Economics of Automobiles

Economics of Automobiles

Economics Term Paper

Jennifer Pham

Overview

History changed when the automobile was invented. Distant places became much

closer. Dreams of traveling and seeing the world were made possible. Economics has affected

automobiles since the first automobile was invented. “Popularity of the automobile has

consistently moved with the state of the economy, growing during the boom period after World

War I and dropping abruptly during the Great Depression, when unemployment was high. World

War II saw a large increase in mass transit because employment was high and automobiles

were scarce.” (Brancheau, Wharton, & Kamalov). Why does demand for automobiles decrease

when events such as the Great Depression occur? Why are hybrid vehicles in demand even

though they are priced higher in comparison to regular automobiles? These questions and

others can be explained using economic principles including Porter’s Five Forces model, the

First Law of Demand, demand shifts, elasticity, price discrimination, and bargaining.

Industry Analysis

Porter’s Five Forces Model:

The automobile manufacturing industry, like all industries, can be analyzed for

attractiveness using Porter’s Five Forces model. Profitability distinguishes an attractive industry

from an unattractive industry. When an industry is attractive, the overall industry is profitable.

On the other hand, as an unattractive industry approaches pure competition, the profits for all

firms suffer.

As the name of the model suggests, Porter’s Five Forces model consists of five forces.

Three of the forces (industry rivalry, potential entrants, and buyers) are from external sources.

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The remaining two forces (suppliers and substitutes) are internal threats. Because being in an

attractive industry is ideal for sustainable long term profits, it is important to analyze the industry

to understand its advantages and disadvantages. According to Michael Porter’s Five Forces

model, the best industries are characterized by:

High barriers to entry

Low buyer power

Low supplier power

Low threat from substitutes

Low levels of rivalry between existing firms

Michael Porter states that, “the essence of this paradigm is that a firm’s performance in

the marketplace depends critically on the characteristics of the industry environment in which it

competes.” (Froeb, McCann, Shor, & Ward, 2013). Let’s now apply the Five Forces model to

the automobile industry to see if the firms in this industry have a good chance of earning

sustainable long term profits.

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Potential Entrants

The threat of new entrants in this industry is low. This is favorable for the industry

participants. There are many barriers to entry so potential entrants find it difficult to enter the

market. Therefore, these barriers to entry restrict competition. The automobile industry

requires a high amount of initial capital. Manufacturing plants and raw materials need to be

purchased which can be quite expensive. In addition to the large amount of capital required,

automobile manufacturers have to continually invest in research and development to keep up

with the improving technology. The manufacturing industry is also labor intensive since there

are significant costs involved in the designing and engineering of automobiles. Another barrier

to entry is attaining economies of scale. It is natural for automobile manufacturers to mass-

produce in order to lower costs of production (The Pennsylvania State University, 2010).

Economies of scale take time to achieve because part of it comes from learning by experience.

When you produce more, you learn from experience. The experience is then brought in to

future production to help you produce at a lower cost (Froeb, McCann, Shor, & Ward, 2013).

Finally, The Pennsylvania State University (2010) points out that access to distribution channels

can be problematic for potential entrants. These multiple barriers to entry all serve to protect

the profits of the firms in the industry.

Power of Suppliers

Suppliers in this industry do not have much power because they can be easily replaced.

Because the automobile supply business is fragmented, suppliers heavily rely on one or two

main automakers for business. Due to the dependence of suppliers on automakers, suppliers

have to consistently meet the requirements and demands of the automobile manufacturer. If

the automobile manufacturer switches suppliers, this could severely impact the survival of the

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supplier’s business (Investopedia, 2013). The effects of globalization are also hurting domestic

suppliers. “Globalization and reduced volume from traditional U.S. automakers are contributing

factors, as are high material and labor costs, which have hurt the financial condition of domestic

automotive suppliers. Due mainly to globalization and the increased availability of cheaper

foreign materials, U.S. automotive suppliers have been forced out of the industry by means of

consolidation and bankruptcy” (The Pennsylvania State University, 2010). Since suppliers have

little power, it creates favorable conditions for the automobile manufacturers in this industry.

