Business & Economics

Goodbye Lemons: How the Internet Revolutionized the Used-Car Market

With sellers holding most of the cards, buyers were in a tough spot. Digital innovations leveled the playing field

Published by
Adam Thierer
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  2. Elon Musk and the Coming Federal Showdown Over Driverless Vehicles
  3. Goodbye Lemons: How the Internet Revolutionized the Used-Car Market
  4. How to Get the Future We Were Promised

While the internet and Big Tech get blamed for seemingly all the world’s problems these days, we sometimes forget the many ways we are better off, thanks to digital technology and online markets. A goal of this monthly column is to defend that proposition and provide real-world examples of how technological innovation benefits society in profound ways. Today’s example deals with a very old market—used cars—and how the information revolution made what used to be a miserable experience into a much more rewarding one.

A couple years back, I took my daughter shopping for her first vehicle. One day while driving down the road, I said to her: “Let’s go kick the tires on a few cars in that lot over there.” She responded: “Why would we want to kick the tires on cars? What does that do?” I laughed as I recognized how I had dated myself using a bygone idiom. It was much like when that same perceptive daughter asked me why I was always telling her to “hang up the phone.”

Regarding the tire-kicking, I explained how, in the old days, people would literally kick car tires based on a misguided belief that it told you something about the quality of the vehicle. It was ludicrous, of course, but it apparently gave some people enough peace of mind that the phrase stuck.

Facing a Stacked Deck

All the cards were stacked against the consumer when buying a used car back then. Whether buying from a stranger or a local used-car lot, you walked into the transaction armed with little knowledge of the vehicle and its history. If you were lucky, you’d be buying from a friend or family member who would be honest and tell you most of what you needed to know about the car—and, you hoped, also cut a fair deal for it.

Most of the time, however, consumers were dealing with strangers or, worse yet, the proverbial shady car salesman, who was probably famous for running bombastic ads in local papers and on radio and TV stations. “Come on down to Crazy Joe’s Car Shack where our prices are CRAZY, CRAZY, CRAZY low!”

So, when my dad and I walked onto a local car lot looking for my first car back in the 1980s, we were at a major informational disadvantage. My dad was a salesman himself (in a different field), so at least he knew how to play the game and spot a con man. He also knew a good amount about cars. But most consumers had neither of those advantages. They went into each used-car transaction hoping for the best and taking a leap of faith when they committed to buy.

Bitter Lemons

This problem was so pervasive that one economist won a Nobel Prize for documenting it and putting a catchy name on it. In a 1970 journal article, George A. Akerlof described how a “Market for ‘Lemons’”—cars that turn out to be defective after they’re purchased—had persisted because buyers were unable to distinguish between good and bad used cars. This meant that buyers were unwilling to pay higher prices for used cars, creating a vicious cycle because sellers would then be unwilling to offer higher quality cars. This made both buyers and sellers worse off.

Akerlof and other economists noted that such information asymmetries also made deception a serious problem in this market. All that existed to protect consumers were limited product guarantees and some anti-fraud laws that were often hard to enforce. Your best hope was that an interest in keeping a good reputation and some degree of competition would keep sellers honest.

One of the biggest problems was odometer fraud. In the old days, a dishonest seller could roll back the mileage on a car by prying open the dash and tinkering with (or replacing) the odometer. State and federal governments eventually passed laws to address the problem, but detection remained challenging. It was a miserable situation for consumers.

Then came the internet, and everything about the car-buying experience changed for the better. In a 2015 study, three Mercatus Center co-authors and I documented “How the Internet, the Sharing Economy, and Reputational Feedback Mechanisms Solve the ‘Lemons Problem’. ” We explained how information technologies and internet-enabled markets have made it safer and easier than ever to buy a used car. These technologies helped build greater trust between buyers and sellers, helping to finally reverse the lemons problem.

The Age of Carfax

In a New York Times article last month explaining “Why It’s Easier Than Ever to Buy a Used Car,” columnist Peter Coy identified the growing use of Carfax as “the single most important game changer.” Carfax gives buyers access to a reliable snapshot of a car’s history through a nationwide database of vehicle information numbers, or VINs. The service began in 1984 but didn’t gain widespread use until the late 1990s, when consumers were able to obtain the data online.

I’ve always been obsessed with cars, and when Carfax came along, I noticed an immediate difference in how transactions took place. When Coy called to interview me about my research, I explained how much it changed my avid car-buying life for the better. “We moved from a world of information poverty to one of information abundance,” I told him. Compared with my pre-internet experience, which was often frustrating and scary, Carfax and other digital tools and online platforms made it easy for me to find great cars. Perhaps too easy! Between 2000 and 2010, I bought and sold six used cars in rapid succession.

