Economic Profile of Automobile Industry - Case Study Example

ECONOMIC PROFILE OF AUTOMOBILE INDUSTRY Table of Contents Page No. Introduction 3 Economic Profile of Automobile Industry 3 Demand and Supply 4 Price Elasticity of Demand 5 Price Elasticity of Supply 6 Positive and Negative Externalities 6 Wage Inequality Impact on Automotive Industry 7 The Impact of Monetary and Fiscal Policies on Automobile Industry 7 Conclusion 9 Bibliography 11 Introduction The Automobile Industry with its gas guzzling pollutant spewing vehicles has been a source of interest for everyone; the owners, drivers, pedestrians and also the breathers of air polluted by automobiles. The industry is involved in designing, manufacturing, marketing and selling the world’s vehicles; the words ‘world’s vehicles’ suggesting globalization of the industry. According to Domansky and Williams (2006), the global automotive industry encompasses a few principal manufacturers such as General Motors, Toyota, Honda, Ford, Volkswagen and DaimlerChrylser that serve the global market. The globalization of automobile industry has resulted from the setup of overseas facilities and mergers between firms in recent times. The joint venture of General Motors and Toyota in New United Motor Manufacturing, Inc. and Fiat holding an 85% stake in Ferrari are examples of such mergers. Economic Profile of Automobile Industry The Automobile Industry is one of the most important industries in the world, employing millions of people, generating billions of dollars in world revenues, placing more than 806 million vehicles on the roads, accelerating the business and commercial activities and linking person to person, area to area and country to country. It is more than a 100 years old. It came into existence in Germany and France and later grew in USA as a result of mass production. However, Papatheodorou and Harris (2007) state that considering the level of employment and revenue it generates, the industry is suffering from financial crisis with profit margins falling from 20% in 1920s to 5% in 2007. This may be due to the maturity of automobile markets in developed countries. According to Encarta Online Encyclopedia (2009), the Automobile Industry has tried to reduce the cost of transportation through mass marketing, mass production and globalized production. There are a number of economic influences that have an impact on the automobile industry: I. Demand and Supply The world is headed towards the crisis of recession and economic slump which is expected to reduce automobile sales worldwide. The present economic downturn has proven to have hit the automobile industry sharply and there has been rapid decline in the sales of the industry. Political and economic instability, credit crunch, banks being more particular about auto financing and the rising prices of cars has impacted the industry’s sales. Jones (2007) believes that much of the reduction in sales can be accounted to the cutting down of incentives such as zero percent financing options and rebates by the automotive manufacturers. That, in addition to the credit crunch and the rise of monthly payments in the housing sector can be seen as major causes. It has been suggested that a decrease in interest rates by the Federal Reserve may help the consumers in securing loans to purchase motor vehicles. Ford’s US sales fell by 9.3% and Hyundai recorded a 13.5% decline in its domestic car sales. These factors have led to a leftward shift in the Demand Curve for the automobile industry, which should have caused the prices of motor vehicles to fall and lower profit margins. However, instead of allowing the prices to fall, many automotive firms in the industry have adjusted and reduced their supply to match the new level of reduced demand, while maintaining the current price level. The year 2009 is predicted to be an immensely difficult year for manufacturers of automobiles. There has been a leftwards shift in the supply curve of automobiles. General Motors in 2007 cut back production at six of its production plants. Statistics compiled by VDA (2008) prove that in USA, sales of vehicles took a nosedive by 32%, whereas, German automakers suffered a sales drop of 13% in 2008. German automakers responded to the decline in sales by cutting back on production at their domestic plants by 10% in October 2007. Cutting back on production has also resulted in the cutting down of the labor force which has negative implications for the firms in terms of workers alienation, resistance, low motivational levels and job insecurity. Honda has tried to match supply with demand by setting up flexible plants, such that production can be switched from Civics to CR-Vs with a downtime of 5 minutes when demand varies. However, Honda had to make an investment of $400m a few years ago and is bearing its fruits at present. Many new manufacturers have also been driven out of the automobile market. Equilibrium prices have remained fairly constant due to the leftward shift in demand backed by a leftward shift in the supply curve. II. Price Elasticity of Demand Price elasticity of demand measures the responsiveness of quantity demanded to any changes in price. According to Anderson et al. (1997), the demand for automobiles in the short run would be relatively price elastic at 1.2-1.4 as it is possible to delay the purchase of a new car for some time. Chevrolet, which is a value leader for GM, is price elastic at 4. Similarly, the demand for a specific motor vehicle is highly elastic due to the availability of a large number of substitutes. In urban areas, where private automobiles run hand in hand with public buses, taxi service and a network of underground trains and there are alternative means to travel, demand for automobiles tends to be price elastic. On the other hand, in rural areas, there are no alternative modes of transportation and demand would be relatively price inelastic there. In the long run, automobiles tend to have an inelastic demand of 0.2 as it is not possible to continue delaying the purchase of a car indefinitely. There is a positive impact of the inelastic price elasticity of demand as the demand remains more of less constant during times of rising prices and results in higher profits for the manufacturers. At times, the fuel costs may rise, causing an increase in the cost of manufacturing automobiles. When the demand is price inelastic, the manufacturers can pass on the rising costs to consumers in terms on higher prices instead of bearing the brunt themselves. III. Price Elasticity of Supply The price elasticity of supply of automotive industries is low in the