Power of Buyers

Buyers have a good amount of power in this industry. “As the foreign automobile

companies entered the United States’ market, the competition became more intense, adding

power to the buyer” (The Pennsylvania State University, 2010). The foreign automobile

companies have an advantage over the domestic automakers because they have lower costs of

production. This allows them to transfer their cost savings to the consumers. The buyers can

get better quality cars from these foreign automobile companies for lower prices than by

purchasing from the domestic automakers. Lastly, thanks to the current economic situation that

we are in, consumers are saving rather than spending. People are wiser when they spend their

money. According to The Pennsylvania State University (2010), consumers learn to maintain

and fix their cars to keep their cars for a longer period rather than habitually trading in their old

cars for new ones. Due to the effects of foreign competition and the current economic

conditions, buyers have power. While this is favorable for buyers, it is unfavorable in the

industry’s point of view.

Threat of Substitutes

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The United States automobile industry has high threat of substitutes. There are

alternative forms of transportation including bikes, buses, subways, trains, and airplanes.

Additionally, many people are commuting to work by carpooling with others to save money on

the higher prices of gasoline. When the price of gasoline rises, people respond by finding

alternatives for transportation. These factors contribute to how unfavorable the threat of

substitutes is for the industry.

Industry Rivalry

GM, Chrysler, and Ford are the major rivals in North America but they also face foreign

competition. Toyota and Honda are two of the largest foreign car manufacturers (Investopedia,

2013). Foreign competitors are able to take advantage of lower raw material and production

costs (The Pennsylvania State University, 2010). In addition to the cost advantages, they are

able to provide equal or better quality automobiles. Competition is high in this industry.

Demand

According to the First Law of Demand, consumers demand (purchase) more as price

falls (Froeb, McCann, Shor, & Ward, 2013). The First Law of Demand can be applied to the

demand for automobiles. When transportation prices decline, demand for automobiles

increase. On the other hand, if prices increase, demand for automobiles decrease.

When the change in demand is caused by non-price factors, the demand curves shift

either left or right. These non-price determinants will shift demand even if prices remain the

same. Since the demand for automobiles is correlated with transportation demand, factors that

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affect transportation demand can be used to analyze the demand for automobiles. The

following factors could affect transportation demand (Litman, 2013):

From the above table, we are only concerned with factors that relate to automobile

demand. Below are detailed explanations of the factors that could shift the demand curve

(Litman, 2013):

Demographics relates to automobile travel because travel tends to increase with

employment and wealth. People who are younger, older, poor, and enjoy exercise tend

to demand more walking, cycling, and public transportation.

Commercial activity does not apply to automobile demand since most commercial

activity require heavy freight trucks, buses, and air travel.

Transportation options such as improved walking and cycling conditions or public

transportation service quality reduces demand for automobile travel. However, caution

must be used because improved walking and cycling conditions don’t necessarily cause

a reduction in automobile travel. Walking and cycling could be considered forms of

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recreational activity that should not be accounted for when analyzing the shifts in

demand.

Land use factors can affect demand for automobile travel. Litman (2013) states, “Per

capita vehicle ownership and travel tend to be higher in rural and automobile-dependent

suburban areas, while walking, cycling and public transit travel tend to be higher in urban

areas.”

Demand management strategies can improve alternative modes of transportation to

reduce vehicle travel. These strategies reduce demand for automobile travel.

Price increases for vehicle, road, parking, fuel, insurance, and public transport reduces

demand and shifts the demand to other substitutes.

Elasticity

How sensitive is quantity to price? Price elasticity measures the change in demand in

response to a change in price. The demand of elastic commodities responds greatly to a

change in price. Another way to interpret this is, “quantity changes by a greater percentage

than price so revenue will rise following a price decrease and fall following a price increase”

(Froeb, McCann, Shor, & Ward, 2013). Elastic commodities have elasticity values greater than

1.0 absolute value. On the other hand, inelastic commodities have less demand response when

the price fluctuates. Therefore, when the price increases, revenue will also increase because

the decrease in quantity in response to the price change is smaller than the increase in price.

Inelastic commodities have elasticity values of less than 1.0 absolute value. Unit elastic means

that the price changes cause proportional demand changes. Unit elastic commodities have an

elasticity value of 1.0 absolute value. Products with close substitutes have more elastic demand

whereas products with many complements have less elastic demand.

