Consumer Behavior in Markets of Durable Experience Goods∗

G. Martin Paredes †
New York University

Job Market Paper

First Version: July 24, 2005
This Version: April 19, 2006

Abstract
Empirical evidence from the automobile industry suggests that cars are experience goods:
consumers do not have complete information about some characteristics of cars, and can
only learn about them after buying and trying them out. This would explain the significant
dispersion of customer loyalty among car brands. In this paper I propose a dynamic model
to study markets for durable experience goods where trade in used goods is allowed and
experience is idiosyncratic. Compared with a situation without uncertainty, I show that the
introduction of experience causes incomplete trade, since some new car buyers that get a good
product fit will decide to keep the car. But incomplete trade does not mean inefficient trade:
since experience is idiosyncratic, no informational gains can be earned by prospective buyers.
Further, customer loyalty is determined by the set of consumers that gets the best fit. In a
model of two brands with different distributions of experience, I characterize an equilibrium
where the brand with a larger probability of a good fit exhibits higher loyalty. Moreover, a
larger proportion of new car buyers of that brand will retain the car for a second period. This
finding matches the empirical evidence that reveal a positive relationship between loyalty and
the average length of the first ownership. I also show that, for a given output and volume of
trade, the brand with the larger probability of a good fit also shows a larger retention value,
as measured by the price decline after one year. This also matches the empirical findings.

JEL Classification: D82, D83, L15.

Keywords: Durable goods, experience goods, consumer dynamics.

∗
Preliminary version. Originally entitled "Uncertainty and the Role of Experience in Durable Goods Markets".
I am grateful to my advisor Alessandro Lizzeri for helpful suggestions at the earlier versions of this papers. I would
also like to thank Luis Cabral, Janusz Ordover, Ennio Stacchetti, and seminar participants at Carleton, Colegio
de Mexico, NYU, Queen’s, and the IV Conference of the Industrial Organization Society. The usual disclaimer
applies. A more updated version can be found at http://home.nyu.edu/~gmp210.
†
E-mail: Martin.Paredes@nyu.edu. Address for correspondence: Department of Economics, New York Univer-
sity, 110 Fifth Avenue, 5th Floor, New York, NY 10011, USA.

1
1 Introduction

The objective of this paper is to provide a framework to study markets for durable experience
goods. One look at the automobile industry can help us identify two important characteristics
about cars. First, cars are durable goods: you usually buy a car with the intention of keeping
for a long period of time; further, you can buy a used or a new car, since it is an industry with a
well-developed secondary market. But cars are also experience goods: you cannot ascertain every
characteristic of the car before buying the car −as far as your utility function is concerned−. You
can learn a lot about cars before buying them, but you still learn a lot after driving them; in
particular, you learn whether they are a good match or a bad match for you.1
Based on these observations, I developed a model that includes both characteristics. As such,
it is not the first model that deals with durable goods, and it is not the first model that deals
with experience goods, but it is the first model that combines them both. I derive a number of
theoretical results and empirical implications from the model I present. Among them, I found
that, in a model with uncertainty and experience, there are some consumers who will decide to
hold on to a used car, a situation I define as incomplete trade, because it means that not all used
cars are traded in equilibrium. But incomplete trade is not an inefficient result in this model,
because I assume that experience is idiosyncratic: the fact that a consumer got a good experience
with a car does not mean that the next owner will get the same experience. In addition, the model
suggests that the larger the probability of a good fit, the larger the fraction of consumers that
remain loyal to a brand. Further, I show that the model fits some stylized facts that I observed
in the car market, based on a dataset that I collected from consulting firms in the industry. More
precisely, the model explains the positive relationship between the degree of loyalty to a given
car brand, the average holding time of a new car of that brand, and the average retention value
of that brand, as measured by the drop in price from new to used.
The paper represents a contribution to both the literature on experience goods and the one
on durable goods. In models of experience goods, consumers do not have complete information
about some characteristics of the product, either because those characteristics are unobservable
1
The analysis in this paper is not exclusive of the car market. Other industries where the results and implications
of the model could be applied include airplanes, and also computers and most electronics, where secondhand markets
have developed thanks to online internet auctions.

2
and cannot be determined before purchase,2 or because the consumer is unsure about the effect
of such characteristics on her own utility, even though they may be observed.3 The only way to
learn is by buying the good and trying it out.
The introduction of durability in an experience goods market brings in some dynamics that
are absent in non-durable goods markets. For example, once purchased, non-durable goods
have no value. Instead, consumers can continue to use a durable good for several periods. Also,
depending on the experience they got, consumers have to decide how long they will keep the good
they currently own. Further, if there is a secondhand market, they can sell the used product to
another consumer.
The paper also contributes to the large literature on durable goods markets, where the impact
of uncertainty and experience has been ignored, and I believe it is worth investigating. The
introduction of uncertainty and experience in a model of durable goods will have an effect over
the consumers’ frequency of purchase. which in turn will have an effect over prices of new and
used cars and over the time they hold on to a car. These factors will influence the pattern of
purchase, especially the type of car consumers buy –new or used–, and the brand they choose.
We can also expect an impact over the decisions on the supply side, especially about obsolescence
and market coverage.
Empirical evidence from the automobile industry suggests that cars are experience goods.
Less than half of returning customers in 2003 repeated purchase of the same brand they bought
before. The first column of Table 1 highlights the fact that there is a substantial dispersion across
brands.4 Further, American brands such as Chevrolet and Ford −not distinguished by their high
quality− exhibit a high rate of loyalty, while some Japanese brands like Nissan and Mazda, or
European ones like Volvo and Volkswagen, do not.5 Table 1 also contains two other indicators
from the automobile industry. The first one is the retention value of the 2003 model, as measured
by the decline in prices after one year. The second one is the average length in months of the first
2
An example from the automobile industry is repair and maintenance services offered by the car dealer: con-
sumers cannot know for certain whether they will be satisfied with them until they bring the car for service.
3
For example, consumers may not know a priori whether the rate of acceleration is adequate for their driving
style, or whether they will feel comfortable with a car with leather seats, until after trying the car out.
4
Loyalty for most brands ranges between 30% and 60%. Chevrolet is the brand with highest loyalty, while Isuzu
has a customer loyalty of just 3.5%
5
However, we can also observe that loyalty does not depend on the origin of the brand, since there are Japanese
and European brands (Toyota, Mercedes Benz) with high loyalty and American ones (Pontiac, Jeep, Mercury)
with low loyalty.

3
ownership for the 1998 model, as computed by R.L. Polk & Co.6 The dispersion of both variables
is not as large as for customer loyalty, although we appreciate in this selection that brands with
larger customer loyalty tend to be kept for a longer time and retain more value. In fact, brands
in the top quartile of loyalty, on average, have a retention value of 72.6% and are kept for 41.3
months, compared to 65.2% and 39.5 months for brands in the lowest quartile.

Table 1: Indicators from the automobile industry - selected brands

Customer Retention Average
Loyalty Value Ownership
(in %) (in %) (in months)
Chevrolet 60.8 61.9 39.4
Toyota 59.3 79.2 43.0
Mercedes Benz 58.7 80.0 44.8
Ford 58.1 63.5 37.6
Honda 57.1 81.1 43.4
Cadillac 52.9 65.6 38.4
Dodge 46.3 61.5 40.9
Nissan 40.6 74.0 39.8
Volkswagen 37.1 73.4 39.6
Mitsubishi 36.7 62.4 39.1
Pontiac 35.3 53.8 39.7
Mercury 33.6 56.6 36.7
Volvo 31.9 77.7 44.0
Mazda 22.2 71.4 37.9
Source : Customer loyalty is from J.D. Power & Associates, retention values were
computed from prices from www.kelleybluebook.com. Average ownership is
from R.L. Polk & Co.

Given the dispersion of consumer loyalty, we need an explanation for brand switching based on
differences across brands. This paper proposes that, if we consider vehicles as experience goods,
consumers may switch brands when the current product did not provide a good match. To
ascertain whether experience has an effect on customer loyalty, I compare it with two indicators
that measure consumers’ satisfaction with their new vehicles during the first three years after
purchase.7 The Customer Satisfaction Index (CSI) evaluates satisfaction with dealer maintenance
and repair services, while the Automotive Performance, Execution and Layout index (APEAL)
quantifies owners’ satisfaction with the design, content, layout and performance of their new
vehicles. Table 2 shows there is in fact a significant positive brand correlation between loyalty
6
The average has been calculated so that a car still retained by its first owner in December 2004 has an ownership
length of 64 months.
7
These two indicators on satisfaction, as well as the customer loyalty, are published online by J.D. Power &
Associates.

4
and both satisfaction indices. Simply put, the higher the satisfaction of a consumer with her car
−which would reflect whether she has had a good experience with her previous car−, the larger
the probability that the customer will repeat the purchase of the same brand.8

Table 2: Correlation Tests of Loyalty and Other Variables

Pearson Correlation Spearman Rank
Test Correlation Test
CSI 35.76% 21.51%
APEAL 31.31% 26.37%
Retention Value 25.69% 22.52%
Average Ownership 21.07% 21.74%
Critical value 10%: 21.77% - Critical value 5%: 27.53%

Table 2 also displays the correlation between brand loyalty and the two other variables from
Table 1. It shows a positive −but weak− relationship between loyalty and retention value, as
well as a positive correlation between loyalty and the average time the original owner holds the
car. Both results are consistent with our previous analysis but, to explore further the relationship
between loyalty and ownership, I obtained from R.L. Polk & Co. the fraction of new cars disposed
of by the original owner after one, three and five years. From this information, I compare the
disposal rate for the brands in the top and lowest quartiles of loyalty, and find that high loyalty
cars are disposed of at a slower pace (see Table 3).

