2004 Corolla is still going strong, tho it has needed a few pricey fixes, but I’m not surprised given that I’ve done atypical things like towed a trailer across country with my Corolla. We just bought a 2016 kia Sorento this summer and have been exceedingly happy with it. Both of these cars were one year old when we bought them. The Corolla had 26k miles on it, and the Sorento had 16k.

      I honestly don’t think that many people treat rental cars horribly. Think of the high costs of damaging one. If you crash a rental car, you’re out more than the cost of the car due to the “loss of use” clause. It’s also a pain to deal with on a vacation. Finally, people are typically more careful drivers when they’re not near home.

      In short, I can see how rental cars might be hit or miss. We have a small sample size. But we will look into an ex rental again in the future.

  6. eemusings Says:

    For us, at this stage in life, it’s having a paid-for car with the high likelihood of maintenance and repairs (beyond regular servicing, obviously), vs a loan, also with the possibility of maintenance and repair costs. Or to simplify: No weekly payments, but beefing up the irregulars fund, vs weekly payments, while still needing to contribute to the irregulars fund just in case.

    • nicoleandmaggie Says:

      Understandable. That’s a kind of credit constrained. You could get a loan but don’t want to… some people can’t get loans so they can only afford used cars (another reason the used car market can exist).

  7. Car Negotiation Coach Says:

    I love your econ logic! I read several supporting articles recently that said some used cars of the same make/model where selling for more than their new counterparts. This was because of the demand for “slightly used” drove up prices and manufacturers were offering deep discounts on new cars. Obviously this is not a common occurence, but is an interesting analomy to see.


    • nicoleandmaggie Says:

      Thanks! And yes, definitely an interesting anomaly– the market gets a little out of whack sometimes when people use heuristics and don’t update them. It evens out in the end though.

  8. Carnival of Personal Finance, Oktoberfest Edition | MMC-NEWS Says:

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  9. Carnival of Personal Finance, Oktoberfest Edition | MMC-NEWS Says:

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  11. chacha1 Says:

    I rented a PT Cruiser once for a wine-soaked weekend on the Central Coast. It sucked. The visibility was crap, the engine was hamster-powered, the cabin was very noisy, everything felt like plastic. Soooo disappointing, because I loved the styling. Oh well!

    So far in my adult life I have owned a Honda CRX (graduation present, drove it for 14 years), a Honda Accord (bought new in 1999, DH still drives it), and a Honda Accord (1995, bought in 2007, runs great).

    The purchase process for the used Accord was about 99% less painful than the process for the new Accord. With the 99 Accord, the dealership literally held my driver’s license hostage for hours while they harassed us into taking their deal. Never again will I hand over ANYTHING to a dealer.

    We screwed ourselves with the 99 Accord by financing (which at the time was not optional) and by going with a lease first. So we probably paid 10K more than we should have for that car. But we love it; we think it’s one of the best-looking Accords ever made (EX V6 coupe), it’s comfortable, speedy, and has a roomy trunk for all DH’s work gear.

    We have driven Lexus, BMW, and other high-end cars since we’ve had that 99 Accord and I would never spend the extra $20K for a “luxury” nameplate. 20K pays for a lot of vacations.

    • nicoleandmaggie Says:

      If they’d had some other rental in stock besides the PT Cruiser, we probably would have just waited for our Accent to be fixed and bought the Civic as planned. What a dreadful dreadful car. They look cute, but yes, everything about them is a PITR.

      It’s good to know the 20K doesn’t buy much on top of the 99 Accord.

  12. Reader Story: How We Bought a New Car | Jackpot Investor Says:

    […] factor in the probability of getting a lemon. (There’s a really famous paper on it, but that’s the subject of a different post, probably one designed to get 200+ comments at […]

  13. Raghs Says:

    Hi – I first read your post at getrichslowly. I am planning to take a plunge into buying a new car within the next one or two months, so your post was really helpful.

    I was wondering if you could post or email me the initial email that you sent to the dealers? I

    Many thanks and appreciate your help in advance.

    • nicoleandmaggie Says:

      Oh man, I don’t have it anymore. I do remember that I didn’t realize I should ask for the walk-away price in the first round of emails, but I figured that out by the time I did the second round.

      Basically I told them I was looking to purchase a 2006 Honda Civic Hybrid (any color) without the navigation system (whatever words I used in the GRS post) on Saturday. I am looking to purchase on Saturday (tomorrow) from the dealership who gives me the best price. How much would it cost to purchase from your dealership?

      It was something like that.

      Good luck! One of my students had very good luck using the same system for her new truck purchase last year (she also used her husband’s email).

      Here’s what the motley fool suggests:

  14. Bear Says:

    Hi Nicole,

    Great article on your negotiation strategy at GRS! I used a very similar techinique when I bought my last BMW motorcycle. Ironically about 1/3 of the dealerships I sent the fax too responded saying “they were BMW and BMW does NOT negotiate.” Of course the other six BMW dealers proceeded to prove them wrong and negotiate! ; )

    I have to whole heartedly disagree on your used vs new discussion though. If your premise were correct then buying new is no better – you’ll still get the lemon!!

