Microeconomics on the Automotive Industry a Study

Microeconomics on the Automotive Industry

A Study of Elasticity and Demand Generation

Global and national economic cycles have a direct effect on demand for the majority of durable goods consumers purchase, with the automotive industry being the most influenced by the cost of capital, interest rates, and elasticity of demand that varies by type of auto and market segment. The intent of this analysis is to evaluate how pricing strategies can be defined to attain the optimal level of profitability in the auto industry given specific microeconomic conditions. Included in this analysis is an assessment of how economic and liquidity impact the purchase of vehicles over the long-term, and how automotive manufacturers strive to attain lower costs of manufacturing through lean production and Six Sigma methods of production. In addition, the aspect of consumer behavior and its impact on the economic cycles of elasticity are also discussed. Favoritism or ethnocentric-based approaches to trade and income in the auto industry, and the converse of this, which is global collaboration and its effects on global automotive demand are also analyzed.

Pricing Strategies for Optimal Profitability in the Auto Industry

Defining the optimal pricing strategy for a given type of vehicle in a specific market, while also taking into account interest rates, cost of capital for dealers to finance their inventories, and consumer confidence requires an optimization-based approach to defining prices. The elasticity of demand in the industry is proportional to the microeconomic factors beyond control of the global manufacturers competing in this industry, yet is also defined by the frequency and innovation of new vehicle introductions, creativity in financing and leasing, and the willingness of manufacturers to allow for customization of vehicles during production (Cassel, McCormack, 1987). In short, the entire value chain of the industry has a direct and significant impact on pricing elasticity of vehicles over time, with its greatest effects in the areas of logistics, supply chain management, lean manufacturing and Six Sigma-based approaches to continual process improvement. These factors are explored in detail throughout this analysis. The continual improvement of these factors streamline and increases the value of the customer experience, thereby making demand even more elastic the higher the price of the vehicle (Wetzel, Hoffer, 1982). As auto manufacturers have continually strived to equate their highest-end models with a specific emotion or human value to more fully personalize their brands, the more luxurious a car, the greater the price elasticity as a result (Wetzel, Hoffer, 1982). This occurs because these highest-end brands have referent branding power in the minds of consumers. The referent image that these higher-end vehicles have leads to price elasticity when a per unit change in the price upward can actually increase sales over time. This may seem counterintuitive from a demand curve-based analysis of the industry, yet the higher the price of a luxury vehicle, the more status it communicates and the greater the upward-driven elasticity and demand becomes. The higher a price for a luxury car the greater the assumption of value, which also leads to more upward-driven elasticity and exclusivity as well. The price-quality relationships in automotive demand is evident in how easily the premium brands of BMW, Lexus, Maybach or Mercedes can easily raise prices and still achieve record financial results (Bajic, 1988). The analysis of this premium segment of the automotive industry has significant implications on the demand curve industry-wide as well. It also has implications for pricing strategies by automotive vehicle strata or product group for each automotive manufacturer's product lines, and the customer segments and the behavior that drives their purchasing. Taken together, these factors contribute to insights that demand curves are significantly different and often contrary to one another throughout each segment of the automotive market. These delineations of these demand curve variations can vary by model class, price points (which is the most common due to the breadth of research in this area) (Wetzel, Hoffer, 1982) and by psychographics or consumer attributes of each class or segment of automotive buyer, a practice that is very common in European marketing of cars (Visnic, Wielgat, Winter, 1998).

There are significantly different demand curves across each of the strata or segments of the market and therefore significantly different messaging, economic packaging, dealer and channel-based incentives, and costing of auto configurations as well. All of these factors weigh on and influence the demand curve by class of vehicle and are either validated or rejected over time by the changing demographics and psychographics of purchasers. The next result of these many economic factors taken together is the need for defining the precise level of inelasticity or elasticity of a given market. In general, the higher-end the vehicle, the greater the elasticity and the paradoxical effect of upward pricing have the effect of increasing the overall market size over time (Wetzel, Hoffer, 1982), This aspect of elasticity is relied on by auto manufacturers who realize the price-quality relationship is a powerful enabler of referent demand and price increases expand a market by driving out emerging competitors at the low-end of their segments (Bajic, 1988). Aside from the referent positioning that price increases on luxury vehicles connote and powerfully communicate, pricing strategies on the part of higher-end luxury car manufacturers have proven to be an effective deterrent for driving competitors out of their markets as well (Rhys, 2005). There are many examples of how BMW, Lexus, Mercedes and others have used price increases to further differentiate themselves from potential competitors in their markets including Hyundai, Hondo, Suzuki and other manufacturers who have unsuccessfully attempted to penetrate the high-end market. BMW, Lexus, Mercedes and other high-end manufacturers have enough economic, sales and analytical data including enterprise software to interpret demand and create a demand curve by product class in real-time. Using this data and pricing further up the demand curve, these competitors continue to be very successful driving competitors out of their markets while increasing profitability at the same time. This also illustrates how effective having real-time demand curve-based data is by product class.