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In addition to evaluating automobiles using elasticity of demand, we can also look at

cross-elasticity. Cross-elasticity analyzes the percentage change in the consumption of a good

resulting from a price change in a substitute good (Litman, 2013). By evaluating cross-elasticity,

we can determine that changes in automobile travel can be caused by factors such as changes

in transit fare prices. For example, a 10% increase in a single fare bus pass will reduce the sale

of those fares by 3.57% and will increase car usage by 1.16%.

One may think that automobile use is inelastic (price changes cause less changes in

demand in vehicle travel). However, automobile travel is elastic. This means that an increase

in price will have a greater decrease in demand. According to the Victoria Transport Policy

Institute, “Short-run price effects are about a third of long-run effects, and most vehicle costs

(depreciation, financing, insurance, registration fees and residential parking) are fixed. A -0.1

short-run elasticity of vehicle travel with respect to fuel price reflects a -0.3 long-run elasticity,

which reflects a -1.2 elasticity of vehicle travel with respect to total vehicle costs, which implies

that automobile travel is overall elastic” (Litman, 2013). The absolute value of -1.2 is 1.2. This

value is greater than 1.0; therefore, demand is elastic. Looking at this from an alternate

perspective, automobiles have many substitutes (bikes, buses, subways, trains, and airplanes)

as identified earlier in the analysis section using Porter’s Five Forces model. Products with

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close substitutes have more elastic demand. Because there are close substitutes, consumers

react to a price increase by switching to the next best alternative. There is little switching cost to

the consumer so revenue falls when the price of automobiles is increased.

We can forecast demand given a percentage change in price to predict the change in

quantity. Knowing that automobiles is price elastic helps automakers to decide how much price

they would be willing to increase given the consequences of the reduction in quantity

demanded. Extra caution must be used when pricing because the demand of automobiles is

elastic. Understanding the non-monetary factors that affect demand can prove useful in this

industry. For instance, higher prices for automobiles could be justified if fuel decreases.

Although hybrid cars cost more, these vehicles save more money on fuel. Based on this non-

monetary factor, automakers can price these vehicles higher without severely impacting quantity

demanded. Finally, cross-elasticity can also be taken into consideration when pricing vehicles.

If the cross-price elasticity of demand identifies product B (ie. bus fare) is a substitute for

product A (automobile), automakers can infer that as the price for product B (ie. bus fare)

increases, the demand for product A (automobile) will increase.

Price Discrimination

Price discrimination is the practice of charging different prices to different buyers or

groups of buyers based on differences in demand. There are two ways to price discriminate –

direct and indirect. In direct price discrimination, the seller can distinguish between the low-

value and high-value buyers. In indirect price discrimination, however, the seller cannot identify

the two groups or they can’t prevent arbitrage. Since the sellers cannot identify the low-value

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and high-value buyers, they must also discriminate by providing different features (Froeb,

McCann, Shor, & Ward, 2013). Sellers price discriminate to earn higher profit. For example,

there are two buyers with different values for a product, $5 and $7. If the seller charges $7, only

one buyer will purchase. In this case, the profit the seller earns is $7. If the seller charges $5,

both buyers would purchase but the seller would lose the potential $2 since the buyer with the

$7 value is willing to pay more than $5. The profit for charging $5 for the product is $10 ($5 plus

$5). Although the profit for pricing at $5 is better than pricing at $7, the seller is not maximizing

his/her profits because there is consumer surplus that is not taken advantage of by the seller. If

the seller can successfully price discriminate, he/she can earn $12 of profit ($7 plus $5).

Car dealers use direct or first-degree price discrimination. Car salespeople have to

figure out how much customers are willing to pay for an item and sell at that price (Glass, 2013).

With a bit of time, car salespeople can distinguish the low-value buyers from the high-value

buyers. They can study your actions or, alternatively, they can screen you to figure out your

needs and wants. After they identify you as either a low-value or high-value buyer, they can try

to sell you the car at the highest price that you are willing to pay.

Are buyers helpless victims of price discrimination then? Is there a way for buyers to

take advantage of price discrimination? Buyers can use signaling techniques to let the seller

know that he/she is a low value buyer. “Signaling describes the efforts of the more informed

parties (consumers) to reveal information about themselves to the less informed party (the

seller)” (Froeb, McCann, Shor, & Ward, 2013). When purchasing a car, one way to signal to the

seller is to go into a car dealership and haggle for a very long time. By spending lots of time

negotiating at the dealership, the sellers are made aware that the buyer’s time is not costly.

