Automobile’s Economics – Demand Factors, Essay Example

This paper focuses on the non-price demand determinants as well as elasticity of demand in the automobile industry.

Cars in most developing economies may still be considered luxury but in the U.S. they are more or less a commodity. Thus, it is no surprise that U.S. remained the largest auto market in the world until it was taken over by China in 2009 (CNBC) where cars are still a luxury. China was able to overtake U.S. because sales jumped 46 percent in 2009 over the previous year and again rose by 32 percent in 2010 which indicates that unlike U.S. where the auto market has matured, China still has an infant auto market. This paper only looks at the U.S. auto sector and thus, sees automobiles as a commodity. For the sake of simplicity, U.S. automobile sector can be divided into two product categories which are luxury cars and mass-producedcars. Luxury cars usually start near $100k and goes into millions for the most expensive cars while mass-producedcars usually sell for less than $50k. The non-price demand factors have different effects on the demand of both luxury and mass-producedcars and same is the case with elasticity of demand. The non-price factors that affect the demand of cars in the U.S. are consumers’ tastes, number of buyers, consumers’ incomes, prices of complementary and substitute goods, and consumers’ expectations(National Council on Economic Education).

Luxury cars are bought for different reasons than are mass-producedcars. Consumers buy luxury cars not with the single purpose of having a mode of transportation but also for other reasons including personal tastes, status symbol, brand perception, high prices (which makes the cars less common), and driving experience. Mass-producedcars are usually bought with the primary purpose of having a mode of transportation. This is why non-price factors have different impact on the luxury and mass-producedcars. Because consumers’ of luxury cars have high expectations and demands, the sale of luxury cars is more sensitive to change in consumers’ tastes than mass-producedcars. Thus, it is no surprise that luxury cars are known to lose greater proportion of their purchase price than mass-producedcars that are able to meet the requirements of their customers’ for relatively longer periods of time. The mass-producedcars also retain their values better because those who see cars as a necessity are more interested in the reliability of the car. This is another reason why some brands such as Honda and Toyota have higher resale values than their American counterparts.

Since Luxury cars are often priced outside the reach of most consumers’ the demand for mass-produced cars greatly exceeds that of luxury cars. Thus, it is no surprise that the sales of luxury cars have only increased by 1.8% since the beginning of the year as compared to 2010 while small and midsize cars have posted gains of 14.3% and 7.5% over the same period, respectively(The Wall Street Journal).Consumers’ income levels also affect the demand for both luxury and mass-produced cars. These days an issue that has sharply divided the Republicans and the Democrats is the tax rates for high income earners. Rich people are able to pay low taxes because a substantial portion of their income comes from investments which are taxed at lower rates than salaries and wages. Thus, one may deduce that since most rich people see less fluctuation in their incomes as compared to low-income and middle-income class, the demand for luxury cars also fluctuates by a lower degree than the demand for mass-produced cars. The U.S. car sales fell to its lowest level in 27 years in 2009 (CNBC) which is mostly comprised of mass-produced cars and the most probable reason seems to be lower demand by low-income and middle-income groups many of whom have lost their only sources of income. Even if rich people see the same decline in their incomes, the size of their net worth means that each dollar has less utility for them as compared to lower-income groups. Thus, they would decrease their demand for luxury products including cars by lower margins as compared to those at the bottom of the economic hierarchy. In other words, we can say that the demand for luxury cars is less income-elastic than the demand for mass-produced cars.

The fourth factor is the prices of complementary goods and substitutes. Here again the complementary goods and substitutes have different impact on luxury cars and mass-produced cars. Probably the most relevant complementary good for both luxury cars and mass-produced cars is fuel but fuel prices have a much larger impact on the demand forces of mass-produced cars while the impact is negligible on the demand of luxury cars. This may be why mass-produced cars see a far steeper decline in sales as compared to luxury cars. The buyers of mass-produced cars are also more likely to take into account the fuel efficiency of the car as well as the gas prices trend while gas prices would almost be of no concern to the buyers of luxury cars. This may be due to the income differences between the consumers of luxury and mass-produced cars but it is also due to some non-price factors. For mass-produced cars’ consumers, their automobile serves as a primary transportation object and in addition, fuel costs comprise a larger share of their total budget as compared to those with much higher income levels and net worth. Moreover, the buyers of luxury cars go ahead with their purchase even when the fuel efficiency is almost half of mass-produced cars which means they do not care about fuel costs in the first place. Moreover, their purpose is to enjoy the driving experience and not merely use the car to get from point A to point B. It is not unusual for them to only drive luxury cars occasionally and buyers of the luxury-cars usually have more than one vehicle.