The low-end of the automotive market is considered to be highly price elastic as well, with a drop in price increasing unit volumes. In fact, this is not always the case, as a precipitous or significant drop in price can communicate or connote a lack of quality in a given vehicle or class of cars over time (Bajic, 1988). The elasticity of demand across the low-end of the market is more dictated by the cost of capital, flexibility and agility of financing and credit offers auto manufacturers and retailers can make, age of product designs and their relative demand with consumers, and the efficiency of manufacturing processes to support lower costs over time. Just as manufacturers have intensive levels of investment in analytics to understand and analyze the demand curve for the high-end of the market due to the high gross margin per model, the same is true at the low end where sales are often measures in tens of thousands of units sold per month (Cassel, McCormack, 1987).

The influence of auto dealers and the extent of asymmetric vs. symmetric pricing and transaction data between them and the manufacturers they rely on can also have a significant effect on the elasticity curve of car models by segment over the long-term. The greater the asymmetric pricing and transaction data provides and shared, the greater the level of transaction elasticity resulting in the potential of a lower per unit price (Cassel, McCormack, 1987). At the low-end of the market, it is production efficiency, real-time pricing and transaction data support and the ability to create low-priced models that resonate with first-time and low- to moderate income buyers (Rhys, 2005). Studies of pricing elasticity in the low-end of the auto market suggest that the breadth and scope of the financing options bring new buyers into the market and the latency of product designs are much more critical to sustaining what would otherwise turn into a highly inelastic demand curve over time (Rhys, 2005). The low-end of the automotive market is one that has the combination of factors that contribute to a flat, inelastic demand curve (Rhys, 2005). The demand curve characteristics of the low-end of the market show no significant change in volume sales when a per unit change in price is made with the best-case scenario being a unitary price elasticity being attained (Wetzel, Hoffer, 1982). The low-end of the market has a series of factors that continually move it to an inelastic market position, flattening the demand curve and making pricing less of a determinant of product demand increases vs. these other elements. First, there is the availability of credit, which has become constrained due to the economic crisis and continued economic recession. Second, the tendency on the part of auto manufacturers to treat this area of their product strategies as areas where older, more proven product designs are used as they have already been amortized. This results in a continual downward spiral however of the price-quality relationship because the majority of new car designs are in fact years, even a decade old, which further reduces their perceived value (Bajic, 1988). Third, there is the critical role of the dealer channel in the low-end of the market and the use of cash incentives or spiffs to steer a new buyer to one vehicle over another (Rhys, 2005). At the low-end of the market auto manufacturers use spiffs or cash incentives in an attempt to move the demand curve through expert opinion and advice from dealers. Cash incentives are also used to steer new customers to the most profitable models a manufacturer has for sale as well (Wetzel, Hoffer, 1982). These are all strategies to mitigate the long-term effects of what is essential a flat demand curve at the low-end of the market (Wetzel, Hoffer, 1982). Pricing alone will not make a low-end auto sell more, yet incentives, accelerated credit options, leasing and cash incentives to dealers can make a difference. The point was made earlier that each segment of the auto market has its own demand curve and pricing elasticity, and in the low-end of the market the use of demand generation strategies has a far great effect compared to the high-end (Wetzel, Hoffer, 1982). Lowering the price may invite more competitors into a market and also create greater confusion over brand quality as well (Bajic, 1988). The need for pricing stability at the consumer level is critical to also attain stability of brand messaging and also ensure consistency of demand forecasting in uncertain economic conditions (Rhys, 2005). Pricing's greatest impact then is in the area of transfer pricing between manufacturers and their own dealers and 3rd party dealer representatives who also resell their vehicles (Cassel, McCormack, 1987).

Liquidity and Economic Conditions' Impact of Auto Purchasing

Economic conditions and relative liquidity as measured by cost of capital, availability of credit, unemployment rate and the measures of broader macroeconomic liquidity have a significant effect on auto purchasing across all vehicle segments (Wetzel, Hoffer, 1982). Economic conditions that freeze capital and reduce the amount of credit available for prime borrowers can collapse entire segments of the auto industry relatively quickly. The last three years of the recession has constrained credit for high risk, first time buyers and as a result the demand curve for entry-level, low-end autos has resisted even the most aggressive pricing strategies to drive sales (Chu, Su, 2010). The value chain has become the central focus for streamlining and improving pricing elasticity, where manufacturers are looking today to drop the manufacturing costs and be more competitive. The next section of this analysis provides insights into this aspect of their operations.

