Used Car Economics | Gresham’s Law

Used Car Economics – explaining why the used car market may be undervalued and also full of “duds”!

Most people believe that markets would allow everyone willing to sell goods at a certain price to make deals with anyone who wanted to buy goods at that price.

A leading Economist suggested that in many cases this may not be true. His work demonstrated that uncertainty caused by limited information can cause markets to fail.

The used car economics theory suggests that buyers and sellers have different amounts of information – and these differences can have disastrous consequences for the workings of the market.

The buyer of the second-hand car has less information about its quality than the seller who already owns the car.

The seller will have been able to assess whether the car is worse than an average similar car.

Gresham’s Law

Around the 1960s an Economist observed that when coins of higher and lower silver content were both in circulation, people would try to hold on to those of a higher silver content, meaning that ‘bad money drives good money out of circulation‘.

You may have encountered Gresham’s Law yourself – if you had a £50 bill in a restaurant, in your wallet was one crisp £50 note and two crisp twenty pound notes and a single ten pound note – which would you use to settle your bill?

As with hoarding of purer coins, sellers with better than average cars to sell will withdraw them from the market because it is impossible for them to get a fair price from a buyer who is unable to tell whether that car is a dud or not.

This means that “most cars traded” will be duds. Car show rooms consequently provide buyers with guarantees to reduce the risk for the buyer of the vehicle. This however does often come at a premium!

To recap the used car economics theory:

 The buyer of a second-hand car has less information about its quality than the seller. This inequality of information creates uncertainty for the buyer…

…who becomes reluctant to pay a high price for any car on the market. Sellers with good cars therefore withdraw their cars from the market.

The market begins to collapse because ‘most cars traded will be inferior’ – duds!