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This lets the sellers know that the buyer’s willingness to pay is low so, therefore, the buyer gets

classified as a low-value buyer in the seller’s mind. Another way to signal to the seller is to send

an email prior to walking in. By sending an email, the buyer is signaling to the seller that he/she

is taking time to compare prices. The seller can infer from this gesture that the buyer’s

willingness to pay is not high. If you are a student, use your student email to email the

dealership for a price quote because it identifies you as a low-value buyer (Bar, 2007). Tips like

these are great signals to the seller that could benefit you the next time you plan on purchasing

a new car.

Bargaining

A lot of bargaining is involved in an automobile purchase. To increase your own

bargaining power, we must either improve our outside option or decrease that of our opponent.

To improve your outside option, you can increase your opponent’s gain in reaching an

agreement (Froeb, McCann, Shor, & Ward, 2013). Car salespeople often earn their salary in

some form of a commission-based compensation scheme. Most car salespeople get paid their

commissions at the end of the month. “Consumers have an incentive to buy at the end of the

month, because dealers receive monthly incentives from manufacturers. The manufacturer will

give the dealer a bonus if it can sell a certain number of cars by the end of the month” (Bortz,

2012). This is the ideal time to purchase your car because the immediacy for these salespeople

to make the sale will raise their gain for reaching the agreement. To take advantage of

bargaining strategy, you can also go into the car dealer to purchase your car at unpopular times

of the year. Salespeople have no outside alternative at these times since there are few

customers around so they have more to gain than you do by reaching an agreement. Finally,

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make the salespeople pursue you. They want your business and you have other options out

there (other car dealers and private sellers). If they need you more than you need them, you

win in the bargaining situation.

Conclusion

With a better understanding of economics as it is applied to automobiles, we can now

answer the questions posed at the beginning:

Question: Why does demand for automobiles decrease when events such

as the Great Depression occur?

Answer: The Great Depression can be considered a non-monetary factor that

shifts demand. This event caused the demand curve to shift to the left

(decrease) even though there was no change in price.

Question: Why are hybrid vehicles in demand even though they are priced

higher in comparison to regular automobiles?

Answer: Hybrid vehicles save consumers more money on fuel. Fuel is a non-

monetary factor that affects demand. Price decreases on fuel will increase the

overall demand of automobiles. Since hybrid vehicles have the benefit of money

savings on fuel (decreases fuel costs), automakers can price these vehicles

higher even though automobiles are price-elastic (more sensitive to price

changes).

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Overall, an understanding of economics can make us more informed and better decision

makers. Questions such as these now make more sense and can be answered with these

basic economic principles in mind. The next time you buy a car, keep these ideas in mind and

get yourself a great deal.

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References

Bar, M. (2007, July 01). Economics Illustrated: Price Discrimination and Buying a Car. Retrieved June 28, 2013, from Money Economics: http://www.moneyeconomics.com/commentaries/economics-illustrated-price-discrimination-and-buying-a-car/

Bortz, D. (2012, June 18). How to Bargain for a New Car. Retrieved June 28, 2013, from Money Personal Finance: http://money.usnews.com/money/personal-finance/articles/2012/06/18/how-to-bargain-for-a-new-car

Brancheau, J., Wharton, A., & Kamalov, F. (n.d.). The History of the Automobile. Retrieved June 28, 2013, from Colorado.edu: http://l3d.cs.colorado.edu/systems/agentsheets/New-Vista/automobile/

Froeb, L. M., McCann, T. B., Shor, M., & Ward, R. M. (2013). Managerial Economics: A Problem Solving Approach. Mason: South-Western Cengage Learning.

Glass, M. (2013). 3 Types of Price Discrimination. Retrieved June 28, 2013, from Chron: http://smallbusiness.chron.com/3-types-price-discrimination-25634.html

Investopedia. (2013). The Industry Handbook: Automobiles. Retrieved June 28, 2013, from Investopedi: http://www.investopedia.com/features/industryhandbook/automobile.asp

Litman, T. (2013, March 12). Understanding Transport Demands and Elasticities. Retrieved June 28, 2013, from Victoria Transport Policy Institute: www.vtpi.org/elasticities.pdf

The Pennsylvania State University. (2010, December 3). Automotive Manufacturing Industry Analysis. Retrieved June 28, 2013, from http://personal.psu.edu/law5039/assign5.html

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Economics of Automobiles