Determinants of product pricing in large firms: supply and demand factors

Supply/Demand

The product being studied is the Prius, the hybrid car from Toyota. The automobile industry is one the largest industries in the world. The major players are Ford, General Motors, Chrysler, Honda, Mitsubishi, Hyundai, several European companies and regional players as well (Investopedia, 2011). These firms all contribute to intense competition among rivals, especially given the size of the industry. The result is an industry characterized by competition both along the lines of differentiation and cost leadership. Firms must sell high volumes of cars at low margins in order to earn revenues, but must also load those cars with features and demonstrate technological leadership in order to attract business.

The large number of firms has an impact on the supply conditions within the industry. Supply is determined by expected sales and by the capacity of manufacturing facilities. In general, the global automobile industry suffers overcapacity. There are high costs associated with building facilities, so companies often build plants on the assumption that they will have increasing market share, the result being industry-wide overcapacity. Some governments have even interfered in the market to limit capacity out of fear for the damage that long-run overcapacity can do (Yang, 2011). It is also worth mentioning that Toyota in particular saw a decline in supplies due to a major disruption in the company's supply chain that occurred as the result of the tsunami in March of 2011 (Hirsch, 2011). Several of the company's key suppliers were located in the affected area and as a result Toyota has had to scramble to source those parts elsewhere or wait until those suppliers rebuilt their facilities and brought production back online. Such shocks are unusual, but they did happen to Toyota this year, and supplies of the Prius were affected as a result of the tsunami.

Demand conditions are affected largely by the state of the economy. For example, developing nations like China see more consumers gaining the ability pay for cars, so their demand is steadily increasing. In mature markets, consumers will often delay car purchases, or buy used cars, during periods of economic uncertainty. Demand conditions for specific vehicles are also related to social trends (such as the rise in SUVs a few years ago) or the price of gas. When gas prices are high, many consumers switch to vehicles that use less gas as a means of saving money. There is also a push element to the strategy. For much of the 00s, even with gas prices relatively high, the Big Three automakers focused on SUVs (AAAT, 2011). In recent years, the Prius has been a major beneficiary of high gas prices. There are also demand conditions affected by government policy. The state of California's high emissions standards and state support of hybrid cars as led to that state being a major market for Priuses (AP, 2008).

The price of automobiles is determined by a number of factors. Broad-based factors (i.e. not including local taxes), these are the cost of production, the price of rivals, the level of demand and the price elasticity of consumers. Because most car companies operate on thin margins, the cost of the vehicle is important to consider in the pricing of the vehicle, to ensure that the company is not selling at a loss. The intensity of competition, however, means that most car brands have very close rivals with similar designs and features. This means that the consumer is going to analyze the price for these vehicles. Thus, there is inherently price competition in the auto industry for just about every vehicle. Consumers have a high amount of information when buying cars, especially as now they can conduct research on the Internet. This increased information implies that the consumer is more prepared when bargaining with the dealer for the price of the car. In addition, because car companies produce ahead of time, they often have excess inventory in their distribution channels. If demand is lower than expected, these companies must then cut prices in order to move this inventory, which at that point is already a sunk cost that must be recovered.

In general, auto manufacturers are focused on building brands that sell in high volumes. This allows them to enjoy production economies of scale. Brands that do not sell high volumes need to be priced at a higher level. Initially, the Prius was priced at a high level, but over time as demand has increased the price has fallen. This is because the fixed costs associated with producing the Prius can be spread out over a greater number of vehicles sold.

At present, the demand conditions for the Prius are high. This means that Toyota is able to build more of them in order to meet this demand. The demand has shot so high that there are waiting lists for Priuses (Hirsch, 2011). This implies that the company is able to increase its production capacity, thereby lowering the average total cost of production, something that should allow it to become more price competitive. There are economies of scale to be earned both in purchasing and in production that should allow for lower costs on the Prius in the coming years.

The one factor that would push the prices higher is the relative lack of price sensitivity for the Prius buyers. The car is the industry leader, gaining first mover advantages and having established a strong brand in hybrids that other companies have yet to match. As such, the price of the Prius is less sensitive to competition than the price of most other automobiles. Indeed, as gas prices go higher, Prius buyers will have increasingly less incentive to be price sensitive, because they will see the vehicle as a means of escaping those higher gas prices. There are strong cross-price elasticities of demand with the price of gasoline and demand for the Prius. This helps to explain the popularity of the car in California, where the price of gas is high and people spend hours every day sitting in freeway traffic.