Table 3: Rate of disposal by original owner

Cars disposed Cars disposed Cars disposed
of within one of within three of within five
year years years
High loyalty 7.3% 42.1% 78.0%
Low loyalty 7.9% 45.1% 82.5%

Difference, t-test 0.476 1.185 2.156

Critical value 10%: 1.746 - Critical value 5%: 2.12

I construct a dynamic model of a durable, experience good with infinitely-lived consumers

and heterogeneous valuations for quality. Cars last two periods and depreciate, so that a used
car has lower quality than a new car. There is a constant output of new cars of each brand
entering the market every period, and consumers may trade their used cars after one period.
8
It is possible that observable characteristics also affect these indices. However, we can expect that, if cars were
completely identifiable before a purchase, consumers will remain loyal to the brand.

5
In the model consumers have two independent differentiation parameters. The first one is their
valuation of quality. I assume consumers know this value, which does not change through their
life. In equilibrium, consumers with higher valuation for quality will purchase new cars. The
second, and most important for the purpose of the paper, is an experience-related parameter,
whose value is unknown for consumers before any purchase. They learn this value only after a
purchase.
The dynamics of the experience parameter can be better explained by means of an example.
Suppose a consumer purchased a new Volvo last period. Therefore, today she owns a used car.
Also, she has already learned her experience-related parameter associated with that car. But I
assume experience is idiosyncratic: other Volvo buyers may have gotten a different experience
than hers. In general, some consumers may get a good fit and some others may get a bad fit.
Depending on your experience, this Volvo owner has to decide whether she keeps her used
car, sell it and buy a new Volvo, or sell it and buy a new car of another brand. I assume that
consumers have short memory: they only remember the experience with the car they owned the
period immediately before. From the point of view of the Volvo owner of our example, she has
no information about other brands. Further, the expectation about the experience she may get
with a new Volvo is a convex combination of the experience she got with the used Volvo, and the
expected experience value in the market. So, each car buyer may expect a different experience
with that same brand on her next purchase.
There is an abundant literature that has studied durable goods markets, but has mostly
ignored the role of experience. Recent developments have focused on the firms’ decision of making
the good obsolete, either through the choice of durability (Waldman, 1996; Hendel and Lizzeri,
1999a) or the introduction of new products (Fudenberg and Tirole, 1998; Lee and Lee 1998).
Another important contribution has been the incorporation of adverse selection in a model of
durable goods (Hendel and Lizzeri, 1999b, Johnson and Waldman, 2003). A survey by Waldman
(2003) provides a synthesis of the evolution of the microeconomics of durable goods.
In turn, there is a large literature on experience goods that has centered on the firms’ strategies
to overcome the asymmetric information problem by signaling high quality or by building a
reputation (Klein and Leffler, 1981; Shapiro, 1982; Riordan, 1986; Milgrom and Roberts, 1986).
More recently, there is a renewed interest on the consumer experimentation problem and its

6
relationship with oligopolistic competition (e.g. Bergemann and Valimaki, 1996, 1997, 2002).9
Other authors have shown the relevance of experience in markets such as the anti-ulcer drug
market (Crawford and Shum, 2005), yogurts (Ackerberg, 2004), and laundry detergents (Erdem
and Keane, 1996). In that context, the contribution of this paper to this literature is the analysis
of experience for a durable good when there is a secondary market.
The paper is organized as follows. Section 2 introduces the model. Section 3 analyzes a bench-
mark model when there is no uncertainty, while Section 4 introduces uncertainty and experience
for the case of two brands with similar distribution of experience. In Section 5, I characterize the
situation where the brands differ in experience. Section 6 concludes.

2 Characterization of the Model: Incorporating Experience

I consider an infinite-horizon model in discrete time. I assume that there is a unit mass of
consumers who live forever, and that no new consumers are born at any period. At any date,
each consumer demands at most one unit of a durable good, which for convenience will be referred
as a car. I assume that cars last two periods, so that there at every moment of time there is a set
of new cars, and a set of one-year-old used cars. Any consumer that buys a new car will always
take into account the future value of the used car. In fact, if she purchases a new car in period t,
she may choose to sell it in period t + 1. Any new car has quality v, while a used car has quality
w < v.
Consumer preferences are characterized by the pair (θ, λ) , with each element of the pair
independent of the other in the population. Given qualities qt ∈ {w, v} and prices pt , a consumer
t
with pair (θ, λ) gets utility u (θ, λ, q, p) = Σ∞
t=0 δ (θqt + λt − pt ) χt , where χt is either zero or one,
depending on whether or not she consumes in period t. The parameter θ represents the measure
of the consumer’s idiosyncratic valuation for quality, is fixed through the consumer’s life and
is known before any purchase. I represent the distribution of θ by the cumulative distribution
£ ¤
function F : θl , θh → [0, 1] , with θh > θl ≥ 0. In turn, λ represents an unobservable experience-
related utility parameter, which is unknown for the consumer before a purchase. The consumer
9
In contrast, here I get away from such problem by limiting consumers’ memory, similar to Villas-Boas (2001),
although there he studied a non-durable good market with overlapping generations of consumers. Our papers also
differ in the characterization of heterogeneity across consumers.

7
only learns λ after buying and trying the product out. All she knows before purchase is that,
with probability π, the car is a good match, and λ = λh > 0; if the car is a bad match, then
λ = λl , with λh > λl .
After purchase, the consumer learns her experience value λ for that car and brand, which is
idiosyncratic: some consumers will get a good match, some others will get a bad fit. Further, she
does not necessarily gain further information about future purchases of that or any other brand.
More precisely, suppose a consumer has bought a new car of brand i at period t − 1 and got
experience λ0 . Then, at beginning of date t, she owns a used car and has some knowledge about
brand i, but not about any other brand. Further, the knowledge about brand i is not perfect. I
assume that the experience-related valuation for quality for a new car has the Markov property
¡ ¢
according to E λ/λ0 = φλ0 +(1 − φ) Eλ, where φ ∈ [0, 1] is a parameter that represents learning
and is fixed across the population. So the consumer’s expectations about a new car of brand i will
depend on the match they experienced in the period immediately before when they also owned
brand i, and the expected market experience value for that brand. When φ = 1, the consumer
expects that a new car of brand i will give her the same fit as the previous one. When φ = 0,
I represent the case where consumers learn nothing from the previous purchases. This learning
process also applies to a used car buyers.10
I assume there is a constant flow of y new units of the product coming into the market at
every date. So, I focus on how such output flow is allocated under conditions of uncertainty
and experience, and ignore the way market structure and cost conditions lead to this exogenous
output. I characterize equilibria for any output flow. The mass of consumers who get to consume
either a new or a used product is at most 2y at any date. I assume that y is sufficiently small so
that, at every moment of time, there are some consumers who do not own a car. In fact, for the
analysis with two brands with symmetric distribution of experience, it is sufficient that y ≤ 12 .
Consumer behavior is characterized by a sequence of decisions regarding what product to
hold in period t, as a function of the product they own at the beginning of that period, and the
experience they got with that product. If the consumer owns a used car, she can choose to hold
on to that car or sell it. If she sells it, she can purchase a new car of the same brand, or of another
brand; she may also choose to buy a used car −and again ,decide whether she switches brands
10
When φ 6= 1, I am also considering that car characteristics may change over time, thus including another
plausible explanation for a consumer to switch brands.

8
or not− or buy nothing. If the consumer owns nothing, she can choose to purchase a new car
−of the same brand than before, or of another brand−, purchase a used car −of the same brand
than before, or of another brand−,or buy nothing. Given the stationarity of the environment,
the analysis will focus on equilibrium outcomes at the steady state, where pnt = pnt+1 = pn and
put = put+1 = pui . As it turns out, we reduce the complexity of the model by imposing such
restriction. It will prove convenient to define a type θk that satisfies 1 − F (θk ) ≡ k, such that
there is a mass k of consumers with higher valuation of quality.

