1. Economics of Automobiles
EconomicsTerm Paper
JenniferPham
Page 1 of 14
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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EconomicsTerm Paper
JenniferPham
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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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EconomicsTerm Paper
JenniferPham
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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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EconomicsTerm Paper
JenniferPham
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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.

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EconomicsTerm Paper
JenniferPham
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Threat of Substitutes
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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EconomicsTerm Paper
JenniferPham
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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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EconomicsTerm Paper
JenniferPham
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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.

8. Economics of Automobiles
EconomicsTerm Paper
JenniferPham
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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)

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

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

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

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EconomicsTerm Paper
JenniferPham
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customers around so they have more to gain than you do by reaching an agreement. Finally,
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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EconomicsTerm Paper
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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
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Bortz, D. (2012, June 18). Howto Bargain fora New Car. RetrievedJune28,2013, fromMoney 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.). TheHistory of the Automobile.RetrievedJune 28,2013,
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