Lemons, Trade-Ins, and Certified Pre-Owned Programs

Problem definition: We study the economic rationale for certified pre-owned (CPO) programs and characterize the mechanism through which they influence secondary markets to create value for durable goods firms and consumers. Academic/practical relevance: Our study on understanding the market impact of CPO programs is highly relevant for industry given their prevalence in practice. Our work also contributes to the adverse selection literature in the context of the "lemons problem" by uncovering the mechanism underpinning CPO programs and how they improve market efficiency. Methodology: We use a game-theoretic durable goods model that captures CPO program features to identify how CPO programs improve market efficiency. We further investigate how CPO program size, as determined by program qualification criteria, plays a role in improving market efficiency. Results: We show that the mechanism underpinning CPO programs consists of two mutually reinforcing effects: a more effective segmentation of used product buyers through high-and low-quality product differentiation and a higher trade-in discount to used product owners. The former effect generates a higher revenue, which, in turn, allows for a higher trade-in discount. This translates to more high-quality products being traded in, more new products being purchased, and more used products being sold in the secondary market (i.e., increased market efficiency). We also show that these two effects are strengthened as the CPO program size increases. Finally, we test hypotheses deriving from our theoretical results in the context of the U.S. automotive industry. Our empirical findings are consistent with the conclusions of our theoretical work. Managerial implications: Durable goods firms can proactively manage their CPO programs by appropriately setting trade-in discounts and managing price discrimination between CPO and non-CPO products. CPO program qualification criteria can be used to alter CPO program size and, hence, the level of market efficiency improvement induced by these choices.