The power of signals – bridging information asymmetry
Consider the quest for the ideal value for money in a hotel room. Guests are willing to pay a substantial premium for excellence in a hotel room if they have a chance to evaluate whether the offered price is adequate. They rely on evaluations from other guests. Powerful signals drive our buying decisions and willingness to pay for a product and services. We trust customer feedback and recommendation when we look for the next mobile phone, when we shop for food or when we look for the right mechanic or when we seek medical advice. These signals come in the form of labels, certificates or ratings.
External and independent parties endorse the most powerful ones. Some of them are mandatory; without them, the market would collapse. Some of them are voluntary, but no less powerful. When do signals work best?
When they do not create information asymmetry between buyer and seller. The financial impact of signals in the automotive industry is substantial. Autovista Group has evaluated the impact of extended warranties and used-car programmes on residual values. Five- and seven-year extended warranties drive the value of a used vehicle up by more than €500 for a 36-month old car in the volume segment.
The market of lemons
Nobel Prize winner George A. Akerlof researched the fundamentals of information asymmetry and its negative impact on the economy in a paper, The Market for Lemons: Quality Uncertainty and the Market Mechanisms. He argues that in the used-car market without proper signals, the asymmetry in information results in the buyer expecting low quality in a product. The seller knows that the prospective buyer will not pay a premium for higher quality, since the buyer cannot assess the real quality. In fact, the seller fares better if he offers lower quality and tries to request a slightly higher price than the actual quality deserves. The result is a downward spiral, the quality of the product and prices deteriorate. The market would work better and create higher economic value with effective signals, which bridge the information asymmetry. Some of these signals have been introduced in the automotive industry, for example in the form of used-car warranties and used-car programmes, which send a credible signal of superior and certified quality.
Used-car programmes drive remarketing results up by approx. €400-600 per vehicle depending on segment and brand for the 36months point in time. There are approx. 300,000 used vehicles sold every year under a used-car label in Germany within that age bracket. If each car delivers a €500 higher transaction price, this amounts to economic value for the German automotive industry of €150 million.