Microeconomics of the Auto Industry: Elasticity and Demand

Introduction: Economic Forces and the Auto Industry

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 vehicle 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 is an assessment of how economic conditions and liquidity affect 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. In addition, consumer behavior and its impact on economic cycles of elasticity are discussed. Favoritism or ethnocentric-based approaches to trade and income in the auto industry — and the converse, global collaboration and its effects on global automotive demand — are also analyzed.

Pricing Strategies for Optimal Profitability

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 setting prices. The elasticity of demand in the industry is proportional to microeconomic factors beyond the control of global manufacturers, 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 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. The continual improvement of these factors streamlines 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 specific emotions or human values to more fully personalize their brands, the more luxurious a car, the greater the price elasticity (Wetzel & Hoffer, 1982). This occurs because these highest-end brands carry referent branding power in the minds of consumers. The referent image that higher-end vehicles project leads to price elasticity in which a per-unit price increase can actually increase sales over time. This may seem counterintuitive from a standard demand curve perspective, yet the higher the price of a luxury vehicle, the more status it communicates and the greater the upward-driven elasticity and demand becomes. A higher price for a luxury car also increases the assumption of value, which leads to greater exclusivity. The price-quality relationship in automotive demand is evident in how premium brands such as BMW, Lexus, Maybach, and Mercedes can raise prices and still achieve record financial results (Bajic, 1988).

The analysis of this premium segment of the automotive industry has significant implications for the demand curve industry-wide. It also has implications for pricing strategies across automotive vehicle strata or product groups within each manufacturer's product line, and for the customer segments and behaviors that drive purchasing. Taken together, these factors illustrate that demand curves are significantly different — and often contrary — across each segment of the automotive market. These variations can differ by model class, price point (the most common distinction given the breadth of research in this area) (Wetzel & Hoffer, 1982), and by psychographics or consumer attributes of each class of automotive buyer, a practice common in European car marketing (Visnic, Wielgat, & Winter, 1998).

There are significantly different demand curves across each stratum or segment of the market, and therefore significantly different messaging, economic packaging, dealer and channel-based incentives, and configuration costing as well. All of these factors influence the demand curve by vehicle class and are either validated or rejected over time by the changing demographics and psychographics of purchasers. The net result of these many economic factors is the need to define the precise level of elasticity or inelasticity for a given market. In general, the higher-end the vehicle, the greater the elasticity, and the paradoxical effect of upward pricing actually increases the overall market size over time (Wetzel & Hoffer, 1982). Auto manufacturers who realize the power of the price-quality relationship use price increases to expand a market by driving out emerging competitors at the low end of their segments (Bajic, 1988). Aside from the referent positioning that luxury price increases communicate, pricing strategies by high-end manufacturers have also proven to be an effective deterrent against potential competitors (Rhys, 2005). There are many examples of how BMW, Lexus, Mercedes, and others have used price increases to differentiate themselves from competitors such as Hyundai, Honda, Suzuki, and other manufacturers that have unsuccessfully attempted to penetrate the high-end market.

BMW, Lexus, Mercedes, and other high-end manufacturers possess sufficient economic, sales, and analytical data — including enterprise software — to interpret demand and construct a demand curve by product class in real time. Using this data and pricing further up the demand curve, these competitors continue to drive rivals out of their markets while increasing profitability simultaneously, illustrating the value of real-time demand curve data by product class.

The low end of the automotive market is also considered highly price elastic, with price decreases typically increasing unit volumes. However, this is not always the case: a significant or precipitous drop in price can communicate a lack of quality in a given vehicle or class of cars over time (Bajic, 1988). Elasticity of demand across the low end of the market is more strongly influenced by the cost of capital, the flexibility and agility of financing and credit offers from manufacturers and retailers, the age of product designs and their relative appeal to consumers, and the efficiency of manufacturing processes in supporting lower costs. Just as manufacturers invest heavily in analytics to understand the demand curve for the high-end market — given the high gross margin per model — the same is true at the low end, where sales are often measured in tens of thousands of units per month (Cassel & McCormack, 1987).

The influence of auto dealers and the extent of asymmetric versus symmetric pricing and transaction data shared between them and manufacturers 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 generated and shared, the greater the level of transaction elasticity, with the potential for a lower per-unit price (Cassel & McCormack, 1987). At the low end of the market, 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 are critical (Rhys, 2005). Studies of pricing elasticity in the low-end auto market suggest that the breadth and scope of financing options bring new buyers into the market, and that the longevity of product designs is far more critical to sustaining demand than price alone — without which the demand curve would otherwise turn highly inelastic over time (Rhys, 2005).

The low end of the automotive market combines factors that contribute to a flat, inelastic demand curve (Rhys, 2005). Demand curve characteristics in this segment show no significant change in sales volume when a per-unit price change is made, with the best-case scenario being unitary price elasticity (Wetzel & Hoffer, 1982). Several factors continually push this segment toward an inelastic market position, flattening the demand curve and making pricing a less decisive determinant of demand than other elements.

First, there is the availability of credit, which has become constrained due to the economic crisis and continued recession. Second, auto manufacturers tend to treat the low end of the market as a space where older, already-amortized product designs are deployed. This results in a downward spiral in the price-quality relationship, as the majority of low-end car designs may be years or even a decade old, further reducing their perceived value (Bajic, 1988). Third, there is the critical role of the dealer channel in this segment, including the use of cash incentives — or "spiffs" — to steer new buyers toward particular vehicles (Rhys, 2005). Manufacturers use these incentives in an attempt to shift the demand curve through expert dealer guidance, directing customers toward the most profitable available models (Wetzel & Hoffer, 1982). These strategies attempt to mitigate the long-term effects of what is essentially a flat demand curve at the low end of the market (Wetzel & Hoffer, 1982).

Pricing alone will not cause a low-end vehicle to sell more units; incentives, accelerated credit options, leasing programs, and cash incentives to dealers can, however, make a meaningful difference. As noted earlier, each segment of the auto market has its own demand curve and pricing elasticity, and at the low end, demand generation strategies have a far greater impact than at the high end (Wetzel & Hoffer, 1982). Lowering prices may invite more competitors into the market and create greater confusion over brand quality (Bajic, 1988). Pricing stability at the consumer level is critical for maintaining consistent brand messaging and ensuring reliability 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 third-party dealer representatives who resell their vehicles (Cassel & McCormack, 1987).

Liquidity and Economic Conditions' Impact on Auto Purchasing

Economic conditions and relative liquidity — as measured by cost of capital, availability of credit, unemployment rate, and broader macroeconomic indicators — 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 years of recession following the 2008 financial crisis constrained credit for high-risk and first-time buyers; as a result, the demand curve for entry-level, low-end autos resisted even the most aggressive pricing strategies designed to drive sales (Chu & Su, 2010). The value chain has consequently become the central focus for streamlining and improving pricing elasticity, with manufacturers looking to reduce manufacturing costs and become more competitive. The following section provides insights into this aspect of their operations.

Conclusion

The price elasticity of auto markets is heterogeneous and defies easy explanation. It varies not only by price band or market segment, but also by the psychographics of buyers (Visnic, Wielgat, & Winter, 1998), the degree of transaction integration and symmetric information flow between dealers and manufacturers (Kim & McCann, 2008), and the ability to create long-term competitive advantage through collaborative information sharing across and between suppliers (Dyer & Nobeoka, 2000). Paradoxically, the study of demand elasticity shows that while many factors are entirely beyond the control of auto manufacturers, the perspective that pricing and elasticity can be used to communicate market position and be transformed into a competitive advantage is one that deserves continued investigation and action.

References

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