In 1970, George Akerlof published ‘The Market for Lemons: Quality Uncertainty and the Market Mechanism’ which later won him a Nobel Prize. There are a few core attributes of a ‘lemon market’:
- Asymmetry of information between buyers and sellers
- Incentives for sellers to misrepresent low-quality for high quality products
- A wide range of sellers across different levels of quality
- Difficulty for sellers to signal quality
- Lack of regulation, guarantees, or warranties
The used car market is the perfect example of a Lemon Market and one that Akerlof uses in his paper. There are many quality grades of used car sellers but few tools for buyers to judge the quality of prospective purchases. When such asymmetry of information exists, ‘lemons’ can drive out good products and distort the functioning of the market.
Used car adverse selection is one reason online car retailers like Carvana, Auto1, and Cazoo are winning market share from incumbents. Each company aims to increase transparency in the car buying experience with no price-haggling, centralised inspection and reconditioning facilities, free warranties, and money-back guarantees. This builds trust and helps reduce uncertainty around the quality of cars sold.
The five attributes above of a lemon market also pertain to the wholesale used car market. These are vehicles that are sold between dealers and fleet or rental companies. ACV Auction (ACV), the leading online dealer-to-dealer wholesale auction marketplace, has a similar mission to Carvana: 'to bring trust and transparency to the entire used vehicle industry’. We interviewed a Former Regional Manager to understand how ACV’s auction differs from the traditional physical auction process.
There are over 22m wholesale vehicles sold each year in the US with 14m sold dealer-to-dealer and 8m from commercial consignors to dealers. Of the 14m, nearly two-thirds is sold via dealer-to-dealer auctions such as KAR, Manheim, and pure-play online auctions like ACV, Backlot, and TradeRev. Of the 9m vehicles sold via wholesale auctions, it’s estimated that ADESA and Manheim have 67% share of the volume, online-only platforms have 10%, and regional and independent auction houses have the remainder.
The ADESA and Manheim physical auction buying experience is complex. Sellers have to transport vehicles to the auction house and buyers have to be present to join the bidding. Although incumbents claim the majority of buying is ‘online’, which includes vehicles sold in transit, on TradeRev, or ADESA Simulcast or DealerBlock, the traditional process is still plagued with adverse selection. The asymmetry largely stems from the difficulty of buyers to inspect the vehicles they are bidding on.
ACV aims to solve this problem by running an extensive 100-point vehicle inspection before it’s listed for auction. This creates a data report, True360, which is more detailed and reliable than those provided by Manheim:
“Manheim Express only supplies 10 to 15 photos of the vehicle, does not use code readers or paint meters and is not doing the same extensive inspection that ACV does. Many dealers run their cars red light at physical auctions, whereas 90% of the cars on ACV run green light as long as it runs and drives and has less than 200,000 miles on it.” - Former Regional Manager at ACV Auctions
Over 90% of vehicles sold via ACV are sold ‘green light’ whereas only 50-60% are green light on Manheim or ADESA. This means ACV sells assurance and takes on the risk of nine out of ten cars being a lemon. ACV stands by the quality of cars sold via the auction to reduce the uncertainty in the buying experience.
Backlot Cars, owned by KAR Auction, and Manheim Express are also running inspections but not to ACV’s level of detail:
“Backlot doesn't do code readers or paint meters, nor do they take as many photos. Inspections are evolving on there, but I have heard from buyer's experience they don't have a GO GREEN program, so many buyers are stuck with cars, which is not a great buyer experience. TradeRev allow some sellers to put their own auctions up, so the sellers can take their own pictures and videos, but the videos are shaky when the sellers are walking around. They allow sellers to post their own auctions, so there are many variations to their auctions.” - Former Regional Manager at ACV Auctions
The quality of the vehicle inspection is crucial to reducing adverse selection. Over 50% of employees at ACV are inspectors and the company runs the most detailed process in the industry. Not only can buyers bid on vehicles nationwide from the comfort of their own lot, the uncertainty of purchasing a lemon is lower relative to traditional auctions.
The lack of physical assets allows ACV to pass on cost savings to customers. The average marketplace fee per vehicle sold is ~$360 which is ~50% of ADESA or Manheim’s physical auction fees excluding ancillaries like transportation. Buyers on ACV get a wider selection, more vehicle data, cheaper prices, and save time by bidding from their lot. This seems to be a far superior buying experience relative to traditional auctions.
Although ACV may reduce uncertainty for buyers, digital auctions still need to attract sellers to provide vehicle liquidity. This is more difficult for many reasons.
Firstly, it seems that many dealers use physical auctions just as much for storage as for wholesaling vehicles. Dealers need to turn vehicles fast; each space on the lot is expensive real estate that cannot hold unwanted inventory. Dealers often use auction houses to clear space to show vehicles that have a higher chance of selling. A lack of storage could limit the growth of ACV relative to Backlot or TradeRev which can now leverage KAR’s physical sites: