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.