The growth of eBay Motors made deals even easier, especially by converting what used to be mostly a local market into one ginormous national one. When I was buying used cars in the 1980s and early 1990s, it was a geographically limited marketplace with significant regional price differences. We found cars mostly through local newspapers, physical bulletin boards or just “For Sale” signs stuck to car windows. This limited our buying options to the surrounding area. People in northern states such as Indiana, where I lived, would talk about someone lucky enough to find a “southern car” that recently had moved up north and had not been exposed to years of rust-inducing snow and sleet. Usually, however, they were very hard to find without a long drive south.

Buying Cars Remotely

EBay and other online services such as AutoTrader.com and Cars.com changed this radically by letting shoppers search nationally and make distant deals. Of the six deals I did during that decade, only two were local. For the four remote transactions, I dealt with buyers or sellers in Florida, Minnesota, New Jersey and Rhode Island—without meeting any of them in person.

Other information technologies helped us build the trust needed to make those deals happen. Most simply, we used the internet to look up information about each other. We also shared professional webpages and social media profiles to build comfort. And then we shared vehicle information and loads of pictures via email. We also purchased Carfax records.

When deals were finally struck, we used a trusted third-party service such as Escrow.com to help us clear the transaction safely. Here’s how that works: The buyer puts money into the escrow account and tells the seller that the agreed-upon sum is there, and also authorizes that a percentage of the funds be released to the seller. Then, after the car is inspected or delivered, the buyer instructs the escrow service to release the balance of the funds to the seller.

Today, eBay directly integrates Escrow.com services into its eBay Motors transactions to make this all even easier. Meanwhile, sellers usually provide a Carfax report and added details up front for no charge because it is easier for them to attract a premium on their car by divulging more information. Nationwide auto-shipping services grew quickly because of all this new online-market trading, giving us another third-party company to help facilitate trust and easier transactions. And online marketplaces have continued to expand over the past decade as Craigslist and Facebook Marketplace began offering used cars for sale.

Delivered to Your Driveway

In this way, information technology helped solve the lemons problem and opened the used-car market to regional and national buying. But the situation in local markets also improved. The competition for cars sold by local used-car dealers is more intense than ever with the growth of services such as CarMax, Carvana, Vroom and AutoNation, which offer a fixed-price, no-haggle business model. During pandemic lockdowns, many of those companies started offering “touchless” delivery of their cars directly to your driveway.

An eight-story car-vending machine operated by online used-car dealer Carvana in Huntington Beach, California. Image Credit: Mark Ralston/AFP via Getty Images

Sellers are now practically throwing information about the car at you. Today, it is not uncommon for some used-car listings to include three or four dozen pictures and pages of information about the vehicle, including a free Carfax report. As a result, buying and selling a used car is a much safer and more pleasant experience.

The market changed in other unexpected ways. Consumer-electronics chain Circuit City started CarMax in 1993, but it foolishly spun off the car dealer in 2002 just as CarMax was starting its explosive growth. By 2009 Circuit City, once the nation’s second-largest electronics retailer, had closed all its stores while CarMax is now the largest retailer of used cars nationally. Digital technology and online markets had decimated Circuit City but simultaneously enhanced CarMax’s visibility and made it a resounding success. It’s another example of how hard it is to forecast market trends.

The Impact of the Pandemic

COVID has thrown a temporary wrench into this well-oiled machine. The used-car market is experiencing record demand and price hikes due to an unexpected and unprecedented supply shock in the market for new cars. The new-car market is dealing with a shortage of computer chips, as well as the shipping issues that also haunt many other markets. There are also trade disputes and new environmental standards fueling the cost increases. With new cars in short supply, used-car prices have risen 42% since last January. Many people (such as me) are getting calls and emails from dealers begging them to trade in their cars.

Of course, this is how markets work. Supply shortages often affect demand in adjacent markets, prices adjust and then markets slowly recalibrate. A report from KPMG predicts that by this time next year, “the used-car market could collapse” as new car production rebounds and supply-chain problems subside. On the other hand, broad-based inflation could moderate the forecasted price decreases.

Regardless of where things stand a year from now, used-car buyers will still be in a much better position than they would have been had America experienced such an unexpected market shock a generation ago. If COVID had hit in the mid-1980s, everything about the car-buying experience would have been worse than it is today.

My daughter is now 20 and she has already owned two second-hand Jeeps. Like her dad, she’s a bit too obsessed with cars! The difference is, she’s newly empowered to shop confidently for vehicles in a market filled with far more plums than lemons, which can all be found, bought and even delivered with a couple of clicks on her smartphone. She and every other car buyer now enjoy a buying experience that my father and I could have never imagined just a generation ago. It counts as one of the most profoundly pro-consumer revolutions of the past quarter century, and we have the internet and information technology to thank for it.

Adam Thierer

Adam Thierer is a Senior Research Fellow at the Mercatus Center at George Mason University. He specializes in innovation, entrepreneurialism, Internet, and free-speech issues, with a particular focus on the public policy concerns surrounding emerging technologies.

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