2. In the late 1990s, car leasing was very popular in the United States. A custo

Question

2. In the late 1990s, car leasing was very popular in the United States. A customer would lease a car from the manufacturer for a set term, usually two years, and then have the option of keeping the car. If the customer decided to keep the car, the customer would pay a price to the manufacturer, the “residual value,” computed as 60% of the new car price. The manufacturer would then sell the returned cars at auction. In 1999, the manufacturer lost an average of $480 on each returned car (the auction price was, on average, $480 less than the residual value). A. Why was the manufacturer losing money on this program? B. What should the manufacturer do to stop losing money?

Explanation / Answer

(A)

Manufacturer's gain = Auction Price - Residual value

In this case, auction price being $480 lower than the residual value, the manufacturer was losing money since it was generating negative gain.

(B)

To stop loss, manufacturer could either increase the auction price and/or reduce the residual value. Since auction pricing is not a variable he could control, he could increase gains (or lower/stop loss) only by lowering residual value.

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