The demand for mass-produced cars is also more fluctuating because there are many substitutes such as subway transit system, buses, and taxis. Now cars that run on alternative energy sources instead of gas are only becoming close substitute. Thus, it is no surprise thathybrid car sales increased by a significant rate in 2008 as compared to 2007 as rising gas prices became a serious concern for the buyers of mass-produced cars (White, 2008). But for luxury car buyers there is no substitute because they pay for the experience and the status symbol instead of a mean to get from point A to point B. Car is the only reliable mode of transportation within city boundaries or where short distances are involved. Some buyers of the luxury cars may have private jets but jets are more suitable to long distance travel. The only substitute may be chauffeur-driven limousines as rich people are often status-conscious but where as substitutes for mass-producedcars could be cheaper in the event of high gas prices, it is hard to imagine chauffeur-driven limousines be more economic substitutes to private luxury cars, even in the event of high gas prices. Thus, luxury cars do not have a close substitute which makes their demand less sensitive to changes in complementary good or substitutes as compared to mass-produced cars.

The fifth factor is consumers’ expectations. The buyers of luxury cars are well aware that their purchases lose greater proportion of overall value over a particular time period as compared to mass-produced cars and yet they still go ahead with their purchase plans. In contrast, many buyers of mass production cars do think about the resale value of their cars and plan their budgets accordingly. Thus, consumers’ future expectations have a much larger impact on the demand for mass-producedcars as compared to luxury cars. Similarly, if consumers expect oil prices to go up, they will go for more fuel-efficient cars or even be willing to pay premium prices for alternative fuel technologies such as hybrid. But buyers of luxury cars will not worry about gas prices because they can afford it and most importantly, the factors that influence their purchasing decisions are primarily non-financial.

As far as price elasticity of demand is concerned, we may conclude with the help of some well-known facts that the price elasticity of demand for luxury cars is less elastic than the price elasticity of demand for mass-produced cars. We all have seen both print and electronic media ads announcing sales events on mass-produced vehicles such as Toyota, Ford, and GM etc. but we rarely hear about sales on Bentley, Ferrari, or Rolls Royce. This makes sense because if a good or service has elastic demand, the total revenues of the sellers will increase through price decrease because the proportion of increased sales will be greater than the proportion of decreased prices. But if a good or service has inelastic demand, lower price or sales will have the reverse impact. In this case, luxury cars have inelastic demand and mass-produced cars have elastic demand. This is why sales help dealers increase their revenue in case of mass-produced vehicles but sales are not appealing to dealers of luxury vehicles.

The demand for mass-produced cars is also elastic due to high number of substitutes as compared to luxury cars. Someone looking to buy a Toyota Camry has numerous options such as Nissan Altima, Honda Accord, Ford Taurus, Hyundai Sonata, and Chevy Malibu. On the other hand, someone looking to buy a Ferrari Italia may only have one close substitute which is Lamborghini Gallardo. Similarly, the consumers of mass-produced vehicles are more sensitive to changes in their income due to limited resources as compared to their rich counterparts. Thus, any positive or adverse event such as economic recession, employment loss, or job promotion has a greater impact on their purchase decisions as compared to the consumers of luxury vehicles who are in a better position to absorb the impact of a negative event. Similarly, future expectations impact sale of mass-produced cars by a greater degree than luxury cars. An expectation that the oil price will continue to rise in the near future will trigger a higher proportional decrease in the sale of gas-fueled mass-produced cars than luxury cars.

The price elasticity of demand for mass-produced cars will become more elastic in the long run. This is because consumers will have a better idea of the overall oil price trends and if necessary, they can switch to alternative fuel cars. Even though the mass-produced vehicles as a market segment will have greater price elasticity in the long run, the individual brands may enjoy inelastic demand due to their reputation with the consumers. As an example, Honda comes to mind because the company has successfully convinced the market that its products are one of the best value for money due to safety, fuel efficiency, and mechanical reliability.The luxury cars’ demand will also become more elastic as consumers will have time to understand their preferences and develop long term tastes. Luxury car makers can also try certain marketing techniques to make their demand more inelastic such as introducing products in limited quantities, distributing them through exclusive channels, and focusing on aspects most treasured by the targeted market. Ferrari is known for its exclusivity which is why some Ferrari models such as Enzo are now sold at far above their original retail prices.

References

CNBC. (n.d.). World’s 10 Largest Auto Markets. Retrieved November 23, 2011, from http://www.cnbc.com/id/44481705/World_s_10_Largest_Auto_Markets?slide=10

National Council on Economic Education. (n.d.). Determinants of Demand. Retrieved November 23, 2011, from http://apeconomics.ncee.net

The Wall Street Journal. (n.d.). Auto Sales. Retrieved November 23, 2011, from http://online.wsj.com/mdc/public/page/2_3022-autosales.html

White, J. B. (2008, June 17). Still Waiting for Hybrids to Be the Smartest Buy. Retrieved November 23, 2011, from http://finance.yahoo.com/loans/article/105257/Still-Waiting-for-Hybrids-to-Be-the-Smartest-Buy