So welcome back audit learners. I want to continue with the used car example because what we have done in the prior lesson is set the table for the value of an audit. You don't want a used car, you want a used car that works. And that comes down to let's make this market function again. Let's make them market such that sellers who have high quality cars are in the market, so that you as a buyer can go in and buy the car, the kind you want. So what do we need to happen? Well we need the bid-ask spread to get smaller on the high quality cars. Remember from the last lesson, that the risk neutral value of the car was $11,000, but the sellers who know they have a high quality car are asking $15,000. And that difference between the $15,000 asking price and the bid of $11,000, that $4,000 difference, is creating too much friction in the market. So we need a market where at least one or more buyers bids overlap with the lowest asking prices and we can think about ways to make the market function again, by bringing in independent third party assurance. Now there's a lot of different varieties of that in the car market. We probably don't call them auditors all the time, but they function that way. So one thing you can do is go to an auditor. If you are buying the car, you might ask the seller, hey do you care if I take the car for a spin and during that time swing by a trusted mechanic. Now this is a mechanic that you would hire, which is actually sort of different than the financial statement auditing environment and they would come in... he or she would come in, and look at the car or you might even ask the seller, can I take this car for an examination by a mechanic? The whole point here, is that the mechanic is going to be able to offer you a report about the quality of the car and really probably about some things that need to be repaired on the car to help you with your negotiations. So, what else can you do if you don't go...but notice that that mechanic is an auditor. What else can we do to make the market function again? So, what I want you to do as I talk about each of these possibilities, is to think about what would be the analogs to these things in the market for audit services for financial statements. Well one thing you can do, briefly alluded to this even in lesson one of this module, is that you can abandon the private market, the want ads in newspapers and online and you could go to a dealer, and you could buy retail with a reputable dealer. But one thing you will get is, for sure, you're going to have to pay more. What are you buying though from that dealer? You're certainly buying more than just the car, aren't you? Because you could buy a car in the private market. What you're buying from the dealer is not just the car, but also the assurance that that car is going to work as advertised. The dealer has an investment in his or her reputation. That investment and reputation is partially due to huge amounts of money they spend on advertising and maybe they even contract with third parties themselves to get a warranty. Sometimes dealers have their own mechanics, there on site, other times they will buy for a fleet of their cars warranties basically trying to make the buyers less worried about the working power, working ability of that car. So a really good question for this course is, how much would you be willing to pay for assurance? Well it depends on how much the mechanic changes your beliefs about the value of the car, after you get the mechanic's report. Let's assume that you go to a good mechanic and that mechanic's report moves the probability that the car is good from 60% to 80%. Now I want you to think for a moment about how much you would pay. Well one thing you should think about doing is asking yourself, how has the market changed for this car? Now if you're the only one who has this mechanic's report, you have more information than anyone else, right? If the seller got the mechanic's report, from an independent mechanic, then anyone who transacts with that seller would now have a basis to believe it's 80% likely that that car is a good car. So let's think about how much buyers would be willing to pay for assurance if they were risk-neutral. Now, one thing that is important to do is not to forget to include the cost of the assurance in the full acquisition price of the car. So, if you think about this particular example, we have a car, that prior to the assurance being provided had an expected value of $11,000. The mechanic's report moves you from 60% likely to 80% likely that it's high quality. The value of high quality car, $15,000. If you take that $15,000 times .8 and add to that now 20% probability times 5,000, you will find that the new expected value of the car is $13,000. But you wouldn't want to pay $13,000 for the car, because you would be paying that price plus any price to the auditor and then you would be in a situation where you're paying more than the expected value. So, let's suppose the assurance report the mechanic gives you is, well for $200 I'll look at the car. Well then, what you need to do as a risk-neutral buyer is not elevate the price you're willing to pay to $13,000 but you stop short of that to $12,800, okay? That's kind of a law of assurance. You want to make sure that your out-of-pocket cost when you pay for that assurance, plus the service or the product you're getting after transacting for that assurance together, that expected value is acceptable to you as a buyer.
