George Akerloff theorized that adverse selection in the used car market could be so bad that the market completely unravels and no good used cars are offered for sale. But, of course, there probably are some good used cars offered for sale in real used car markets. What methods have developed in the used car market to overcome this problem of asymmetric information and to prevent market unraveling?

Question

What will be an ideal response?

Answer 1

There are several ways in which the market for used cars has overcome (or at least mitigated) the effects of adverse selection. Warranties are a very direct way of removing uncertainty—not necessarily the uncertainty about the condition of the car, but at least the uncertainty regarding costs associated with a lemon. There are lots of signaling mechanisms, such as "certified pre-owned" programs that many manufacturers employ, or even things like advertising, the showroom and other dealership amenities. The signal that is sent by flashy expenditures like this is that the dealership must be selling good cars, or they wouldn't be able to stay in business while at the same time making these expenditures. Financing offers can be thought of as signals too, since one wouldn't normally want to finance the purchase of a lemon, since the tendency is for buyers to stop making payments on cars that have ceased running. Markets for the missing information have arisen too, such as CarFax, a service through which a potential buyer can receive the title and service history of a car. (Some sellers offer CarFax reports to buyers, which is a form of signaling