Now the value of assurance in the used car market is so prolific that one of the most common ways one sees used cars sold today is certified pre-owned. This is where individuals maybe take their Porsches or their BMWs or Hondas back to a dealer. They maybe want to get a new car, or purchase it or lease it, but they went in to give...trade in their car. Rather than just sitting that car on the lot and putting it for sale, what has been proven to be value, as a valuable business proposition, is for these dealers to subject these cars to a battery of tests so that you can put in the window that this is a certified pre-owned car. And the price that you'll have to pay for a certified pre-owned car is higher than a used car that hasn't been subjected to this audit. Okay? The same thing is true in financial statement context. Now, in the used car market, there are couple of other things that you can look at to protect yourself as a buyer. One of them, of course, there's this third party organization called the Kelley Blue Book, you may or may not be familiar with this organization. But they purport, and I think they are pretty good at being independent, but they purport to give buyers ranges of prices that they should expect to pay for cars that have different characteristics. Good condition, excellent condition, bad condition. But what I want to show you here from this particular slide, is that the fair market range of certified pre-owned cars are higher than the fair market range for a purchase from a private party. And that's kind of the point of this exercise, because the certified pre-owned is the auditor. It's actually very, very popular option for automobile purchases. Just like you would see in a financial statement auditing situation, where you have hundreds of thousands of companies in the United States that are not a public company. If you talk about public companies in the United States, and I know many of you may not be residing in United States, I'm just using it for an example, there are about 10 to 11,000 public companies in the United States. How many companies do you think there are in the United States? Well if you were to look at recent census data, you would find that there are over 6 million different companies. Now some of these are very small, but what you will also find that many of these private companies get some form of assurance over their financial statements, much like you see in this car market. So let's talk about this in terms of sort of fancy academic jargon. It's always good to know the jargon for a profession. It gives you an ability to say things in a succinct way and it's a common way to communicate with other professionals. So what I would like you to know here is that someone who voluntarily buys an audit, subjects their services or their goods to an audit, what that does is signal to the market that their quality is legit, that it's a high-quality product. So if you look across the market and you see some automobile dealers saying, sure, subject it to a mechanic's look. And others saying, I'm not so sure that's something we want to do. That's a signal to you. The signal does this to you, it helps you understand which of these sellers actually have high-quality products. If you're in a market where people are buying audit services, the sellers, that's going to drive away those people who have low-quality products, who do not want to buy assurance, because if they were to buy assurance what would happen? Well, it would be revealed that they're selling low-quality products. When you have the signaling value occur, when there's money left on the table without the signaling, what happens is that auditing and here's the fancy term is endogenously demanded, endogenous demand as opposed to exogenous. I understand these are academic terms, but they have a home in economics, that's where they come from. An endogenous demand is one that bubbles up from within the market. It's one that exists without a mayor, or a president, or a legislature saying we must have audits. And that's what you often would see. If you have an audit that is adding value, you would like it to be demanded endogenously, not just because the government said so. So real quickly, some of the laws of assurance or the law of assurance we have covered in this exercise is, are the out-of-pocket costs of assurance less than its benefits? An assurance is going to potentially add value if the assurance fee is less than the current bid-ask spread. So, in our example, remember, the high-quality car was worth $15,000 if you knew for certain, the risk-neutral buyer is $11,000, it's all he or she will be willing to pay. It's a big bid-ask spread. Assurance has potential value there, even if it costs as much as $4,000. And of course if it's $4,000, you can't pay more than $11,000 for the car. That's probably not going to be a workable solution. But if you can get a seller to agree to some incremental over 11,000, let's say 13,000, you could afford to pay even $2,000 for that assurance and still be equally well off. You should understand that the chance of their trading occurring, it increases with increases in the buyer's bid prices and decreases in the seller's asking prices. But that's just saying that as the bid-ask spread shrinks, the probability of a transaction increases. Anytime you look in the market, and it's fun to do this with the Wall Street Journal or New York Times some big newspaper, you can look at stocks and you can look at their bid-ask spreads. Stocks that have a larger difference between the bids that buyers are willing to pay and the asking price is that sellers are asking for, smaller bid-ask spreads tells you that there's lower information asymmetry. That there's more agreement between buyers and sellers about the value of that stock or in our case that car. So, if we were to summarize the two lessons here. So, you want to buy a new car or a used car, excuse me, and you want to buy a used car that works, what we need to understand is that information asymmetry can cause market failure. Such that the highest quality service and the highest quality products are not even offered. The sellers who have these products are scared away from the market because it can only command prices that are much much lower due to the presence and threat of low-quality products. But, the good news is, various kinds of audit related mechanisms bubble up often within the economy to keep that market functioning. The value of that audit depends, in part, on how much belief revision occurs as a result of that assurance. Now that last statement is important and it can be restated in another way. The value of the assurance depends on the quality of the assurance. If you have lousy mechanics, they're not going to result in very much belief revision. But if you have expert mechanics who really understand the Porsche 911, backwards and forwards, and they are trustworthy, that assurance will be quite valuable indeed.