3 A Benchmark: Equilibrium with no Matching Uncertainty

Before starting the discussion regarding the effects of experience, we need to understand the
behavior of the model when there is no uncertainty. Assume that consumers have complete
information about all the characteristics of both brands of cars and their own preferences, so
that, for brand i = a, b, λ has a degenerate distribution function at Λi > 0. Let pui,d and pni,d
denote the price of a used car and a new car of brand i in this deterministic benchmark. Let
V (θ) denote the value for a consumer of type θ that owns no car. Then:

V (θ) = max {V n (θ) , V u (θ) , 0} (1)

where V n (θ) ≡ max {Vin (θ)} and V u (θ) ≡ max {Viu (θ)} denote the value of purchasing a new
i=a,b i=a,b
car and a used car, respectively, where:

Vin = θv + Λi − pni,d + ViO (θ) (2)

Viu = θw + Λi − pui,d + V (θ) . (3)

The last term in equation (2) defines type−θ0 s value of owning a used car of brand i at the
beginning of a period, which is just:

ViO (θ) = pui,d + V (θ) (4)

If, for example, this used-car owner decides to hold on to that car, his utility is ViO (θ) = θw +
Λi + V (θ) .
Suppose that both brands are identical, i.e., Λa = Λb = Λ. Then pna,d = pnb,d = pnd and
pua,d = pub,d = pud ; otherwise, all consumers will prefer to buy the cheapest brand, regardless of

9
their preference for quality. If, in addition, a consumer who is indifferent between both brands
will continue to buy the brand on which it has previous knowledge, then consumers will have no
incentive for switching brands, and the difference between brands becomes irrelevant. Hence, a
used car owner will just decide between holding on to the used car, or selling it and buying a
new car of the same brand, while a consumer that owns no car will decide between buying a new
car, buying a used car, or not buying at all:

V O (θ) = max {θw + Λ + δV (θ) , pud + V (θ)} , (5)

© ª
V (θ) = max θv + Λ − pnd + δV O (θ) , θw + Λ − pud + δV (θ) , 0 . (6)

From a quick look at both V O (θ) and V (θ) we can infer that a consumer that owns no car and
decides to buy a used car at period t will never purchase a new car. Further, if a consumer does not
own a car at the beginning of period t and decides to purchase a new car for that period, she will
never hold on to a used car, and therefore will buy a new car every period. To see this, suppose a
consumer buys a new car in period t, which means that θv+Λ−pnd +δV O (θ) > θw+Λ−pud +δV (θ) .
Since V (θ) = θv +Λ−pnd +δV O (θ) , we can rewrite the inequality as V (θ) > θw+Λ−pud +δV (θ) .
This just implies that V O (θ) = pud + V (θ).
Based on the preceding discussion, we can define the utility a consumer gets for buying a new
1
car every period as Udn (θ) = 1−δ (θv + Λ − prd ), where prd ≡ pnd − δpud is the rental price paid by
1
a new car buyer. In turn, Udu (θ) = 1−δ (θw + Λ − pud ) denotes the utility for buying a used car
every period. Given that a consumer will buy the previous brand when indifferent, then there is
100% loyalty in both new and used cars.11
The lowest-type consumer that buys a new car is type θd , who is indifferent between buying
¡ ¢ ¡ ¢
new and buying used. This defines a condition Udn θd = Udu θd , which in turn defines the
equilibrium price of a new car as pnd = θd (v − w) + (1 + δ) pud . In turn, the lowest-type consumer
who buys a used car is type θd , who is indifferent between buying used and not buying. This
¡ ¢
defines a condition Udu θd = 0, which defines the price of a used car as pud = θd w + Λ. So we
¡ ¢
can rewrite the price of a new car as pnd = θd (v − w) + (1 + δ) θd w + Λ . Figure 1 illustrates the
characterization of the equilibrium.
11
The introduction of an observable difference between brands (e.g., introducing horizontal differentiation a la
Hotelling) will provide the same result on loyalty, i.e., that a consumer will stay loyal to the brand she has bought
the previous period..

10
 Figure 1: Symmetric Equilibrium with
Two Brands and No Uncertainty

θh

Buy new car

_
θd

Buy used car

θd

Buy NO car

θl

To determine the demand for new cars of brand A, notice that there will be a constant fraction
σ n of consumers who will purchase new cars of brand A every period, so that the demand for new
n = σ
£ ¡ ¢¤ n
£ ¡ ¢¤
cars is Da,d n 1 − F θ d . Analogously for brand B, Db,d = (1 − σ n ) 1 − F θ d . Market

clearing conditions in the new car market requires that σ n = 12 , since one half of the total supply
¡ ¢
of new cars is from brand A. Then θd = θy satisfies F θd = 1 − y. Similarly, the demand for
u = σ
£ ¡ ¢ ¡ ¢¤ u = (1 − σ ) F θ
£ ¡ ¢ ¡ ¢¤
used cars will be given by Da,d u F θd − F θd and Db,d u d − F θd

but, since no new-car buyer retains her used car, there is also a mass of y consumers who is able
to buy used cars, meaning that all cars are traded in the used-car market in equilibrium. Hence
¡ ¢
σ u = 12 and θd = θ2y satisfies F θd = 1 − 2y.
Suppose now that Λa 6= Λb . In this case, prices will not be identical. More precisely, if
Λb − Λa = ∆Λ > 0, then brand B will provide a higher gross utility, and equilibrium will require
prices for new and used cars of brand B to be higher. As such, prb,d − pra,d = pub,d − pua,d = ∆Λ. But
all the other characteristics of the equilibrium, namely the thresholds between new car buyers,
used car buyers and non buyers, remain the same. The equilibrium only takes a different form

11
if va 6= vb or wa 6= wb . For example, when va > vb > wa > wb , then consumers are partitioned
according to their types: the group with highest types will buy new cars of brand A every period;
a second group will buy new cars of brand B, a third group will buy used cars of brand A, and
so on.
The results in this section extend those in Proposition 1 in Hendel & Lizzeri (1999) by
considering the possibility of having two brands that are different, and introducing an additional
”experience” term Λ, which in this benchmark is just a constant. Notice that both equilibrium
prices increase with Λ; moreover, the extra cost of buying a new car, pnd −pud , which also represents
the depreciation of a new car, also increases with Λ.

4 Matching Uncertainty with Two Identical Brands

We shall now assume that a prospective car buyer does not know the realization of λ before any
purchase. Consider a consumer of type θ that owned a used car of brand i the previous period12
and got experience λ0 . Then, she owns no car at the beginning of the current period, and her
¡ ¢
utility value, denoted as Vi (θ, ·) ≡ V θ, λi = λ0 , λj = Eλ , can be defined as:

Vi (θ, ·) = max {Vin (θ, ·) , Viu (θ, ·) , 0} (7)

where V n (θ, ·) and V u (θ, ·) determine the value of purchasing a new car and a used car, respec-
tively, and are defined as:
© ¡ ¢ ª
Vin (θ, ·) = max θv + E λ/λ0 − pni + δEViO (θ) , θv + Eλ − pnj + δEVjO (θ) (8)
© ¡ ¢ ª
Viu (θ, ·) = max θw + E λ/λ0 − pui + δEVi (θ) , θw + Eλ − puj + δEVj (θ) . (9)

If the consumer decides to buy a new car, as shown in (8), she still has to decide between staying
¡ ¢
loyal to brand i, for which she expects to get an experience E λ/λ0 = φλ0 + (1 − φ) Eλ, or
switching to brand j, for which she has no experience and thus expects λ = Eλ. In any case,
at the beginning of next period she will own a used car, whose (expected) value is denoted by
¡ ¢
EViO (θ) . More precisely, denoting as V O θ, λi = λ0 , λj = Eλ the value of owning a used car of
brand i :
© ª
ViO (θ, ·) = max θw + λ0 + δVi (θ, ·) , pui + Vi (θ, ·) (10)
12
That means that either she bought a used car last period, or she bought a new car two periods ago and kept
it for two periods.

12
 It is important to distinguish the differences with the value functions when there is no uncer-
tainty. A look back to equation (4) indicates that a consumer is indifferent between keeping her
current used car, or selling it and buying a used car of the same brand. Instead, equation (10)
emphasizes that a used car owner has some privileged information on the car she currently owns,
because she has already realized her experience-related value associated with that used car. In
other words, she faces no uncertainty regarding her current (used) car, while there are different
levels of uncertainty with any other cars.13 A comparison of (1) − (3) with (7) − (9) also indicates
that a consumer that owns no car has an informational advantage regarding brand i, based on
¡ ¢
her experience last period, as measured by E λ/λ0 .
Further observation of the set of equations (7) − (9) reveals that, for a consumer with expe-
rience in brand i that owns no car, the decision between buying a used car or a new car of that
particular brand does not depend on her experience. This means that, in a stationary equilib-
rium, there is a consumer of type θi such that any other consumer with type θ ≥ θi that owns
no car but has experience with brand i will prefer to buy a new car of that brand. Obviously,
the consumer may decide to switch brands, based on that past experience. But it suggests the
convenience to study consumer behavior by looking separately at two different groups: one group
© ª
of consumers with type θ ≥ θ ≡ min θa , θb that has access to buy new cars, and another group
with type θ < θ who does not.14 We will see that, in a symmetric equilibrium, θa = θb = θ,
meaning that only consumers with θ ≥ θ will buy new cars.

4.1 Consumer Behavior of Used Car Buyers

Consider first the set of consumers that never buys a new car. It includes consumers of type
© ª
θ < min θa , θb . These consumers either buy a used car every period, or they never buy a car
at all. It may be also possible that some consumers buy used cars every other period, depending
on their experience. Further, if they buy a used car every period, they may remain loyal to the
original brand or switch every period, according to their experience. First, notice that their value
13
Notice that, whenever λ0 ≤ Eλ, a used car owner will prefer getting a different used car of that brand rather
than keeping the current one. However, in equilibrium both actions are dominated by the option of switching
brands.
14
If, without loss of generality, θa > θb , it is still the case that a consumer with θ > θb that owns no car will
choose to buy a new car of brand B over a used car of that brand, even though she might choose to switch to
brand A.

13
function reduces to:
© ¡ ¢ ª
Vi (θ, ·) = max θw + E λ/λ0 − pui + δEVi (θ) , θw + Eλ − puj + δEVj (θ) , 0 .

