In the late 1990s, car leasing was very popular in the United States. A customer would lease a car from the manufacturer for a set term, usually two years, and then have the option of keeping the car. If the customer decided to keep the car, the customer would pay a price to the manufacturer, the “residual value,” computed as 60% of the new car price. The manufacturer would then sell the returned cars at auction. In 1999, manufacturers lost an average of $480 on each returned car (the auction price was, on average, $480 less than the residual value).

Suppose two customers have leased cars from a manufacturer. Their lease agreements are up, and they are considering whether to keep (and purchase at 60% of the new car price) their cars or return their cars. Two years ago, Maria leased a car that was valued new at $17,000. If she returns the car, the manufacturer could likely get $8,840 at auction for the car. Hubert also leased a car, valued new at $12,000, two years ago. If he returns the car, the manufacturer could likely get $8,400 at auction for the car.

Use the following table to indicate whether each buyer is more likely to purchase or return the car.

Buyer              Keep and Purchase Car                 Return Car

Hubert

Maria

The manufacturer will lose money (at auction, relative to the residual value of the car) if  ______?_______  returns the car instead of keeping and purchasing it.

True or False:

Setting a more accurate residual price of each car would help attenuate the problems of adverse selection.

True

False