Since 1990 car leasing has grown rapidly. In 1994, three million vehicles, one out of every four cars and trucks, were leased. Some automobile executives expect that, by the year 2000, half of all cars and trucks will be leased. In the short run, leasing is profitable because dealers reduce new car inventory. Anecdotal evidence suggests that the recent surge in automobile leasing stems from substantial increases in new car prices in the face of stagnant wages. Consumers prefer leasing because of its greater affordability - the down payment is minimal and monthly payments are lower. Proponents of leasing also argue that it creates brand loyalty. A Ford Motor Company study finds that those who lease their products are twice as satisfied as traditional buyers. Skepticism over the long-term profitability of leasing arises because of uncertainty surrounding the used car market. After a car's lease expires, it is returned to the manufacturer who must sell it in the secondary market. There is a risk that consumers will view these low-mileage, well-maintained cars as a good substitute for a new car and firms may end up competing with themselves. Furthermore, a firm's finance arm is at risk. A customer who leases a car only pays for the proportion of the vehicle's worth she uses. Companies determine a consumer's payments by estimating the car's wholesale value at the end of the lease (i.e. residual value). A flood of off-lease cars to the used car market as well as other unforeseen events could result in a resale price lower than expected. Ex post, the company discovers that the consumer's monthly payments were too low and it loses money on the lease. In order to analyze the profitability of leasing in a theoretical framework, one needs to accurately capture the benefits and risks of this marketing tool. The issues mentioned above are for the most part ignored in the research on durable goods. With few exceptions, the existing literature focuses on durable good monopoly, which is not appropriate for investigating brand loyalty. Research on switching costs does not examine durable goods. In addition, the ability of the secondary market to limit the profitablility of the primary leasing market is unexplored. Optimal maintenance and its effect on the quality of cars in the secondary market also plays an important role. This project analyzes a theoretical model which extends durable goods research by allowing for brand loyalty and by endogenizing the consumer maintenance choice for rented goods. A two-period model in which duopolists produce a horizontally differentiated durable good is examined. Firms lease new products at the beginning of each period and later sell the used goods in a perfectly competitive market when the lease expires. The firms generate brand loyalty by offering a contract for maintenance which stipulates lower fines for loyal customers. These results are compared to a situation whereby firms sell new goods each period. The results of this preliminary model are then used to develop a theoretical model which provides conditions under which firms offer both sales and leasing contracts in equilibrium. There are plans to test the theoretical results empirically.
