Ian answers: Buying a car can be fun but the choice is often less about finances per se, and more about minimising the real chance of buying one that’s prone to breakdowns. Such a car, a so-called “lemon”, may end up costing a lot more than expected, in terms of inconvenience and time as well as money.
Some people favour brand-new cars, believing the risk is reduced this way. A new car may prove more reliable and is more likely to come with a guarantee or breakdown protection. But there is a well-known price premium that disappears the moment a new car is driven off the lot.
Knowledge is power
It’s because of this that a used car may cost considerably less – even if it is only a year old. It may still be under warranty. And it may be for sale for genuine reasons – not because it is a “lemon”. Here lies the difficulty.
The buyer will generally have far less information about the car than the seller, who might simply be trying to offload a dud. This “information asymmetry” is explained by George Akerlof in a classic research paper.
Essentially, a seller of a good used car is more likely to want a higher price than average for it. But since the buyer cannot be certain of the quality of a used car, he or she tends to be reluctant to offer the higher price.
The seller of a poor quality “lemon” will probably be happy with the average price. This encourages the sale of lemons, and acts to reduce the number of better-quality vehicles on the market.
Lessons I learned last time
Chances are the buyer of a “lemon” will kick themselves for years to come, thinking “if only I had bought a different car”. This is particularly powerful because of loss aversion, the way people tend to feel the pain of a loss more than twice as much as the joy of an equivalent gain.
Loss aversion plays a role when buying a car as well, because people tend to overweight small probabilities of loss. What is the real chance that a used car develops an expensive fault? And how willing am I to take that risk?
This insight is key to a seminal paper on prospect theory, looking at the way people choose between two risky alternatives. The co-author has also examined how thinking we understand a topic affects decision-making.
This is particularly relevant to car buying – not least because most of us don’t buy a car often enough in life to really learn much from our experience.
Decision making dynamics
I suspect there are even more dynamics at play here. The seller may fall for the endowment effect and believe the car is worth more than a buyer is willing to pay. Buyers may also pay too much for a vehicle that appeals to their emotions – in a favourite colour, or with high-performance specs .
Trade-ins may also change the situation. A study has found that sellers may increase the overall price, perhaps by bundling in extra items and services, if a trade-in is offered. This is because the very act of offering a trade-in gives the seller clues to what the buyer will pay.
Finance deals and tax concessions which vary across countries also come into play. The best approach is to do your research, and only visit a seller when you’ve got a shopping list and a budget that you will stick to. And do work out the total cost, including interest, over the full term of any hire-purchase agreement as well as the regular payments every month.