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The Role of Leasing under Adverse Selection

  • Igal Hendel
  • Alessandro Lizzeri

Leasing contracts are extensively used in durable goods markets. These contracts specify a rental rate and an option price at which the used good can be bought on termination of the lease. This option price cannot be controlled when the car is sold. We show that in a world in which quality is observable, this additional control variable is ineffective. Under adverse selection instead, leasing contracts affect equilibrium allocations in a way that matches observed behavior in the car market. Consistent with the data, our model predicts that leased cars have a higher turnover and that off-lease used cars are of higher quality. Moreover, the model predicts that the recent increase in leasing can be explained by the observed increase in car durability. We show that leasing contracts can improve welfare but that they are imperfect tools. We also show that a producer with market power can benefit from leasing contracts for two reasons: market segmentation and better pricing of the option. Moreover, despite the fact that lessors could structure contracts to prevent adverse selection, we show that this is not in their interest.

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Article provided by University of Chicago Press in its journal Journal of Political Economy.

Volume (Year): 110 (2002)
Issue (Month): 1 (February)
Pages: 113-143

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Handle: RePEc:ucp:jpolec:v:110:y:2002:i:1:p:113-143
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  1. Alessandro Lizzeri & Igal Hendel, 1999. "Adverse Selection in Durable Goods Markets," American Economic Review, American Economic Association, vol. 89(5), pages 1097-1115, December.
  2. Laffont, J.J. & Tirole, J., 1995. "Pollution Permits and Compliance Strategies," Papers 95.395, Toulouse - GREMAQ.
  3. McConnell, John J. & Schallheim, James S., 1983. "Valuation of asset leasing contracts," Journal of Financial Economics, Elsevier, vol. 12(2), pages 237-261, August.
  4. Bond, Eric W. & Samuelson, Larry, 1987. "The Coase conjecture need not hold for durable good monopolies with depreciation," Economics Letters, Elsevier, vol. 24(1), pages 93-97.
  5. Mussa, Michael & Rosen, Sherwin, 1978. "Monopoly and product quality," Journal of Economic Theory, Elsevier, vol. 18(2), pages 301-317, August.
  6. Sharpe, Steven A. & Nguyen, Hien H., 1995. "Capital market imperfections and the incentive to lease," Journal of Financial Economics, Elsevier, vol. 39(2-3), pages 271-294.
  7. Preyas Desai & Devavrat Purohit, 1998. "Leasing and Selling: Optimal Marketing Strategies for a Durable Goods Firm," Management Science, INFORMS, vol. 44(11-Part-2), pages S19-S34, November.
  8. repec:oup:qjecon:v:84:y:1970:i:3:p:488-500 is not listed on IDEAS
  9. Grenadier, Steven R., 1996. "Leasing and credit risk," Journal of Financial Economics, Elsevier, vol. 42(3), pages 333-364, November.
  10. Grenadier, Steven R., 1995. "Valuing lease contracts A real-options approach," Journal of Financial Economics, Elsevier, vol. 38(3), pages 297-331, July.
  11. Smith, Clifford W, Jr & Wakeman, L MacDonald, 1985. " Determinants of Corporate Leasing Policy," Journal of Finance, American Finance Association, vol. 40(3), pages 895-908, July.
  12. repec:oup:qjecon:v:101:y:1986:i:4:p:729-49 is not listed on IDEAS
  13. Waldman, Michael, 1997. "Eliminating the Market for Secondhand Goods: An Alternative Explanation for Leasing," Journal of Law and Economics, University of Chicago Press, vol. 40(1), pages 61-92, April.
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