Question

Use the following information to work. Larry has a good car that he wants to sell; Harry has a lemon that he wants to sell. Each knows what type of car he is selling. You are looking at used cars and plan to buy one. How can Larry signal that he is selling a good car so that you are willing to pay Larry the price that he knows his car is worth, and a higher price than what you are willing to offer Harry?

Short answer

Larry can signal that his car is good by offering a warranty, providing maintenance history, and obtaining a third-party inspection.

Step-by-step solution

Understand the Problem

Larry has a good car that he wants to sell, and Harry has a lemon. Larry needs to signal to potential buyers, like you, that his car is a good one so that he can get a higher price.

Identify Potential Signals

Larry must use credible signals that cannot be easily mimicked by Harry. Examples of such signals might include offering a warranty, showing a complete maintenance history, or getting a third-party inspection report.

Describe Warranty as a Signal

A warranty is a strong signal because it indicates that Larry is confident in the long-term condition of the car. Issuing a warranty would be costly for Harry if his car is actually a lemon.

Maintenance History as a Signal

Providing a full maintenance record for the car can demonstrate consistent care and lack of major issues. This is hard for Harry to provide if he has a lemon.

Third-Party Inspection as a Signal

Larry can also get a third-party mechanical inspection, which is a credible assurance from an expert that the car is in good condition. Harry is unlikely to want such an inspection if his car is a lemon.

Sum Up the Signals

By offering a warranty, showing a full maintenance history, and getting a third-party inspection, Larry can effectively signal that his car is good. These actions are costly for Harry to mimic with a lemon car.

Key concepts

signaling in economics

Signaling in economics is a way by which one party (often the seller) can convey information to another party (often the buyer) when there is asymmetric information. Asymmetric information occurs when one party has more or better information than the other. Sellers of high-quality products need to find ways to signal their products' superior quality. In our exercise, Larry needs to signal to potential buyers that his car is a good one. Effective signals must be credible and costly for sellers of inferior products (like Harry) to imitate.

market signaling

Market signaling involves providing observable indicators that convey some hidden quality or characteristic of a product. For Larry, market signaling may include offering warranties, providing maintenance history, and getting third-party inspections. These strategies are strong because they reveal the car's good condition. Most buyers might not know the true quality of the cars on their own, so these observable signals can bridge that information gap.

information asymmetry

Information asymmetry refers to a situation where one party has more information than another. In the car market, sellers typically know more about their cars than buyers do. Buyers struggle to differentiate between a good car and a lemon. Thus, Larry's challenge is to reduce this information asymmetry by using signals to prove his car's value. Only by reducing the information gap can Larry ensure he gets the right price for his high-quality car.

warranty as a signal

A warranty acts as a signal by providing assurance to buyers about the car's quality and reliability. If Larry offers a warranty, it indicates that he is confident in his car's long-term performance. For Harry, who knows his car is a lemon, offering a warranty is risky and costly since the likelihood of future problems is high. Therefore, a warranty is a credible and effective signal from Larry, illustrating that his car is a good investment.

third-party inspection

A third-party inspection serves as an objective evaluation of the car's condition by an expert. Larry can utilize this signal to show that an independent professional has verified his car's quality. This is valuable for buyers as it reassures them that they're making a well-informed purchase. Since Harry’s lemon is likely to get negative remarks from an inspection, he would be less willing to use this signal. Hence, third-party inspections are a strong, credible method for Larry to signal his car’s superiority.