David Genesove ["Adverse Selection in the Wholesale Used Car Market," Journal of Political Economy, 101(4), August 1993:644-65] observed this difference in adverse selection at wholesale used-car auctions. Both used-car dealers, who sell only used cars, and new-car dealers, who sell both new and used cars, attend these auctions. Dealers trade because they receive too many or too few used cars in trade-in, have the wrong mix of cars for their local retail customers, or are trying to unload lemons.

Retail customers, who have time to inspect and test-drive cars, are more likely to spot a lemon than a dealer at one of these auctions. At the auctions, potential buyers have only a few minutes to inspect a car and cannot drive it, so they don't know if the car is a lemon. After these quick, visual inspections, bidding takes place. The owner then accepts or rejects the highest bid.

New-car and used-car dealers differ substantially in their likelihood of selling a given car. There are three principal differences between new- and used-car dealers.

First, new-car dealers tend to sell to final customers only recent-vintage used cars that are close substitutes for new cars—especially during tough economic times when many customers are unwilling to pay top dollar for new cars. Nearly 60% of the used cars sold by new-car dealers are no more than 4 years old, compared to only 30% for used-car dealers.

Second, new-car dealers obtain a higher share of their used cars through trade-ins: 69% versus 26%. Third, new-car dealers obtain more used cars in trade-ins. Used-car dealers are relatively small: 85% obtain fewer than 100 cars in trade-ins and only 2.5% obtain 300-600 cars a year. In contrast, only 7% of new-car dealers obtain fewer than 100 cars, one-third receive 300-600, and 14% obtain over 600 trade-ins a year.

Because new-car dealers have more trade-ins and sell relatively few older cars, they are more likely to want to sell their older cars at the wholesale auctions. Indeed, new-car dealers are twice as likely to sell a six-year-old trade-in at wholesale. Because of this greater tendency to unload all old cars, they are less likely to engage in adverse selection and keep the higher-quality, old cars.

Thus, if the seller is known to be a new-car dealer, we would expect buyers to be willing to pay more for their older cars. Indeed, new-car dealers receive a premium of 17% ($400) over other dealers when they sell six-year-old or older cars. Thus, buyers use the identity of the seller as an imperfect signal of quality.

Similarly, buyers apparently view the number of previous owners as a signal as to whether the car is a lemon. A one-owner car sells for 9% ($330) more than a multiple-owner car.

Thus, by using information about the number of former owners and the current owner, potential buyers adjust their estimates of the quality of a car. Although these signals decrease the probability of paying too much for a lemon, they do not eliminate that possibility.