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16.3 Market Outcomes in the Automobile Industry

Learning Objectives

  1. What kind of competition is there in the automobile industry?
  2. How do market outcomes differ in the short run compared to the long run?

The interactions among buyers and sellers in the car market ultimately lead to prices and quantities of all the different cars that are produced. But what is the right way to think about that interaction? Automobile markets are not examples of competitive marketsA market that satisfies two conditions: (1) there are many buyers and sellers, and (2) the goods the sellers produce are perfect substitutes.—many firms each producing an identical product. Nor is there a single car producer acting as a monopolist. To study markets such as the car market, we have an intermediate situation where firms

  • sell goods that are imperfect substitutes for other goods in the markets in the short run, and
  • enter and exit in response to profit opportunities in the long run.

Competition among Producers in the Short Run

When we think about market outcomes for automobiles, there are two different markets to consider. There are business-to-businessA market where firms sell goods and services to other firms. markets in which manufacturing firms sell cars to dealerships, and there is the business-to-consumerA market where firms sell goods and services to consumers. market in which dealerships sell cars to the final consumer. This pattern of trade is quite normal: most firms do not sell directly to the final consumer but instead sell their goods through retailers.

So far we have said that automobile producers determine prices for their cars. But the companies do not actually set the price you will ultimately pay for a new vehicle. That price is determined through a bargain between you and a dealer. The price that the company sets is the price at which it sells to the dealer. Given the numerous dealers, you would not expect them to be able to make much profit. Competition will force the price to be close to the cost of the car to the dealer. But the producer retains market power and can dictate a price for selling the car to the dealer.

This might make it tempting to think about the final market for cars as being roughly competitive. After all, one of the conditions for a competitive market is that there should be a large number of buyers and sellers. Another condition, though, is that sellers should be selling identical goods. In the case of cars, this is evidently not the case. We have already pointed out that firms produce many different models of vehicles with various options available. On top of that, dealerships may differ in terms of the quality of service they offer both before and after the sale of a vehicle. Consumers, when choosing which car to buy and where to buy it, are choosing from a large set of different, imperfectly substitutable products. We call these differentiated productsProducts that are similar but not identical, so they are not perfect substitutes for one another..

Each dealer therefore possesses a degree of market power. Some of this market power comes from the fact that there will be only a small number of sellers of a particular model in a given region. Some of the dealer’s market power stems from specific features of the dealership, such as location and after-sales service. The key point is that each dealership faces a downward-sloping demand curve for the cars that it sells. The seller chooses a point on the demand curve. Because there are competing cars available from other dealerships in the market, the position of the demand curve depends on the prices set by other firms for other models.

Although dealerships possess some market power, the retail market for automobiles is still quite competitive. Demand is relatively elastic because consumers have different dealerships and cars to choose from. In addition, information about the price at which dealers obtain vehicles from manufacturers is readily available. Under most circumstances, therefore, dealers are able to enjoy only a small markup over this price. (The exception is when a particular model of vehicle is in particularly high demand for some reason.)

From a dealer’s perspective, marginal cost is determined largely by the price at which it obtains the car from the manufacturer. The producer sets the price to the dealer to maximize its own profit. Producers understand that the demand for their products is affected by the prices of competing vehicles. This strategic interaction means that the elasticity of demand (and hence the markup) for a particular car depends on the prices set by other manufacturers. We explained this in detail in Chapter 14 "Busting Up Monopolies". Likewise, dealers set their prices based in part on the prices at other dealerships. On the demand side, households take the set of products offered in the market and their prices (subject to a little bargaining with dealers) as given as well. Their decisions about which cars to purchase and when to purchase them generate the market demand curves faced by dealerships.

Market Dynamics in the Long Run

So far we have taken as given the types of cars produced, the location of plants, and the identity of the automobile producers. Over a short period of time, such as a year, this is a good way to think about the market for cars. But over longer periods of time, the market is much more dynamic. There are changes in the models of vehicles; there are changes in the location of manufacturing plants; and there is entry and exit of manufacturers. One way to see this is to look at the evolution of the automobile market since the early part of the 20th century.

The beautiful car shown in this picture is called a Marmon.This discussion draws a history of the Marmon that can be found at Bill Vance, “Motoring Memories: Marmon,” accessed March 14, 2011, http://www.canadiandriver.com/2000/03/16/motoring-memories-marmon.htm. The photo is of a 1932 model. A Marmon won the first Indianapolis 500, and nearly 22,000 models were sold in 1929. But by 1934, the company was gone, a casualty of the Great Depression. Small fringe producers like Marmon disappeared from the automobile industry. Left behind were the large producers who were to dominate the US automobile industry from that time onward. By the mid-1930s, the US market was largely ruled by three manufacturers.

A 1932 Marmon.