short run as it is not easy to close down plants if the price fall indicates a falling demand in the market for automobiles. This is because closing down of plants has negative implications in terms of laying off the workforce and there are high costs of leaving the market due to expensive technology involved that will have to be sold. In the long run, it is possible for the supply of automotive industries to respond to changes in price level as many of the firms operate under capacity like General Motors. The impact of being price inelastic in the short run is that the automobile industry has to keep on manufacturing, resulting in accumulation of inventories. In the long run, there is a positive impact as supply can then respond to the signals given by the changes in price levels, either by setting up flexible plants in response to falling prices or by setting up new plants and working at full capacity in response to rising prices. IV. Positive and Negative Externalities Positive and negative externalities those benefits and costs that are enjoyed or borne by the third party, i.e. those not directly involved in the act of production and consumption. The positive externalities associated with the automotive industry stated by Angelina (2008) are lower costs and a source of employment. Motor transportation has made the distribution of goods easier, cheaper and faster and accelerated trade. It also provides individuals with freedom of movement from one place to another. Businesses can send their trainees to foreign countries for business meetings etc. The Automotive Industry also generates employment and in 2008, one out of every ten people was employed in US Auto Industry and approximately 4 million people are employed by the Big 3 firms alone. Automobile industry has also helped to correct trade balances of countries that are involved in export of automobiles. The impact on automobile industry of the positive externalities is that the demand had been rising steadily until the world economy started going into a recession in 2008 and many governments are providing aid to the industry to keep it afloat as it provides employment to millions of people over the world. The negative externalities associated with the automotive industry are the air, lead and noise pollution generated by the gas-guzzling monsters which present a health risk to the population. Moreover, it has also caused the depletion of natural oil resources and traffic congestion leading to road accidents. Governments across the world have taken measures to reduce the external costs. Fuel taxes and congestion tolls have been imposed and emission standards set up. Governments are spending money to develop alternative fuels to reduce dependence on oil. The impact of negative externalities on automotive industry is that it has encouraged the industry to install emissions control and fuel efficiency technology in cars. V. Wage Inequality Impact on Automotive Industry America pays its labor higher wages as compared to foreign countries. This wage inequality has been harmful for the US automotive industry. There has been an influx of inexpensive and good quality automobiles and increased competition from foreign countries where labor is cheaper. These foreign countries have been able to pass on the benefit of cheaper labor force to the consumers in terms of lower and competitive prices. America vehicle makers have been hit really hard as their local sales and exports have both fallen rapidly in the face of competition. General Motors has had to close 12 manufacturing plants and cut down hourly jobs due to falling sales in 2008. VI. The Impact of Monetary and Fiscal Policies on Automobile Industry Monetary policy deals with the money supply and interest rates in the market. If the government injects more money into the economy, the money supply increases and the interest rates decrease. As a result, the demand for luxuries like automobiles increases. This generates employment, which leads to increase in income and demand increases again. Hence, the cycle continues. Moreover, when the interest rate decreases, it is cheaper for people to secure loans from banks and hire purchase financers. That also increases demand for automobiles and has a positive impact on the automotive industry as it leads to growth of the business. On the other hand, when the money supply decreases and interest rate rises, the demand for automobiles decreases causing the industry to shrink. Higher interest rates would encourage people to save money, reducing consumer spending and demand for luxuries. As a result, unemployment would increase as automotive firms close down their plants to match supply with the reduced demand. Demand would further decrease as people lose their jobs and hence leading to a downward spiral. Fiscal policy deals with taxation and government spending. High tax rates across the country would mean less discretionary income for people. This would limit consumer spending, causing demand to fall and the automobile industry to shrink. High tax rates for the automobile manufacturers would mean a rise in the cost of production which would be passed on to the consumers in the shape of higher prices. That would cause a decline in demand for its motor vehicles. Moreover, the firms will try to cut on their labor force to compensate for higher tax expenses, leading to unemployment and less incomes being generated, again leading to a fall in demand for luxuries such as automobiles. On the other hand, if the government decreases tax rates and increases government spending, discretionary income, purchasing power and demand would rise, causing growth of automobile industry. Conclusion There are a number of economic influences which may either lead to the success or failure of an industry. This also applies to the automobile industry. Economic influences according to Angelina (2008) include: Consumer choice Government intervention Competition from foreign markets Cost of raw materials Labor costs The profits of the automobile industry depend upon its sales, which in turn depends on consumer choice. Consumer choice will be affected by the price of automobiles; higher price makes the consumers search for alternatives whereas lower prices encourage increased consumption. Government intervention in terms of minimum wages and lower tax rates will increase income of the population and also purchasing power, leading to the growth of automobile industry. Increased government spending on roads, bridges and hospitals will generate employment and inject money into the economy. This would also ensure success of the industry. