Are Buyer Fears of Risk Hurting Your Bottom Line?

Three Economic Principles That Shed Light on Consumer Behavior during the Car-Buying Process


Our thirty-second president Franklin D. Roosevelt famously said, "The only thing we have to fear is fear itself." For dealers trying to sell cars — and maintain a strong bottom line, fear can be a powerful enemy — buyer fear, that is. What exactly are buyers afraid of? That's part of the problem. While some buyers are afraid of getting a bad deal — or a lemon — others merely have a general unspecified fear of the process itself. They don't know where exactly the risks are but they are particularly wary, given the amount of money involved — the largest or second largest purchase that most people ever make. Uncertain consumers tend to be unwilling to commit, whether it's to the sale at hand or to sales in the future. Understanding a few basic economic principles about what drives consumer behavior can help dealers build trust with buyers to allay their fears and increase sales — now and later.

1. When making a "risky" purchase, buyers will generally aim to pay less than what the product is worth in order to protect themselves against the risk involved.

Buying a car involves a number of different components that a buyer could perceive to be risky. For starters, given the significant cost of a new vehicle, it is especially important that the buyer makes the "right" choice. The quality of the car is certainly an issue, although less so nowadays due to the impressive progress made by automakers in developing safe and reliable vehicles. But making the right choice also includes selecting the vehicle — including option packages — that will best match the buyer and his lifestyle. Once the vehicle itself is selected, a whole new avenue of potential risk opens up for the buyer when he has to negotiate the price. Here again there are typically multiple aspects to consider and "get right:" total price, monthly payments, term of the loan or lease, interest rates, trade-in value, residual, cost of option packages, warranty, insurance, and so on. Of these, buyers commonly report that the most unnerving part of the price negotiation is dealing with the infamous F&I because this is where buyers feel the least informed and the most at risk of getting a bad deal.

Economic research tells us that the more uncertain a buyer is about any aspect of a purchase, the more important paying a low price becomes to the buyer. This fixation on price stems from the buyer's view of how much risk is associated with the transaction and can explain why car buyers who otherwise willingly pay a premium for various purchases (e.g., for designer clothes at Nordstrom) become aggressive "nickel and dime" negotiators when buying a car. For dealers, time spent haggling over the price with a buyer means not only possibly earning lower margins on a deal but also losing time that could be used to make other sales.

2. Both buyers and sellers can act to reduce the risk in a risky purchase.

The good news is that there are ways to reduce or eliminate risk. Economic theory recommends insurance to protect the buyer. For example, a person buying a risky stock could also opt to buy a put option, giving him the ability to sell the stock for a certain value. In the case of buying a car, insurance can take a variety of forms, given the different types of risk. One of the most common forms of insurance associated with a car is a warranty, which provides insurance against many vehicle quality issues occurring after the purchase.

However, most risk associated with a car purchase occurs before the purchase is made. Information can be a powerful form of insurance against this kind of risk. Buyers can minimize the risk of making the "wrong" choice by researching and comparing vehicle characteristics and reading third party reviews of vehicles on automotive research websites such as Edmunds.com. Similarly, buyers can these kinds of websites to inform themselves about competitive prices, trade-in values, loan terms, and other aspects of the financial negotiation.

On their side, sellers also can act to reduce risk for buyers by increasing buyer trust in the seller and the transaction. In general, sellers can build trust by taking steps to develop a reputation for fair and honest dealings and for good products and services. Such reputations require time to create and result from an accumulation of transactions with satisfied customers who become return customers and/or share their positive experiences with other potential buyers. Thanks to the Internet, reputation building no longer depends on person-to-person word-of-mouth but is facilitated by websites that offer reviews and forums in which the dealer can be discussed. Economic research has found that positive feedback from online ratings mechanisms tends to result in price premiums for sellers from buyers with no personal experience with the seller.

Another important — and perhaps overlooked — way for a seller to reduce risk for the buyer is to offer pricing that can be readily assessed against a benchmark with which the buyer is familiar. For example, the popular "Employee Pricing Program" occasionally used by General Motors, Chrysler, and Ford offered buyers the discounted prices that auto industry employees pay for new cars rather than the sticker price MSRP — a known "good deal." Another tool is for the seller to use third party valuations, such as Edmunds.com's True Market Value┬«, in their negotiations with buyers to show the buyer that the seller is negotiating in good faith.

3. Uncertainty is a major obstacle to sales growth.

The importance of gaining buyer trust and thereby reducing the risk a buyer associates with buying a car cannot be emphasized enough. One has to look no further than the U.S. economy to get a sense of the problems that uncertainty can cause. That is, recent slow growth can be traced to our numerous unresolved fiscal issues, including a host of tax rates and subsidies that are due to expire at the end of this year (the oft-called "Fiscal Cliff"). Since businesses and consumers won't know what their tax burdens or other costs are until these issues are resolved, many have delayed spending, including hiring, because of the potential risk that these measures are not extended and the economy falls off of the Fiscal Cliff. The resulting slow jobs growth leads to less spending, which in turn reinforces the decisions of businesses not to hire, which leads consumers to spend less, and so on. Similarly, the car-buying process can drag on when buyers are uncertain about the transaction and don't have or don't "think" they have enough information to make the right decision, or when they do not trust the seller enough to feel confident about the deal being offered. Too often the result is sales lost or profit lost, both of which can be minimized with the right mindset and by taking advantage of tools to reduce buyer fear of risk.

Lacey Plache is the Chief Economist for Edmunds.com. Follow @AutoEconomist on Twitter.

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