The Cost of Driving a Car Off the Dealer's Lot

Personal experience and the literature on automobile pricing agree on at least one point: It is very costly to take retail delivery of a new car ("drive a new car off the lot"). As Akerlof wrote, "The usual lunch table justification for this phenomenon is the pure joy of owning a 'new' car" (1970, 489).(1) Miller agreed, defining cost of acquisition as the difference between purchase price and the immediate resale price: "With respect to a new car, the cost of acquisition is dramatic. You may have to take a substantial loss of as high as 25 percent if you try to turn right around and resell your brand new car" (1991, 14).(2) Although few consumers plan to resell right away, it still is sobering to see how much a car's value has fallen shortly after taking delivery.(3) The popular press agrees a new car loses a large percentage of its value when it is first delivered (Taylor 1990). Consumers are sometimes advised to buy used cars to avoid this problem, sometimes known as the "driveoff phenomenon" ("Risky Business: Buying a Used Car" 1991). However, it is not clear that the driveoff phenomenon can be escaped by avoiding new car purchases. ELEMENTS OF NET ACQUISITION COST This analysis investigates the loss of value in taking retail delivery of a car. In this discussion, three prices are relevant: (1) the retail transaction price of the new car, |P.sub.n^ ("price new"); (2) the trade-in value a dealer would offer immediately after the customer had taken initial retail delivery, T; and (3) the retail price at which the dealer could resell the now-used car, |P.sub.u^ ("price used"). The net acquisition cost as defined by Miller is the difference between the price when new and trade-in value (or |P.sub.n^ - T). With |P.sub.n^ |is greater than^ |P.sub.u^ |is greater than^ T, this cost is usefully broken down into two elements. First, there is the difference between the retail price of a new car and an almost new used car (|P.sub.n^ - |P.sub.u^). For someone who has yet to buy, this is the "new-car smell premium."(4) Second, there is the difference between what a dealer would pay for a trade-in and the price at which the dealer would resell the trade-in (|P.sub.u^ - T). This second element is analogous to the bid-ask spread in securities markets. Dealers can be modeled as bidding T for used cars and then reselling them at an asking price of |P.sub.u^, earning a bid-ask spread of |P.sub.u^ - T. Loss of the new-car smell is unique to new car transactions. Both new-car and used-car buyers, however, face a bid-ask spread if they decide to trade a newly acquired car; there is no a priori reason to assume new-car net acquisition costs are higher than those for used cars. If the car's age is indexed with i (so that |P.sub.o^ = |P.sub.n^ or "price new"), then a null research hypothesis of interest is |H.sub.0^: (|P.sub.i^ - |T.sub.i^)/|P.sub.i^ = (|P.sub.i+1^ - |T.sub.i+1^)/|P.sub.i+1^, against the alternative |H.sub.1^: (|P.sub.i^ - |T.sub.i^)/|P.sub.i^ |is not equal to^ (|P.sub.i+1^ - |T.sub.i+1^)/|P.sub.i+1^. The popular view that net acquisition costs for new cars are extraordinarily high can be formalized as |H.sub.2^: (|P.sub.0^ - |T.sub.0^)/|P.sub.0^ |is greater than^ (|P.sub.i+1^ - |T.sub.i+1^)/|P.sub.i+1^, for all i |is greater than or is equal to^ 0. DATA FOR MEASURING NET ACQUISITION COST If transaction prices could be directly observed, net acquisition cost would be simple to calculate. However, transaction price data tend to be incomplete or proprietary and unavailable to researchers. Fortunately, there are widely available proxies for |P.sub.n^, |P.sub.u^, and T. This study uses manufacturer's suggested retail price (MSRP) as a proxy for |P.sub.n^. |P.sub.u^ is proxied by the average retail price of used cars as published in the Official Used Car Guide (National Automobile Dealers Association, serial). NADA reports these prices are a regional average of actual retail prices reported by dealers. …