Manufacturer Lease Pricing and Adverse Selection
32 Pages Posted: 9 Jul 2008 Last revised: 19 Aug 2008
Date Written: October 8, 2007
Abstract
This paper examines how car manufacturers use buyback prices in lease contracts to address problems of adverse selection in the secondary market. While theoretical work on adverse selection and leasing has largely focused on the automotive industry, empirical work has been limited to other industries (Gilligan, 2004). This paper builds on work from Desai and Purohit (1998, 1999), Hendel and Lizzeri (2002) and Johnson and Waldman (2003) to dissect the multiple considerations of the manufacturer in lease pricing. Using a rich dataset of 1 million new car transactions, I isolate the adverse selection effect through the contract relationship between the money factor, the residual value, and the monthly payment. This relationship allows the calculation of subsidization and buyback price adjustments jointly determining the contracted residual value. I then link this buyback adjustment to vehicle quality uncertainty, one of the primary determinants of adverse selection. This relationship is further identified through the use of vehicle warranties, which reduce adverse selection risk. I find evidence consistent with adverse selection considerations being an important part of vehicle lease pricing. This finding is unique in its examination of manufacturer behavior as consistent with predicted leasing responses to the adverse selection problem.
Keywords: adverse selection, automotive industry, durable goods, leasing
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