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Supply and Demand in a Car Dealership

Alexander Corporation is a used car dealership serving Los Angeles Metropolitan area. The company has experienced a rather sharp decline in used car prices in recent years. A casual observation of the secondary car market by the management reveals that this is an industry wide national trend and it is not specific to the Alexander Corporation or Los Angeles market. At the same time, the management has noticed that for several years, major manufacturers of automobiles in the United States have offered flexible payments, easy credit, rebates, and zero percent financing deals to buyers of new cars. Consequently, an increase in demand for new car has been evident. A consultant offers two reasons for the observed decline in the price of used cars. The first is the increase in the supply of used cars provided by those customers who buy the new cars. As more individuals trade in their cars to buy new ones, there will be more used cars on the market. The second reason is the decrease in demand for used cars resulting from increase in demand for a substitute product, that is, the new cars. Further, the consultant asserts that the deals offered by car manufacturers accelerate the rate cars lose their value as they age. The explanation is that buying a car, say for $20,000 when a $2,000 rebate is offered, renders the actual cost of a new car to be $18,000. This rebate, in turn, instantly lowers the new car's value by the same amount and at simultaneously reduces the trade-in price of the previous year's model. The effect then cascades through all older models and affects their value by substantial amounts.

a. Use supply and demand to analyze the effect of a $2000 new-car rebate on the price and quantity of used cars. Explain in words the effects of the rebate on supply and/or demand and its effects on quantity and price.

b. Suppose the owner of a one-year old Ford Taurus is going to purchase a new Toyota SUV. Is the Taurus owner better off if he goes to purchase the Toyota after Ford introduces a rebate on the purchase of a new sedan?

Solution Preview

a) Used cars and new cars are substitutes. In other words, consumers will buy either a new car or a used car, but not both. In the new car market, the $2000 rebate increases the demand for new cars. Because consumers ...

Solution Summary

This solution uses the theory of supply and demand to predict and explain in detail the effect on the used car market of a rebate on new cars.