Consider the set of consumers who did not own a car last period. They will decide not to
buy any car if θw + Eλ − pui + δEVi (θ) < 0. Since the expression is independent of λ −after all,
they have no experience−, then we can define θ = min {θa , θb } as the lowest consumer that has
access to buy a used car, where θi satisfies θi w + Eλ − pui + δEVi (θi ) = 0. As such, consumers
of type θ < θ never buy a car of any type.
To analyze the consumer behavior of used car buyers, consider the set of consumers that
bought a used car of brand i last period. Suppose θa = θb , which means that their decision
is restricted to one of the two brands. Then, the following Lemma characterizes the optimal
behavior of these consumers:

Lemma 1 For consumers who buy used cars, the decision whether or not to switch brands is
£ ¤ £ ¤
characterized by a continuous function ziu : θl , θh → λl , λh such that a consumer of type θ
switches brands if she gets an experience below ziu (θ) .

Proof For consumers that own a used car of brand i and got experience ziu , they will switch
brands whenever φ (ziu − Eλ) < pui − puj + δ (EVi (θ) − EVj (θ)). Since the terms in the right
hand side are independent of λ, this means that, if there are any consumers that switch
brands at all, it will be those who got the lowest experience last period. In other words, if
a consumer got experience λ < ziu , she strictly prefers to switch brands, where ziu can be
written as:
1¡ u ¢ δ
ziu = Eλ + pi − puj + (EVi (θ) − EVj (θ)) (11)
φ φ
Further, we can define the expected value of owning no car as
Z ziu Z λh
¡ ¢
EVi (θ) = θw + Eλ − puj + δEVj (θ) dλ+ (θw + φλ + (1 − φ) Eλ − pui + δEVi (θ)) dλ
l
λ ziu
(12)
Solving for EVi (θ) and EVj (θ) , we can obtain that:
µ ¶ µ ¶
1 1
EVi (θ) − EVj (θ) = Mi − Mj
(δ + 1) (1 − G (ziu )) (δ + 1) (1 − G (ziu ))

14
 where

Mi = θw − pui G (ziu ) − puj (1 − G (ziu )) + Eλ (1 − (1 + φ) G (ziu )) + φG (ziu ) E (λ/λ < ziu )

. Therefore, ziu depends on θ.¥

Notice that we cannot determine a priori whether ziu is an increasing or decreasing function
of θ, but it can be seen that whenever ziu > zju , which occurs when pui > puj , then ziu is increasing
in θ and zju is decreasing in θ. Further, pui = puj = pu if and only if ziu = zju = z u , in which case
z u = Eλ, independent of the consumer’s preference for quality. In any case, whenever a used car
buyer gets an experience above ziu (θ), she will remain loyal to the brand she owned the previous
period, as illustrated in Figure 2 for the case where ziu (θ) is increasing in θ. Otherwise, she will
switch brands. In addition, notice the possibility that ziu (θ) lies outside the support of G (·) .
¡ ¢
When ziu θ0 < λl , all consumers of type θ0 will remain loyal to brand i and buy a used car of
¡ ¢
that brand, regardless of experience; if ziu θ0 > λh , those consumers will always prefer to switch
brands and buy a used car of brand j.

Figure 2: Behavior of Used Car Buyers

_
θ

Switch brands, used car

Distribution Buy used car same brand
of types θ

θ _
λl zui(θ) zui( θ ) λh

Distribution of experience λ

Lemma 1 also applies to the case where θa 6= θb , but we have to consider also the behavior
of those consumers whose preference for quality is located between θa and θb . Without loss of
generality, suppose θa < θb . Then those consumers with θ ∈ [θa , θb ] only have access to used

15
cars of brand A. We can realize that they will only buy a used car of brand A when they get
¡ ¢
a high experience. To observe this, notice that θw + E λ/λ0 − pu + δEV (θ) is increasing in
λ, for any given θ ∈ [θa , θb ] , meaning that there is a minimum experience λ such that those
consumers refrain to buy a used car again if they get an experience below that level. However,
since I assume that experience is Markovian, these consumers will return to the used-car market
after one period, given that θ ≥ θa = θ.

4.2 Consumer Behavior of New Car Buyers

Consumers who buy new cars have to decide periodically what to do with their used cars. Consider
the set of consumers that owns a used car of brand i. Suppose for a moment that this is the only
brand available. As such, used car owners have to decide between holding on to their used car,
or selling it and buying a new car, as shown below:
© ¡ ¢ ¡ ¢ª
V O (θ, λ0 ) = max θw + λ0 + δV θ, λ0 , pui + V θ, λ0 (13)
¡ ¢ ¡ ¢
where V θ, λ0 = θv + E λ/λ0 − pn + δEV O (θ) . As in the case with no matching uncertainty,
some consumers will purchase a new car every period but, conditional on experience, some other
owners may decide to keep a used car. The following lemma helps clarify that possibility:

Lemma 2 For consumers who buy new cars, the decision whether or not to keep their used car
£ ¤ £ ¤
is characterized by a continuous, strictly increasing function xi : θl , θh → λl , λh , such that a
consumer of type θ holds on to a used car if she gets an experience above x (θ) , with:

θ (v − w) − (pri − pui ) + (1 − φ) Eλ + δφE (λ|λ < x) G (x) + δ (1 + δφ) E (λ|λ ≥ x) (1 − G (x))

x (θ) ≡
(1 − (1 − δ) φ) (1 + δ (1 − G (x)))
(14)

Proof Suppose a new car buyer of type θ got experience x. As a used car owner, she will hold
on to that car when θw + x + δV (θ, x) ≥ pui + V (θ, x) , which can be rewritten as:

(1 − (1 − δ) φ) x ≥ (1 − δ) (1 − φ) Eλ + (1 − δ) θv − θw + pui − (1 − δ) pni + (1 − δ) δEV O (θ)

Therefore, for any λ > x, the inequality is strict, meaning that if the consumer prefers to
hold a used car when she got an experience x, then she strictly prefers to hold such car if

16
 she gets an even better experience. Since there is only one cut-off for every θ, then x (θ) is
a function, defined by:
1 £ ¤
xi (θ) = (1 − δ) (1 − φ) Eλ + (1 − δ) θv − θw + pui − (1 − δ) pni + (1 − δ) δEV O (θ) .
(1 − (1 − δ) φ)
(15)
Further, since consumers with λ > x keep used cars, we can define the expected value
R x(θ) R λh
of owning a used car as EV O (θ) = λl (pua + V (θ, λ)) dλ + x(θ) [θw + λ + δV (θ, λ)] dλ.
Solving for EV O (θ) and replacing it in (15) , we obtain (14) .

To prove that x (θ) is increasing, suppose two values: θ0 and θ00 , where θ0 > θ00 . Using the
definition of x (θ) in (15) we have:
¡ ¢ ¡ ¢ 1 £ ¡ ¢ ¡ ¡ ¢ ¡ ¢¢¤
x θ0 −x θ00 = ((1 − δ) v − w) θ0 − θ00 + (1 − δ) δ EV O θ0 − EV O θ00
(1 − (1 − δ) φ)
¡ ¢ ¡ ¢
Suppose by contradiction that x θ0 ≤ x θ00 . Then we must have
¡ ¢ ¡ ¡ ¢ ¡ ¢¢ ¡ ¢
0 ≥ ((1 − δ) v − w) θ0 − θ00 + (1 − δ) δ EV O θ0 − EV O θ00 ≥ ((1 − δ) v − w) θ0 − θ00
¡ ¢ ¡ ¢
where the first inequality follows from x θ0 ≤ x θ00 , while the latter holds because type
θ0 can always use the same rule as type θ00 . This is in contradiction with θ0 > θ00 . Therefore
¡ ¢ ¡ ¢
x θ0 > x θ00 ¥

It is easy to interpret x (θ) by observing that a consumer must be indifferent between holding
on to a used car that has given her an experience x (θ) for a second period, or sell that car at
a price pui and buying another car. Notice also that, since x (θ) is an increasing function of θ,
consumers with higher valuations of quality are more likely to trade their used cars. Further, it
¡ ¢
is possible for x (θ) to lie outside the support of G (·) . If x θ0 < λl , then consumers of type θ0
¡ ¢
will always hold on to their used car, regardless of experience; if x θ0 > λh , those consumers
will always prefer to sell their used cars.
The language in Lemma 2 emphasizes that consumers that purchase new cars will keep their
used cars when they get high realization of experience, but not the opposite. This is because we
have assumed that only one brand is available, in which case a bad experience is correlated with
getting a new car. But the presence of an additional brand B gives owners of a used car of brand
A the choice of switching brands when they get a bad experience. In other words, it expands the
range of options for the consumer.

17
 To understand the behavior of used car owners when another brand is available, notice first
that, for a consumer who has access to buy new cars, the purchasing decision when they own
no car is reduced to a decision rule between brands that is very similar to the one of used car
buyers. Obviously, such a consumer has already made a decision regarding the used car.15 So,
going a step back, when the consumer owns a car, the decision rule between brands also applies,
although in that event each consumer has a third alternative, which is to keep her current used
car.

Lemma 3 For consumers who buy new cars, the decision whether to buy a new car of the same
£ ¤ £ ¤
brand or switch brands is determined by a continuous function zin : θl , θh → λl , λh such that
a consumer of type θ does not switch brands if she gets an experience above zin (θ) .