    I have bought almost all of my vehicles used (over 55 different ones at this point in my life – I like cars, trucks and motorcycles and often own several at once) and have only had 2 lemons in all that time. For each of my kids we bought used cars and NEVER got a lemon! The key is to stick to proven models – grab Consumer Reports and check out they recommended used buys in your price range in their sping edition (April or March I think) .

    It’s sad to see that you bought a new car for the supposed “safeness” from lemon hood and the gizmos and aren’t even using the gizmos. It just goes to show that having the “newness” is never a lasting feeling of fulfillment or pleasure. Yet one more reason to buy a good quality 4-5 year old car. Except of the two lemons I’ve owned I’ve never had major serious issues with my used cars – NEVER! With the two lemons as soon as I realized the situation I quickly sold them with full disclosure of their problems. Sure I lost some money but not near as much as having bought new due to depreciation and I didn’t have near as much money at risk like you would have if you bought a new car and got a lemon.

    Second major error you are making in your thinking – buying with a loan. Never, EVER, buy depreciating assets with loans – NEVER!!!! One of the things I’ve passed on to each of my kids is that a key to financial independance is to pay cash for all depreciating assets, never carry a balance on a credit card and pay yourself first (10% minimum) with every paycheck. Each of them are well on they’re way to retiring very early just like their Dad! Yay!

    Great post – thanks for sharing and being so open to input! Great expample of a quality GRS post!!

    • nicoleandmaggie Says:

      Obviously there are some proportion of new cars that are lemons. The idea is that because of adverse selection in the process outlined above, people keep their peaches longer than they would if there was full information and everybody knew which cars were lemons instead of sellers being the only people who know what cars are lemons. This drives up the probability that a car is a lemon in the used car market, which drives down the price of cars in the used car market compared to what they would be if everybody had complete information about the value of each car instead of just the sellers knowing. That, in turn, keeps people who know their cars are peaches from selling their cars on the used market because they *know* their car is worth more than the average car price on the market, but because they’re not selling, that means there’s a higher probability of lemons and the market price of cars drops further.

      I’m not saying to never buy used and to always buy new. All I’m saying is that it’s a wash. It’s equivalent. You’re making trade-offs when you buy used vs. new or new vs. used. The price exactly reflects those trade-offs. If used cars were always better then they would be more expensive than they are now. And you see that in models that don’t lose very much value when they’re driven off the lot. Some used cars only cost a little bit less than new ones and those are the ones that are known to be higher quality or certified etc. (And, actually, Honda Civics are among those– you don’t gain much buying used over new, exactly because the used are known to be high quality.) Consumer reports helps with that.

      Normally I would agree with you not to buy a depreciating asset with a loan– my sister spent some time in high school working for a lawyer that repossessed things. She would literally call people on Christmas Eve to foreclose or repossess. But in this case we ran the numbers and didn’t see any risk of repossession. It helps that as professors they cannot terminate us without at least a year’s advance notice. Additionally, we did have some additional money stashed in stocks that I didn’t want to sell since we would have the money in 2 months anyway (and I’d just be putting it back in the same stocks, but I’d have to pay capital gains on what we sold– the market was still doing well back then), but we could have sold in an emergency situation. The two months wait just didn’t seem worth owning a car that we didn’t want as much until it was time to buy another car 10 years later. Plus, we totally could have arbitraged that loan simply by putting the 6K into a CD at the same credit union for the length of the loan term. Which is why we didn’t pay that loan off right away when we got the money– our online savings was giving more than the 5% of the loan. We did pay it off in a lump sum the moment the online savings dropped below 5%.

      And no, we’ve never carried a balance on a credit card, though we did float on a 0% interest rate when we had moving expenses (that were slow to be reimbursed) between graduate school and having real jobs with 5X the salary and only a fraction of the living expenses (moving from a big city to a small town). But again, we were going to be ok, and indeed, we were ok. Though we never did get around to furnishing the great room in our house. (Eventually we split up our living room set across the two living rooms.)

      I’m not making excuses about the loans. We thought very carefully about those issues, ran the numbers, and decided it wasn’t enough of a risk to make the trade-offs we didn’t want to make.

      p.s. We are using a lot of the fun things with the Hybrid– like not needing to get gas more than once a month. The steering wheel control of the radio and temperature is also pretty neat. It’s just there were a ton of screen things you could play with that help increase your driving efficiency and tell you how much energy you’re saving. We are now more efficient drivers because of them, but they do get distracting. So now DH has it set to giving outside temperature instead of those things.

    • nicoleandmaggie Says:

      p.s. Thanks for the comment!

  15. Calvin Says:

    Ya know, it’s just a CAR. It’s not some mythical, unknown creature. You can pop open the hood, check out the engine, examine the tires, take it for a spin, etc etc. If you don’t know about cars, find a reputable mechanic to go with you to check it out. Some mobile mechanics even offer this service.

    I felt like there should be a giant asterisk next to this article saying it’s for people who know nothing about cars and are going to wear a blindfold while they go check out the car.

    New cars are great, but there are literally thousands of decent used cars out there. I just bought a car at auction for $1800 that was in fine shape. I washed it, gave it an oil change, drove it for a month and then sold it for $3500.

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  21. Uk Used cars Says:

    We are still going to hang on to our used cars(2004 Honda Accord & 2006 Nissan Frontier) for many years to come.

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