Saturday, August 13, 2005


My theory about car-buying economics

A sort of open letter to my blogging buddy Tom Bozzo: car nut and economist

A couple of weeks ago, B and I brought our car into the dealership to have the horn fixed. When I came out of the dealer's office after settling up with the cashier, I saw what looked like some guy hitting on B right there in the car lot. He was leaning (lasciviously it seemed to me) into the car window. He saw me approach and hurried away. And B was writing down his number!
"What was that about?" I asked.
"Oh, I said we might get in touch with that guy about buying his used Cilantro. [Name of actual car model changed to preserve anonymity.] It's right over there."
Sure enough, a few feet away was a blue 2003 Cilantro with a for sale sign in the window.

That is so not going to happen.

I have a very definite theory about car buying. Although I'm not economist, it seems to make good common sense, and I plan to adhere to it unless I'm convinced otherwise by an economist who knows more about cars than anyone who does not work in or study the automotive field.

My theory is that if you can afford to buy a new car for cash (without financing it), there's no point in buying a used car. Used cars, while cheaper than new cars, are almost never a better value, and are usually a worse value.

Think about it. Q: How do you get a great deal on a used car? A: When the seller sells the car for a lot less than it's worth. How does that happen? Either (a) when the seller has bad information compared to the buyer about the car's value that causes the seller to undervalue it substantially; or (b) when the seller is in some sort of financial strait that causes him to sell at a desperation price (and the buyer has good information about the car's value). Negotiating basically comes down to who has better information and who is better able to walk away from the deal -- the party with those two characteristics will always get the better end of the deal.

You and I are virtually never going to have better information about the value of a used car than the used car dealer, armed with car selling experience and access to mechanics who can examine that particular car. Yes, you can pay $30 or so and have your trusted mechanic check out the car you're considering, but you're going to get only $30 worth of advice -- which is not going to match up well with the dealer's information.

If you luck out and time your purchase at a time when the dealer has some independent incentive to move the car off the lot, maybe you'll get a deal because your relative walk-away power will overcome your information deficit. But I'm putting the odds of that at much less than 10%. Used car dealers have to earn a profit off of used cars, and that profit has to be built into out-dealing the individuals who sell to and buy from them. Buying a used car from a dealer strikes me as astonishingly commonplace given how it's an inevitably losing proposition for the buyer.

With amateur private car sellers, the issue is one of mutual ignorance. Neither party has really good information about what the car is worth. Of course, you can get generic information about the make and model -- it's blue book value and what it's selling for on average on the used car market -- but there will be huge unknown variables stemming from how the car was handled and maintained by its owner(s).

In contrast, these variables are lessened in the case of new cars. Although there are lemons, of course, new cars are going to be more similar to one another because standardized production will be a much bigger factor than variable owner handling and maintenance.

I think you can get a good deal on a used car by shopping long and hard enough to stumble across the desperate or ill-informed seller, but you can't count on it without investments of time that start to add up to significant costs of their own.

Many people assume that used cars are a "bargain" (in the sense of better value) based on the old canard that "the car loses value as soon as you drive it off the lot." I suppose that there is a steep drop in the resale price of a vehicle once it is "driven off the lot" in the sense that it has morphed from a new into a used car. People assume from this odd fact of life that there is thus a new car premium that is merely aesthetic or otherwise unrelated to the car's utility; and that, by buying a used car, you necessarily get good value, since you avoid this essentially worthless premium.

I think that there really is no new car premium. If cars lose disproportionate "value" when driven off the lot, it may be because this market is likely to have a disproportionate number of lemons, and the potential buyers' fear of buying a lemon pushes down the price. But hardly any cars are sold in this condition, and I believe that prices quickly catch up to value within a couple of months and a couple of thousand miles.

There's also a related depreciation myth. Newer cars depreciate (lose resale price/value) faster than older cars, and again many people mistakenly assume that's because the cars are losing "new car smell" rather than driving utility. I think that's false.

From a consumer standpoint, I believe that the depreciation structure reflects a reality that new car miles are more valuable than used car miles. New cars get better gas mileage, have fewer maintenance issues, and are more likely to have repairs covered by warranty. Used cars may be cheaper at the front end to purchase, but hit you harder with the pay-as-you-drive expenses (gas, maintenance and repairs).* And certain aesthetic values of new cars aren't just about how the car looks -- they may be about comfort or even safety.

Obviously, new-car-buying is fraught with pitfalls of its own. But because of the tendency of new cars to be more standard out of the new car lot, the market price is likely to be better correlated with value than the price of a used car.

In my book, the only reason to buy a used car is because your current financial situation does not allow you to buy a new car for cash. In that case, the rip-off of car financing can in essence raise the purchase price of the new car so that you pay far more than its value.

Having written a long, humorless and pontificatory post, I should add the disclaimer that I may not know what the heck I'm talking about.

*Collision insurance is more expensive on newer cars, but I'm not sure that this offsets the higher maintenance costs of older cars. Underinsuring a car for collision damage carries hidden costs that may be more expensive than insurance premiums, because collision damage is likely to affect safety and driveability rather than just aesthetics.

UPDATE: Bozzo answers. I'm no economist, but I know an elegant economics turn of phrase when I see one. His bottom line: "A used car can be a rational purchase choice, though not likely because it constitutes an exceptional bargain over a comparable new car: the low price is, in effect, a risk discount."


Congratulations, you've hit on a version of the key insight in a Nobel prize winning paper! The "Market for Lemons" by George Akerlof (Quarterly Journal of Economics, 1970). It's really a very accessible paper, very little math...

Sorry for the needless self-promotion, but for a JSTOR link and somewhat clear exposition, try here.

The counter-argument is that the used-car market is set up to counter this lemons
Oops...The other side of the logic is that the "market" recognizes this problem and tries very hard to solve it...
Oscar, Isaac has stolen part of my thunder, but look for a responsive post later today.
you left off an important, but likely statistically insiginificant reason used cars may come onto the market at a siginifcantly reduced rate: revenge. Yes, that's right... those anecdotes one hears about buying a mercedes for 5 dollars from a soon-to-be divorcee actually do happen in real life.
I do a calculation based on cost per mile. Let us say a new Subaru Legacy is $26k, and I expect to get 150k miles before major maintenance expenses. This allows a simple calculation of cost/mile of purchase price for the new car. Compare this number to the same number calculated for a used Subaru: a mechanic's check will usually provide enough information to add the cost of repairs to the purchase price of used. I've bought a number of used cars this way. The only time I've failed to get a better deal (by this calculation) out of a used car than buying new, was with a Toyota Sienna, which manifested a surprising variety of essential fluid leakages after 18 months. Part of the problem here was paying the Toyota reliability premium (used Toyotas do not depreciate as much as used Fords, etc), but not actually getting better reliability..
However, the other six cars I've bought this way saved so much that I'm still well ahead of the game.
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Great post! I was actually looking for to buy a used car this weekend at Rio Grande Texas Ford so I have been online making sure I get the right one. That's how I came across your post, this was a great read. Thank you for sharing this with us!
Are you suggesting that we shouldn't have a talk with amateur private car sellers? I am actually aiming for having Cars in Texas and badly need some helpful tips.
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