Adverse selection is overrated

An anonymous correspondent sends me news of the young Henry Schneider, Yale Ph.d. student.  Here is the abstract to his Estimating the Effects of Adverse Selection in Used Car Markets:

In this paper, I address the long-standing question of whether adverse selection prevents used
cars from reaching owners who value them most highly. In doing so, I confront the challenge
of identifying the effects of adverse selection separately from the effects of efficient sorting of
vehicles based on their conditions. This latter process would usually occur simultaneously to
adverse selection and also affects the distribution of vehicles that trade. Using the prediction
in Hendel and Lizzeri (1999), that adverse selection and efficient sorting both increase the
rate of price depreciation, I propose to use their joint effect as an upper bound on the effect of
adverse selection. My estimate of this joint effect, based on proprietary data on one million
dealer used car sales and trade-ins, is close to zero, a result that indicates that adverse selection
is unimportant. Using Consumer Expenditure Survey data, I provide additional support
for this conclusion by showing that vehicles that were recently purchased from a dealership
received approximately the same number of repairs as comparable continuously-held vehicles.
I conclude with a discussion of the role that sellers’ concerns for their reputations may play
in limiting information-based inefficiencies.

But Henry is no apologist for the market.  Here is his paper on how much auto mechanics rip you off.  Half of all the money spent on auto mechanics appears to be deadweight loss.  He does note they neglect urgent problems 77 percent of the time, which suggests some stupidity instead of (in addition to?) pure venality.

Here is Alex’s earlier post on adverse selection.


Used-car buyers aren't helpless. They can minimize their risks by purchasing cars with a reputation for reliability. It's no secret that a Honda or Toyota is likely to prove much more reliable than a Ford or Pontiac.

Adverse selection in the used car market is really a feature of sales with private sellers. As a college student who recently went through the process of buying an (older) used car, I found that in general there was little or no difference in quality between vehicles being sold by a dealer and vehicles being sold privately, although dealer vehicles were of course considerably more expensive. The primary reason for that must have to do with overcoming adverse selection problems by using reputation as a proxy for less-available information. Like a risk premium, a seller that buys from a private seller receives a "risk surplus." However, one that knows something about cars (and is willing to forego some other desires) may do very well this way.

That said, re: Peter's comment, I would also say that brand name is a proxy for less-available information (although I bought a Nissan). The graph of car lifespans must have a pretty big skew, and it's possible to do well with a brand that's not known for reliability. My schoolteacher sister has a Dodge Caravan that's going strong with 270,000 miles. In my experience, if I had to pick a characteristic that would be the best indicator (knowing nothing about the car), I would say it's the owners and their attitude toward maintaining the car, something you can only assess in a private sale, so go figure.

At last an economist focuses on the real problems of real people.

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