The proof is analogous to the one in Lemma 1, with the main difference being that consumers
that own no car will own one at the end of the period. Thus zin (θ) satisfies:

1¡ n ¢ δ¡ ¢
zin = Eλ + pi − pnj + EViO (θ) − EVjO (θ) . (16)
φ φ

In order to account for the possibility that consumers retain the used car, the expected value of
owning no car is defined as
R zin ³ u ´
EViO (θ) = λRl p i + θv + Eλ − p n + δEV O (θ) dλ
j j
x ¡ ¢
+ zni pui + θv + φλ + (1 − φ) Eλ − pni + δEViO (θ) dλ (17)
R λi h ¡ ¡ ¢¢
+ xi θw + λ + δ θv + φλ + (1 − φ) Eλ − pni + δEViO (θ) dλ

and xi satisfies (15) . Figure 3 shows the structure of decisions for new car buyers that have
previous experience with brand i. We can interpret the optimal behavior of a used car owner of
type θ in two parts: if she got a superior experience (higher than xi (θ)), she will decide to hold
on to her used car, because she is already certain that such car was a good fit for her. If not, she
will sell it and buy a new car, and such decision depends again on whether the car was a good
or a bad match. If she had an inferior experience (lower than zin (θ)), she will switch brands, but
if she had a superior experience (λ ∈ [zin (θ) , xi (θ)]) she will buy a new car of brand i.
15
To be more precise, there are two circumstances where a new car buyer does not own a used car: (a) last
period she decided to held her used car , and thus will buy a new car this period, or (b) this period she is deciding
not to keep her used car and buy a new one, so she now has to decide which brand to buy.

18
 Figure 3: Behavior of New Car Buyers

θh

Switch brands, new car Buy new car same brand

Distribution
of types θ
Keep used car
_
θ
_ _
λl zni(θh) zni( θ ) x( θ ) x(θh) λh

Distribution of experience λ

Figure 3 shows the case where zin is a decreasing function of θ and xi (θ) ≥ zi (θ) for any θ.
Notice that, for the same reasons explained in the case of used car buyers, it is not possible to
determine a priori whether zin is an increasing or decreasing function of θ. Again, we can realize
that pui = puj = pu if and only if zin = zjn = z n , in which case z n = Eλ, and that whenever
zin > zjn , which occurs when pni > pnj , then ziu is increasing in θ and zju is decreasing in θ. Further,
it is possible that, in a non-symmetric equilibrium, xi (θ) < zi (θ) for some θ close to θ. In words,
the option of buying a new car of brand i is dominated by both option of keeping the used car
or switching brands. In that case it is still the case that consumers with superior experience will
retain the used car, with a cutoff experience λ” where the consumer is indifferent between both
choices.
Another caveat is in place: If θa 6= θb , then consumers whose type is between those cutoffs
will not have access to new cars of one of the brands. More precisely, if we assume without loss
of generality that θa < θb , consumers in that range will choose between used cars of brand B
and new cars of brand A, such that consumers who own a used car of brand A and got a bad
experience will switch brands and buy a used car of brand B.

19
4.3 Equilibrium

In equilibrium, both markets (of new cars and used cars) should clear, which means that Din = Sin
1
and Diu = Siu for i = a, b. Since we assumed that a fraction 2 of new cars is of brand A, then
1
San = Sbn = 2 y, To ascertain the demand for new cars (Din ) and used cars (Diu ) for each brand,
we can define as µni,t (θ) the proportion of consumers of type θ who are present in the new-car
market in period t to purchase brand i, and µui,t (θ) as the proportion of type-θ consumers that
are present as buyers in the used-car market. Then, in a steady state:
Z θh
Din = µni (θ) dF (θ) .
min{θa ,θb }
Z max{θa ,θb }
Diu = µui (θ) dF (θ) .
min{θa ,θb }

In addition, notice that a fraction G (xi (θ)) µni,t (θ) of consumers of type θ will be selling their
used cars next period. It includes consumers that got a good experience but decide to renew
their cars, and those who got a bad experience and decide to switch brands. Then, in a steady
state, the supply of used cars can be written as:
Z θh
Siu = G (xi (θ)) µni (θ) dF (θ)
min{θa ,θb }

Therefore, we only need to determine µni,t (θ) and µui,t (θ). Without loss of generality, sup-
pose that θb ≥ θa > θb ≥ θa . Define κi,t (θ) as the proportion of consumers of type θ that
bought a new car of brand i the period immediately before and decided to hold on to the
£ ¤
used car. Then, for consumers of type θ ∈ θb , θh , it has to be the case that, in equi-
P ³ n ´
librium, µi,t (θ) + κi,t (θ) = 1. Of those consumers that bought a new car of brand
i=A,B
i last period, a fraction κi,t (θ) = (1 − G (xi (θ))) µni,t−1 (θ) decide to hold on to their used
car, and therefore will buy a new car of the same brand in period t + 1. Further, a fraction
(G (xi (θ)) − G (zin (θ))) µni,t−1 (θ) of consumers will decide to sell their used car but remain loyal
to brand i and thus buy a new car of brand i in period t. Finally, a fraction G (zin (θ)) µni,t−1 (θ)
will sell their used car and switch to a new car of brand j. Then, the proportion of consumers of
type θ that wants to buy brand i includes: (a) consumers who were not present in the new-car
market in period t − 1, and owned a used car of brand i that period, (b) consumers who bought

20
brand i the previous period and got an experience λi ∈ [zin (θ) , xi (θ)] , and (c) consumers who
bought brand j 6= i the previous period and got a bad experience, i.e., λj < zjn (θ) . Therefore:
¡ ¢
µni,t (θ) = κi,t−1 (θ) + (G (xi (θ)) − G (zin (θ))) µni,t−1 (θ) + G zjn (θ) µnj,t−1 (θ) . (18)

In a steady state, µni,t (θ) = µni,t−1 (θ) , and (18) can be rewritten as:
³ ´
G zjn (θ)
µni (θ) = µn (θ) .
G (zin (θ)) j
Solving for µni (θ) , we get:
³ ´
G zjn (θ)
µni (θ) = ³ ³ ´ ´.
(2 − G (xi (θ))) G zjn (θ) + (2 − G (xj (θ))) G (zin (θ))
£ ¤
Consider now the set of consumers of type θ ∈ θb , θa , who are regular used car buyers.16
Since they have only two options, then µua,t (θ) + µub,t (θ) = 1. It can be seen that, at any point
of time, the proportion of type-θ consumers who wants to buy a used car of brand i includes (a)
those consumers who bought a used car of brand i the previous period and got an experience
λi ≥ ziu (θ), and (b) those who bought a used car of brand j 6= i the previous period and got an
experience λj < zju (θ). That is:
¡ ¢
µui,t (θ) = (1 − G (ziu (θ))) µui,t−1 (θ) + G zju (θ) µuj,t−1 (θ) (19)

In a steady state, µni,t (θ) = µni,t−1 (θ) . Using µua,t (θ) + µub,t (θ) = 1 and (19) , we get:
³ ´
G zju (θ)
µui (θ) = ³ ´.
G (ziu (θ)) + G zju (θ)

Proposition 4 There exists a symmetric equilibrium with a set of prices pn = pna = pnb and
pu = pua = pub where:

(i) Consumers with θ > θ buy new cars.

£ ¤
(ii) Consumers with θ ∈ θ, θ buy used cars
16
£ ¤
In a symmetric equilibrium, we will see that θa = θb and θa = θb , so the sets of consumers θa , θb and [θa , θb ]
are empty. In a non-symmetric equilibrum, it is possible that they are not. A description of the equilibrium for
those ranges can be provided by the author upon request.

21
(iii) There is a cutoff z ≡ Eλ such that all consumers switch brands every time they get an
experience lower than z.

(iv) Consumers with θ > θ that get experience λ ≥ x (θ) decide to hold on to their used cars

The proof is presented in the Appendix, while the implication of the results are laid out in
the next subsection, but at this point it is useful to visualize the equilibrium. Figure 4 shows the
behavior of a consumer that owned a car (of any type and brand) last period and got experience
λ. In a symmetric equilibrium, there is a group of high-type consumers that buys a new car every
time they are in the market, regardless of the experience they got. Similarly, there is a group of
intermediate types who buy used cars every period. Further, any consumer switches brands every
time she gets a bad experience, defined as λ < Eλ, regardless of the type of car they had owned.
Observe that, for a fixed level of output, θ = θd = θ2y . In words, any consumer with θ ≥ θ owns
a car, and no consumer with θ ≤ θ has access to a car at any moment of time.17 Notice also that
a consumer of type θ that owns a used and got an experience λ = Eλ is indifferent between keep
the car, selling it and buying a new car of the same brand, or selling it and switching brands.
Similarly, when such consumer does not own a car, she is indifferent between buying any type of
car.
17
To be more precise, consumers with θ < θ have no experience with any brand, so in Figure 1 all of them are
located right at z = Eλ.

22
 Figure 4: Symmetric Equilibrium with
Uncertainty and Two Identical Brands

θh
Switch brands, new car Buy new car same brand

_ Keep used car

θ
Distribution
of types θ
Switch brands, used car Buy used car same brand

Buy NO car

θl
λl zu=zn=Eλ λh
Distribution of experience λ

4.4 Comparative Analysis

Several interesting features can be uncovered when we compare the situations with and without
uncertainty.