Impact of Lean Manufacturing and Six Sigma in Auto Manufacturing

The elasticity of demand varies so significantly by strata or class of auto that the need exists for defining lean manufacturing and Six Sigma-based approaches to ensuring a high degree of price management by each model's development cycles. Auto manufacturers are finding that concentrating on the knowledge-sharing network aspects of their operations has a cumulative effect of reducing costs over time and increasing quality (Dyer, Nobeoka, 2000). At the low-end of the market, this is stabilizing the demand curve for price-sensitive buyers by increasing the speed and accuracy of product designs and production yields. At the low-end of the auto market, the reliance on production efficiency and removing as much variation as possible through the use of Six Sigma is critical for keeping costs low and producing an optimized mix of models based on dealer forecasts. The contributions of a knowledge-sharing network between suppliers is also well-known and quantified through the Toyota Production System and the findings of researchers who ascertained that having greater cross-supplier integration over time led to high quality, fewer returns and a more stabilized demand curve as a result (Dyer, Nobeoka, 2000). For the low-end of the auto market, this finding also is supported by the asymmetric sharing of information across the value chain including insights from dealer and channel partners as to which specific promotions are being effective or not and why (Rhys, 2005). The asymmetric information flows across the manufacturing, supplier and dealer channels, if accelerated over time can lead to significant gains in the overall stability of price elasticity and the potential to differentiate not just on price but also user experience and uniqueness of design as well (Wetzel, Hoffer, 1982).

Consumer Behavior and the Impact of Economic Cycles on Elasticity

The behavior of consumers is dictated more by their perception of quality and trust in a brand than on price alone, as evidenced by the pervasive reliance on the price-quality relationship within brands as a means to determine relative value (Bajic, 1988). The continual increase in pricing for luxury vehicles is deliberately done to drive lower-end competitors out of entering their markets, as these established luxury car makes realize that pricing elasticity works in their favor when they send a message of greater value and exclusivity by raising prices. The greater the elasticity of price the fewer the substitutes and this is clear in how luxury car manufacturers continually price their vehicles (Chu, Su, 2010). Consumers then rely on more than just price to determine which vehicle to purchase, and it is more dictated more by which customer and psychographic segment they are members of (Visnic, Wielgat, Winter, 1998) and the effects of the dealer in defining pricing stability while influencing the purchasing decision (Cassel, McCormack, 1987).

Favoritism or Ethnocentrism between Trade and Income in the Automobile Industry

The globalization of the auto industry is being driven by the need to continually adjust and align production strategies, raw materials costs, and the development of more effective cost control programs over time (Kim, McCann, 2008). The outsourcing of manufacturing jobs from the U.S. To other regions of the world is being driven by the drastically changing elasticity of demand for each class or segment of vehicle type. This shift in the demand curve by segment is also leading to an acceleration in how American manufacturers are relying on knowledge-sharing networks to increase their competitiveness globally, looking to transform their insights and expertise into a competitive advantage (Dyer, Nobeoka, 2000). Elasticity and pricing concerns also are fuelling entirely new development in the emerging nations of Brazil, Russia, India and China (BRIC) where pricing strategies are completely different and much more orientated to the coordination of global supply chain partners (Kim, McCann, 2008). The backlash to American auto manufacturing jobs going overseas needs to be balanced with the recognition that the BIRC nations long-term offer significantly greater growth potential for all auto manufacturers and that the burdened cost per labor hour could easily price an entire nations' companies out of this fastest growing market (Chu, Su, 2010). Demand curves and pricing elasticity vary drastically across each of the BRIC nations as well, and the tendency to see American auto manufacturers pursuing these markets through a perspective of ethnocentrism misses the point. The growth of BRIC nations' demand for new cars will eventually deliver a higher Return on Invested Capital (ROIC) for American auto manufacturers which will in turn lead to them having the financial resources to create more fuel-efficient and cost-effective autos for the American market as well (Kim, McCann, 2008). This globally-focused mindset must pervade auto manufacturing as the pricing and elasticity curves by market vary significantly often with completely different pricing dynamics as dictated by their own economies, segmentation criteria and own unique approach to defining channel strategies. The BRIC nations will define pricing elasticity at the low end of the market globally for decades to come as their potential for growth is the greatest (Chu, Su, 2010). What appears to be ethnocentric is in fact a focused strategy for ensuring a higher level of ROIC gets generated over time globally, which paradoxically leads to greater stability of employment for everyone in these companies.