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, the manufacturer lost an average of $480 on each returned car (the auction price was, on average, $480 less than the residual value). A. Why was the manufacturer losing money on this program? B. What should the manufacturer do to stop losing money?

Answer:

A) This example highlights the problem of adverse selection. This problem arises due to asymmetric information, which is when different people have different information. Asymmetric information occurs because even though information is beneficial it is costly to acquire. It arises when one party to the transaction is better informed than the other party. Here, the cutomers who have leased the car have more information than the manufacturer who is going to be auctioning the returned car. Even the residual value of the car is computed to be 60% of the new car price, the value of the car after two years may not necsessarily be that amount. In such a scenario the customer would not want to this residual amount and would instead return the car to the manufacturer. When this happens the manufacturer auctions the car and gets whatever money is received from the auction. In 1999, the manufacturer lost an average of $480 on each returned car. This is because the auction value reflects the true market value of the car, which was less than what the company's residual value, on an average. Therefore, the manufacturer was losing money on the program.

B) The manufacturer can reduce its losses by gaining access to more information. This can be done by getting the car checked by the mechanic/engineer. This process is called as screening. The manufacturer (who has less information) 'screens' the leased car and accordingly sets the residual price for the customer. This will help solve the problem of asymmetric information and will thereby help in curbing the losses.

Further, it is possible that the manufacturer sets the minimum bid for the cars to be auctioned at a price which more closely reflects the true market value of the used car. Also, the losses ccan be curbed by altering the contract terms of the leased cars. Either the cost of leasing can be increased or special terms can be included in the contract that cover the cost of the damages to car.