4.4.1 Trade and Market Coverage

In the new car market, define as W the fraction of cars that are withheld by the original owner
for a second period. In a stationary equilibrium, the total number of cars retained by new car
Dn −S u 18
owners is just Dn − S u , so W ≡ Dn . In turn, T denotes the average time a new car buyer
1
keeps a car. Since cars last two periods, then T = Dn [(1) S u + (2) (Dn − S u )] = 1 + W. In
other words, the larger the fraction of cars that are retained by the original owner, the larger the
18 Su
We can also define D ≡ Dn
as the fraction of new cars that are disposed of by their original owners after one
period. So D + W = 1.

23
average time of ownership. In a symmetric equilibrium:

Proposition 5 With uncertainty, in equilibrium there is incomplete trade: not all new car buyers
will sell their used cars.

Proof By contradiction, suppose that there is complete trade. This can only be true if θ = θy .
That also means that all new car buyers must sell all realizations of experience, i.e., x (θ) ≥
¡ ¢
λh for any θ ≥ θy . Define U n θ, λ0 as the utility of a consumer of type θ that buys new
¡ ¢
cars and always trade her used car, while U u θ, λ0 denotes the utility of that consumer
¡ ¢ ¡ ¢
if she were to buy only used cars every period. Then U n θy , λ0 = U u θy , λ0 defines the
marginal consumer that is indifferent between buying new cars and used, which is precisely
a consumer of type θy , given that all cars are traded. Such condition can be reduced to:

θy (v − w) = pr − pu (20)

In particular, a consumer of type θy that bought a new car and got the best fit possible
would sell the car next period. In other words,
³ ´ ³ ´
θy w + λh + δU v θy , λh < pu + U n θy , λh
¡ ¢
where U v θy , λh represents the utility of the consumer when she decides to keep the car
for some xy < λh . Making use of (20) and simplifying we get that:
³ ´
(1 − δ) (1 + δ (1 − G (xy ))) (1 − φ (1 − δ)) λh − Eλ <
Z λh Z λh
2
(1 − δG (xy )) δφ (λ − Eλ) dF λ − δ (1 − φ (1 − δ)) (λ − Eλ) dF λ
Eλ xy

but the right hand side satisfies:

Z λh Z λh
2
(1 − δG (xy )) δφ (λ − Eλ) dF λ − δ (1 − φ (1 − δ)) (λ − Eλ) dF λ
Eλ xy
Z λh ³ ´ ³Z λh ´
< (1 − δG (xy )) δφ λh − Eλ dF λ − δ 2 (1 − φ (1 − δ)) λh − Eλ dF λ
Eλ xy
¡ ¢³ ´
= (1 − δG (xy )) δφ (1 − G (Eλ)) − δ (1 − φ (1 − δ)) (1 − G (xy )) λh − Eλ
2

We can easily verify that we have arrived to a contradiction, and that in fact a consumer
of type θy that gets the highest experience will keep the used car. More generally, there is

24
 a positive fraction of new car buyers that keep a positive fraction of used cars. Thus trade
is not complete.¥

The intuition for the absence of full trade is as follows: In order to have full trade as an
equilibrium, the lowest type that purchases a new car must be willing to sell her used car, even
when the car was a good fit. But all used cars are priced the same, and this consumer does not
get a price pu high enough to make her sell their used car. In fact, such a car is priced as if it
provides an average experience. Therefore, in a stationary symmetric equilibrium, W > 0. In
fact, we can rewrite W as:
R θh G(x(θ))
θ 2−G(x(θ)) dF (θ)
W =1− R h
θ 1
θ 2−G(x(θ)) dF (θ)
1 1
where we have already calculated that µni (θ) = 2 2−G(x(θ)) .
Notice that, despite having incomplete trade, the result is not inefficient, as any model of
adverse selection predicts (e.g. Hendel and Lizzeri (1999) or Johnson and Waldman (2003)).
Recall that, in models of adverse selection, there are some consumers who own a car of good
quality and want to sell their used cars, but cannot do so because the price is based on the
average quality of a used car. In the experience model, there are no informational gains that
can be earned by prospective buyers. Experience is idiosyncratic: the fact that the first owner
obtained a good fit does not mean that the next owner will get the same fit as well.
The following result is an immediate consequence of Proposition 5, and shows that, given a
fixed output, there is a larger proportion of consumers that buy new cars.

Corollary 6 With uncertainty, in equilibrium the lowest type to buy a new car is lower than
when there is no uncertainty, i.e., θ < θy

Proof Since the volume of trade is less than 100%, it must be the case that some types below
θy buy new cars, otherwise, the market of new cars will not clear.¥

Regarding the effect of the learning parameter φ, notice that, for a given distribution of the
experience parameter, the smaller the possibility of learning from a previous purchase, the larger
the mass of new car buyers that will decide to keep a used car. This can be easily verified by
∂W
noticing that, for any distribution of experience, ∂φ < 0. Further, when the consumers’ belief

25
that they learn more from their previous experience is very small, there are more consumers that
∂θ
have access to a new car ( ∂φ < 0), and less consumers that buy a new car when they have gotten
∂θ e
a good experience ( ∂φ > 0). In turn, this also means that the average ownership length decreases
with φ because more consumers trade their used cars away.

4.4.2 Customer Loyalty

To determine customer loyalty, recall that, among those new car buyers that bought brand i one
year ago and got a good experience, a group of consumers will sell their used car and buy a new
car of brand i today. Another group of consumers will decide to keep the used car for another
period but, after the used car runs out of life, one year from now they will be once again in the
new car market, and all of them will buy a new car of brand i. Therefore, the model identifies
consumers that experience a good match as those who remain loyal to the brand.
A more accurate definition of customer loyalty is as follows. Define Cin as the proportion of
customers of type θ that bought brand i before −either one or two years ago− and want to buy
a new car (of any brand) today. Define also Fin as the fraction of consumers included in Cin that
Fn
want to buy brand i again. Then, Lni ≡ C ni represents costumer loyalty among new car buyers.
£ ¤ n i
For a consumer of type θ ∈ θ, θh , Ci,t (θ) includes (a) consumers that bought a new car of
brand i last period, got an experience λ < zin (θ), and are coming back to the new car market
to switch brands, (b) consumers that bought a new car of brand i last period, got an experience
λ ∈ [zin (θ) , xi (θ)] , and are returning to the new car market to renew their car −thus selling
their used car−, and (c) consumers that bought a new car of brand i two periods ago, got an
experience λ ≥ xi (θ) , and as a result they kept the car one more year, so they are coming back
to the new car market after two periods. Therefore:
n
Ci,t (θ) = G (zin (θ)) µni,t−1 (θ) + (G (xi (θ)) − G (zin (θ))) µni,t−1 (θ) + (1 − G (xi (θ))) µni,t−2 (θ) (21)

and Z θh
n n
Ci,t = Ci,t (θ) dF (θ)
min{θa ,θb }

Further, of the consumers included in Ci,t (θ) , only the last two terms represent consumers that
want to buy a new car from brand i again. Then:
n
Fi,t (θ) = (G (xi (θ)) − G (zin (θ))) µni,t−1 (θ) + (1 − G (xi (θ))) µni,t−2 (θ)

26
and Z θh
n n
Fi,t = Fi,t (θ) dF (θ) .
min{θa ,θb }
n (θ) = µn (θ) and F n (θ) =
In a stationary, symmetric equilibrium, it is easy to see that Ci,t i i,t
(1 − G (Eλ)) µni (θ) . As a result, Lni = (1 − G (Eλ)). This also gives an important implication
of the model: the larger the probability of a good fit, the larger the fraction of consumers that
remain loyal to the brand next time they buy a new car.
The result on loyalty also extends to the used car market. In that case, all consumers
£ ¤ u (θ) = µu u
of type θ ∈ θ, θ will buy a used car every period, so Ci,t i,t−1 , of which Fi,t =
(1 − G (Eλ)) µui,t−1 will repeat purchase of the same brand. Again, in a stationary equilibrium,
Lu (θ) = (1 − G (Eλ)) . In fact, used car buyers with a good match will keep buying a used car
of the same brand, and will do so until they get a bad experience, in which case they will switch
brands.
Such results on loyalty are summarized in the following proposition:

Proposition 7 In a symmetric equilibrium, customer loyalty to each brand is L (θ) = π ∀θ ∈

£ h¤
θ, θ

In other words, loyalty does not depend on the distribution of the consumers’ preference
for quality or on their learning process, only on the distribution of the experience parameter.
Further, the skewness of the distribution of λ determines the magnitude of brand loyalty. Define
1
mλ as the median of the distribution of λ, such that G (mλ ) = 2. Since the Pearson Median
Skewness is defined by √ Eλ−mλ , whenever the distribution of experience is negatively skewed,
E(λ−Eλ)2
1
G (Eλ) ≤ G (mλ ) = 2 and the larger the proportion of consumers that would remain loyal.
The converse is true: if the distribution of λ is positively skewed, then there will be less loyal
costumers.

4.4.3 Prices

Let’s turn to discuss the impact of experience on prices, since it will allow us to gain an insight
regarding how experience might affect the producers’ behavior, given that we are assuming a
fixed output.