Economists Tim Bresnahan and Daniel Raff looked at data on automobile plants during this time period.See Timothy Bresnahan and Daniel Raff, “Intra-industry Heterogeneity and the Great Depression: The American Automobile Industry, 1929-1935,” The Journal of Economic History, June 1991, 317–31. They found that the number of plants (remember that one firm may have multiple plants) that were producing cars fell from 211 in 1929 to 121 in 1935. There is no single explanation of exactly why these producers failed and had to close their plants. The Great Depression evidently led to a large decrease in the demand for automobiles. But on top of that, surviving firms were marked by advances in product and process development. In the early stages of the automobile industry, small producers operated at a small scale. Such producers simply could not compete with Ford’s lower-cost production process. This competition from Ford led to the exit of producers of cars like the Marmon. In the end, the industry was left with a small number of powerful firms.

In this market, firms were selling differentiated products, so they had market power. Over the long run, there was entry and exit of competing products (that is, firms introduced new products and retired old ones). There was also entry and exit of entire firms. The conditions governing entry and exit are the same as those that we explained in Chapter 8 "Growing Jobs". A firm will introduce a new product if it expects to make sufficient profits (in terms of discounted present value) to justify the fixed entry costs. A firm will discontinue a product if the discounted present value of profits that it expects from that product is less than the value of the firm’s recoverable assets. Similar conditions apply to entire firms in the market.

Over the past 70 or so years, after the shakeout in the 1920s and 1930s, the big three producers have remained the dominant sellers. From that perspective, you might think that there was little entry and exit. However, the story is more complicated. First, the market share of the three main producers declined due to foreign competition. American consumers started buying cars made in Europe, Japan, and elsewhere. Second, the products produced by the firms have evolved considerably over time. This is a very dynamic market in terms of product innovation. Although there may not have been very much entry and exit of firms, there was considerable entry and exit of products. Sometimes, manufacturers retire entire brands, such as the Hummers that General Motors (GM) stopped producing in 2010.

The Used Car Market

When households choose a car, one option is not to purchase a new car but instead to buy a (as the dealers like to put it) “preowned” vehicle. From the perspective of the buyer, there is one critical difference between a new car and a used car. With a new car, it is relatively easy to make a reasonably good judgment about the attributes of a product, partly from reviews in magazines and on the Internet. With a used car, it is much harder to judge the quality of the product and thus place an accurate valuation on it. We explained a similar problem in terms of health care in Chapter 15 "A Healthy Economy".

With new cars, you bear only a small risk that the car will not perform properly when you buy them. This is not the case in the market for used cars. Imagine (or perhaps you have actually experienced this) going to a used car lot to look for a car. Here is what you might hear from a member of the sales force: “This is the best used car I have ever seen. No lie—it was purchased new by an elderly woman a few years back, and she treated it like one of her kids. It is only here on our lot because she has decided to stop driving. At this price, it is a steal.” You are much less likely to hear this: “Yeah, that car is a lemon. Some guy bought it from the dealer a few months back, and it never was right. One problem after another; it was back in the shop every week. Sure there is low mileage, but my guess is that there are no more miles from that car anyway. Go ahead, buy it if you like. But don’t say I didn’t warn you.”

When you see a used car for sale, ask yourself: why is that car here? The true answer could be one of these two stories. If it is the first situation, then the car is probably a good buy. But if it is the second, then you could be getting ripped off. And the problem is that the seller may give you the first story even when the second is the truth.

The fundamental difficulty here is that you and the seller have very different information. The seller of the product knows its quality (is the car good or bad?) while you, as a buyer, do not know its quality. This does not mean you should never buy a used car. But it does mean that your willingness to pay for a used car should reflect the uncertainty you face with regard to the quality of that car. Because all buyers face the same problem, the end result is that the market valuation of used cars will be low. Accordingly, the price of a used car is lower than it might be if the quality of cars was known. And this can also mean that there are fewer good used cars on the market. This is the problem that economists call adverse selectionA market process in which low-risk individuals leave a market, while high-risk individuals remain..

You can also perhaps spare some sympathy for the used car dealer as well. We have described this problem from the perspective of a buyer. Even if a dealer really does have a car that is of high quality, it is hard for him to convince prospective buyers of that fact. If you want to sell a car you own, you will probably encounter this problem: you may know that your car is high quality, but you cannot convince buyers.

Key Takeaways

  • Car companies compete in markets where they sell differentiated products.
  • In the long run, the entry of competitors (in the form of either new firms or new products) continues until profits are equal to zero.

Checking Your Understanding

  1. Use the condition that marginal revenue = marginal cost (consult the toolkit if needed) to explain the difference in the price of two cars of your choice.
  2. Some used car sellers include a warranty with your purchase. Would that help overcome the lemons problem?
  3. If two cars are close substitutes, what do you predict about their prices?