In the late 1990s, car leasing was very popular in the United States. A customer would lease a car from the manufacturer for a set term, usually two years, and then have the option of keeping the car. If the customer decided to keep the car, the customer would pay a price to the manufacturer, the “residual value,” computed as 60% of the new car price. The manufacturer would then sell the returned cars at auction. In 1999, manufacturers lost an average of $480 on each returned car (the auction price was, on average, $480 less than the residual value).Suppose two customers have leased cars from a manufacturer. Their lease agreements are up, and they are considering whether to keep (and purchase at 60% of the new car price) their cars or return their cars. Two years ago, Edison leased a car valued new at $14,500. If he returns the car, the manufacturer could likely get $10,150 at auction for the car. Kyoko also leased a car, valued new at $16,000, two years ago. If she returns the car, the manufacturer could likely get $8,160 at auction for the car.
Use the following table to indicate whether each buyer is more likely to purchase or return the car.
|Buyer||Keep and Purchase Car||Return Car|
The manufacturer will lose money (at auction, relative to the residual value of the car) if returns the car instead of keeping and purchasing it.
True or False: Setting a more accurate residual price of each car would help attenuate the problems of adverse selection.
Let’s analyze the situation for both buyers, Edison and Kyoko, and determine whether they are more likely to purchase or return the car:
Edison should return the car because the expected auction price ($10,150) is higher than the residual value ($8,700). So, Edison is more likely to return the car.
Kyoko should keep and purchase the car because the residual value ($9,600) is higher than the expected auction price ($8,160). So, Kyoko is more likely to keep and purchase the car.
Now, regarding the statement:
“The manufacturer will lose money (at auction, relative to the residual value of the car) if Kyoko returns the car instead of keeping and purchasing it.”
This statement is True. If Kyoko returns the car, the manufacturer will lose money at the auction because the expected auction price ($8,160) is less than the residual value ($9,600). So, the manufacturer will incur a loss if Kyoko returns the car.
As for the statement:
“Setting a more accurate residual price of each car would help attenuate the problems of adverse selection.”
This statement is also True. Adverse selection occurs when buyers make decisions based on private information that the seller (manufacturer) does not have. In this case, if the manufacturer sets a more accurate residual price that better reflects the market value of the returned cars, it can reduce the likelihood of buyers making suboptimal decisions (keeping or returning) based on their private information. This can help mitigate adverse selection problems and lead to more efficient outcomes in the leasing market.