27
Proposition 8 In a symmetric equilibrium, for a given constant output of new cars, prices are
as follows:

pu = θw + Eλ + δφ (E (λ/λ > Eλ) − (1 − G (Eλ)) Eλ)

pn = θ (v − w) + (1 + δ) pu + δ (1 − φ (1 − δG (Eλ))) (E (λ/λ > Eλ) − (1 − G (Eλ)) Eλ)

Proof In equilibrium, the lowest type buying a used car is θ. This consumer has to be indifferent
between buying or not for any experience λ. So the expression for pu comes from setting
EU u (θ) = 0, where EU u (θ) is the expected value for consumer of type θ of buying a car
when she has no previous experience and is defined as EU u (θ) ≡ θw + Eλ − pu + δEV (θ) .
In turn EV (θ) is as defined in (12) , setting z u = Eλ.
¡ ¢ ¡ ¢
The expression for pn is determined from setting U n θ, λ0 = U u θ, λ0 for any λ0 =
© l hª ¡ ¢
λ , λ , where U n θ, λ0 is the utility a consumer of type θ gets when buying a new car,
given that she does not own a car, and that her previous experience was λ0 :
½ ¡ ¢
¡ ¢ θv + φλ0 + (1 − φ) Eλ − p¢n + δEV O θ when λ0 ≥ Eλ
n
U θ, λ = 0 ¡ ,
θv + Eλ − pn + δEV O θ when λ0 < Eλ
¡ ¢ ¡ ¢ ¡ ¢
where EV O θ is as defined in (17) , but setting z u = x θ = Eλ. In turn, U u θ, λ0 is
the utility that the same consumer gets when buying a used car:
½ ¡ ¢
u
¡ 0
¢ θw + φλ0 + (1 − φ) Eλ¡−¢pn + δEV θ when λ0 ≥ Eλ
U θ, λ = ,
θw + Eλ − pn + δEV θ when λ0 < Eλ
where again EV (θ) is as defined in (12) , setting z u = Eλ.¥

To understand the effects of experience on prices, I will compare the equilibrium prices under
uncertainty to those in the case of no uncertainty. For the purpose of the comparison we need
cars to have the same characteristics except for the uncertainty. As such, I will assume that
E (λ) = Λ. Recall that pud and pnd denoted prices for the case without uncertainty, and were
defined by:

pud = θd w + Λ

pnd = θd (v − w) + (1 + δ) pud
R λh
By rewriting (E (λ/λ > Eλ) − (1 − G (Eλ)) Eλ) = Eλ (λ − Eλ) dGλ, we realize that the
effect of experience on the price of used cars is unambiguous: used car buyers always pay a

28
higher price. The reason is that any buyer has the possibility of reaching a higher utility: in
the event of a poor fit, the buyer has the chance to switch brands. This effect, which I call
R λh
choice effect, is captured by the term δφ Eλ (λ − Eλ) dGλ. As a result, the utility level of all
used car buyers is higher with experience. Also, the effect is larger when learning has a stronger
effect. Further, notice that, on average, the consumer with valuation θ −who is the lowest type
that buys a used car− gets a positive utility. This is because she is indifferent between buying
a used car again or not when she gets a bad experience, in which case she switches brands
(EU u (θ) = 0). But when she gets a good experience, she expects to get a positive utility (and
¡ ¢
equal to E λ/λ0 = λh − E (λ)). As a result, because of experience, the average utility with
uncertainty is discontinuous at θ because of experience.
The effect of experience on the price of new cars is more complex, but we can identify three
causes for the difference between pn and pnd :

(a) Shift of the marginal consumer. Since in the equilibrium with experience more consumers
have access to a new car, the marginal consumer is lower: θ < θd

(b) Resale value effect. The presence of experience increases the resale value of the new car,
since pu > pud . This in turn increases the willingness to pay of new car buyers.
R λh
(c) Choice effect. This is captured by the term δ (1 − φ (1 − δG (Eλ))) Eλ (λ − Eλ) dGλ, which
was absent in the case without experience. In words, new car buyers also have the chance
of switching brands after a bad experience, in a similar way than for used car buyers.

Effects (b) and (c) push up the price of new cars, while effect (a) pushes it down. A priori, we
cannot determine which effect dominates. However, when the consumers’ valuation of quality is
uniformly distributed, it can be shown that effects (b) and (c) dominate, in which case the price
of new cars is higher with experience.

5 Two brands with different distribution of experience

So far, I have characterized a model with two brands that have the same distribution of experience
so that, from the viewpoint of a consumer that did not own a car last period, both brands provide
the same expected utility before purchase. One of the results of the model was that, the larger the

29
probability of a good fit, the larger the fraction of consumers that remains loyal to the brand. But
the empirical evidence revealed a significant dispersion of loyalty across brands. If the prediction
of the model is correct and loyalty increases the larger the probability that a car provides a good
fit, the empirical evidence then suggests the need to extend the model to assume brands with
different distributions of experience. Further, we can also explain the strong, positive correlation
between loyalty and the average length of time the original owner holds on to a car that we found
before, as well as the positive but weak relationship between loyalty and the retention value of
the car, as measured by the decline in prices after one year.
In order to characterize a durable experience good market where brands have different distri-
butions of experience, I will continue to assume that there are two brands. But I introduce some
modifications to the model to have a much clear picture. First, I simplify the space of consumers’
characteristics by assuming that experience can only take two states: a consumer gets a good
experience λh with brand i with probability π i ; she gets a bad experience λl with probability
1 − π i . To introduce the fact that brands are different, I assume π b > π a . Further, I assume that
the consumers’ valuation per unit of quality (θ) takes only two values, θh and θl , with θh > θl ,
1
with a fraction σ < 2 of the population belonging to the group of high-type consumers. With two
types of consumers, it is easier to focus on the new car market, by assuming that the price of new
cars is high enough so that, in equilibrium, low-type consumers never drive new cars, meaning
that only high-type consumers have access to new cars.
A second modification is the assumption that cars are produced in a perfectly competitive
industry, with every producer having a marginal cost of c and no fixed costs. This means that
consumers can demand as many cars as they want. The introduction of perfect competition
helps keep the volume of trade endogenously given. Further, since there is a larger proportion of
low-type consumers, the prices of used cars are defined, i.e., excess supply of used cars is not a
possibility.
The analysis of the asymmetric model focuses on the behavior of three parameters. The
first one is customer loyalty which, when experience takes only two values and the probability of
¡ ¢
getting a good fit is π i , is simply Li θh = π i . We are also interested in the fraction of new car
Din −Siu
buyers that hold on to their used car for a second period, which is given by Wi ≡ Din .Finally
pu
we want to compare the retention value of each car, which can be expressed as Ri ≡ pni . With
i

30
perfect competition, to determine which brand retains more value it is enough to compare both
used prices: the brand that retains more value is the one whose used car price is higher.

Proposition 9 Suppose that market conditions are such that there is incomplete trade for all
brands. Then, in equilibrium, the brand that has a larger probability of a good fit:

(i) exhibits higher loyalty

(ii) tends to be kept for a longer time, and

(iii) retains more value.

Proof In order to have incomplete trade in this simplified model, it has to be the case that
all new car buyers that got a good experience decide to hold on to their used car for
another period. This implies that, when such buyers get a bad experience, they switch
brands. Therefore, demand for new cars of each brand is Din = σµni , where µni again
indicates the proportion of high-type consumers that want to buy brand i. The demand
includes those consumers who were not present in the new car market in period t − 1 and
owned a used car of brand i that period, plus those consumers who bought brand j 6= i
the previous period and got a bad experience. For brand i, µni,t = κi,t−1 + (1 − π j ) µnj,t−1 ,
where κi,t = π i µni,t−1 represents the proportion of high-type consumers. In a steady state,
(1 − π a ) µna = (1 − π b ) µnb which, given that π b > π a , already indicates that the brand with
a larger probability of providing a good experience is also the brand that exhibits a higher
1−π b 1−π a
demand. Solving we get µna = 2(1−πa π b ) and µnb = 2(1−π a π b ) and as a result the demand for
new cars is given by:
1−π b 1−π a
Dan = 2(1−π a π b ) σ Dbn = 2(1−π a π b ) σ

Regarding the supply of used cars, only a fraction (1 − π i ) µni of high-type consumers will
sell their used cars, meaning that, in a steady state:
(1 − π a ) (1 − π b )
Sau = σ = Sbu
2 (1 − π a π b )
Hence, the proportion of consumers that hold on to a used car of brand i is just Wi = π i .
In other words, a larger proportion of consumers of the brand with highest probability of a
good experience.

31
 Let’s now prove that pua < pub . First, only low-type consumers buy used cars. Further,
since σ < 12 , a fraction of low-type consumers ψ ≡ 1 − σ − (Sau + Sbu ) owns no car. Then,
in stationary equilibrium, the marginal consumer that buys a used car of any brand is a
low-type consumer who did not own that brand in the period immediately before: either
she owned no car, or she owned a used car of the other brand and got a bad experience. To
see this, consider the set of consumers that bought brand A last period. A fraction π a Sau
got good experience, so they will repeat purchase of brand A, but there is still a fraction
(1 − π a ) Sau in the market to be purchased. Those cars are bought by consumers with no
immediate experience with brand A.

Then, ∀i,
³ ´ ³ ´
Vi θl , Eλi = θl w + Eλi − pui + δEVi θl = 0 (22)

where:
³ ´ ³ ´ ³ ³ ´ ³ ´´
EVi θl = (1 − π i ) Vj θl , Eλj + π i θl w + E λ/λh − pui + δEVi θl (23)

Solving for pui using (22) and (23) , we get:

³ ´
pui = θl w + λl + (1 + δφ (1 − π i )) λh − λl . (24)

Since π b > π a , then pub > pua .¥

Proposition 9 is self-explanatory. As long as conditions in the market are such that some new
car buyers decide to keep their used car, more consumers will remain loyal to the brand with
higher probability of a good match. In fact, we can realize that there are two effects of experience
over the consumers’ decision whether to dispose of their used cars. On the one hand, the larger
probability of a good fit, the larger the mass of consumers that would like to retain a used car.
This is because we have that all consumers that get a good experience keep their used car. On
the other hand, a larger probability of a good fit reduces the uncertainty of getting a bad fit.
As such, consumers will prefer to buy a new car. The empirical evidence indicates that the first
effect dominates, and in this simplified model only such effect is present. So we need to generalize
the equilibrium analysis of brands with asymmetric distribution of experience to the case when
experience has a continuous distribution.

32
 Suppose then that the distribution of experience for brand B first-order stochastic dominates
the distribution for brand A. As such, for any given experience λ, Ga (λ) < Gb (λ) , i.e., brand
B provides a better experience. The discussion will be less formal given the preceding analysis.
First, notice that low-type, used-car buyers will continue to buy the same brand if Vi (θl , λi ) >
Vi (θl , Eλi ) = Vj (θl , Eλj ) = 0, which defines a cutoff experience ziu = Eλi such that consumers
that get an experience λ ≥ Eλi with brand i will continue buying that brand. Then, used car
¡ ¢
prices are again determined by (22) where EVi θl is now:
³ ´ ³ ³ ´´
EVi θl = G (Eλi ) Vj (θl , Eλj ) + [1 − G (Eλi )] θl w + E (λi /λi > Eλi ) − pui + δEVi θl

where the first term is again zero. It can be verified easily that pub > pua .
Since only high-type consumers purchase new cars, the decision on whether to hold on to
a used car, sell it and buy a new car of the same brand, or sell it and switch brands, depends
mostly on experience. The equilibrium in the symmetric case for high type consumers −which is
also reproduced in Figure 5− will be as follows:

£ ¤
• Consumers that get experience λ ∈ λl , zin will switch brands.

• Consumers that get experience λ ∈ [zin , xi ] will decide to sell the used car and buy a new
car of the same brand
£ ¤
• Consumers that get experience λ ∈ xi , λh will decide to keep the used car, and next
period, they will buy a new car of same brand.

Figure 5: Behavior of High-Type Consumers in an Asymmetric

Equilibrium with Two Brands, Two Valuations of Quality

Switch brands Buy new car, same brand Keep used car

λl zni xi λh

Notice that consumers who will remain loyal to the brand are those who get an experience λ >
zin . Therefore, for new car buyers, loyalty is defined by Ln ≡ 1 − G (zin ) . In turn, only consumers

33
with experience λ > xi will hold on to their used car for one more period, so withholding is
defined by W ≡ 1 − G (xi ) .
Suppose that the distribution of experience for brand A is uniform, while for brand B is
£ ¤
uniform with a mass α > 0 at the top. I assume the support of the distribution of λ is 0, λh .
bi ≤ λi ≤ λh for any brand i. I focus my attention
Further, I only consider the cases where λl ≤ λ
on the effects of a change in α, which represents the measure of the difference between brands
in terms of experience. The other parameters of the model are held constant at c = 3, θh = 2,
θl = 1, v = 2.5, w = 1, and δ = 0.8.
In Figures 6 to 8 we can appreciate the evolution of customer loyalty, the fraction of high-type
consumers that hold on to their used cars, and the retention value, all as a function of α. Observe
that, for small values of α, consumers of the brand with the larger probability of a good fit exhibits
higher customer loyalty, tends to be kept for a longer time, and retains more value. These results
are consistent with the empirical evidence. Notice that, although all the graphs seem to show a
monotonic trend, this is not the case. A comparison between the evolution of customer loyalty
and withholding for brand A shows that, for larger values of α, high-type consumers that own
a used car of brand A will either sell it and switch brands. Further, in the extreme case where
α = 1 −which means that the distribution of experience for brand B is degenerate at λh −, no
consumer purchases brand A, and all new car buyers of brand B will sell their used cars after one
period.

34
 Figure 6: Customer Loyalty

0.7

Loyalty 0.6

0.5

0.4

0.3

0.2
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2
x
Brand A Brand B

Figure 7: Withholding
0.37

0.35

0.33
Withholding (W)

0.31

0.29

0.27

0.25
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2
x
Brand A Brand B

Figure 8: Retention Value

0.72

0.715
Retention Value (R)

0.71

0.705

0.7

0.695

0.69
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2
x
Brand A Brand B

35
6 Concluding Remarks and Extensions

I presented a model of a durable good market with trade of used goods that introduces the
concept of experience. As such, we have seen that in a model with experience, a larger number of
returning customers will remain loyal to the brand that offers a higher probability of a good fit.
Under those circumstances, the predictions of the model are in line with the empirical facts that
show that brands with higher loyalty retain more value (i.e., their price declines a slower pace)
and are kept for a longer time by the original owner. Further, I have shown that the reason for
consumers to hold on to their used cars may not be an inefficient problem as predicted by models
of adverse selection, but rather a result of experimentation.
There are at least two ways in which this paper can be extended. Up to now, I have mostly
ignored the market structure, with the exception being the model of two brands with different
distributions of experience, where I introduced perfect competition and allow consumers to buy
as many new cars as they want. If firms have market power, there is the possibility of strategic
behavior of firms in two fronts: market coverage (i.e., how much to produce) and obsolescence
(i.e., how fast to depreciate the quality of the good).19 The analysis of the effect of experience on
prices gives us a few hints regarding production: In fact, the decision will depend on the net effect
on the price of new cars and whether or not the choice effect dominates the shift in marginal
consumer.
A second possibility of extension involves to consider that goods that last more than two
periods. If, for example, cars were to last three periods, there will be two secondhand markets,
and two used prices: one for one-year-old cars, and another for two-year old cars. Then, we can
study whether the process of learning λ is immediate, based on the rate of disposal of cars. We
can also analyze whether there are other factors that make consumers keep a used car longer,
such as a slow rate of quality depreciation, or a change in preferences
19
Firms can also make the durable good obsolete by introducing new, improved versions of the good.

36
7 Appendix A

Proof of Proposition 4

To prove that a symmetric equilibrium exists, suppose first that prices are the same: pua =
pub = pu and pna = pnb = pn . Then, from (7) − (9) , θa = θb = θ and also, θa = θb = θ. In
other words, only consumers with preference for quality θ ≥ θ buy new cars, and only those with
£ ¤
θ ∈ θ, θ . In addition, from (11) , zau (θ) = zbu (θ) = z u = Eλ, independent of θ. Analogously
from (16), zan (θ) = zbn (θ) = z n = Eλ. It is also easy to verify that if θa = θb and θa = θb , then it
has to be the case that pua = pub and pna = pnb .
Then, recall that θ is defined by θw + Eλ − pui + δEV (θ) = 0, as described above, where
R Eλ R λh
EV (θ) = λl (θw + Eλ − pu + δEV (θ)) dλ+ Eλ (θw + φλ + (1 − φ) Eλ − pu + δEV (θ)) dλ. Solv-
ing for EV (θ) and replacing the value in θw + Eλ − pui + δEV (θ) = 0 we obtain:

1 u
θ (pu ) = (p − δφE (λ/λ > Eλ) − (1 − δφ (1 − G (Eλ))) Eλ) . (25)
w

In turn, θ is the consumer who is indifferent between buying a new or a used car, defined at the
¡ ¢ ¡ ¢ £ ¤
level of quality preference where Vin θ, · = Viu θ, · for any λ ∈ λl , λh and brand i = A, B,
¡ ¢
where EV θ is defined as above and
¡ ¢ R Eλ ¡ ¢
EV O θ = λl pu + θv + Eλ − pn + δEV O (θ) dλ
R λh ¡ ¡ ¢¢
+ Eλ θw + λ + δ θv + φλ + (1 − φ) Eλ − pn + δEV O (θ) dλ
¡ ¢
where x θ = Eλ at θ. Then, in a symmetric equilibrium:

1
θ (pu , pn ) = (pr − pu − (1 − φ (1 − δG (Eλ))) (δE (λ/λ > Eλ) − δ (1 − G (Eλ)) Eλ))
v−w

Market clearing conditions require that Dn (pu , pn ) = S n = 12 y and Du (pu , pn ) = S u (pu , pn ) :

Z θh
1
dF (θ) = y
θ(pu ,pn ) 2 − G (x (θ))
Z θh
¡ u n
¢ u G (x (θ))
F θ (p , p ) − F (θ (p )) = dF (θ)
θ(pu ,pn ) 2 − G (x (θ))

It can be verified that the Jacobian of the system is nonsingular, thus guaranteeing the
existence of a symmetric equilibrium.¥

37
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39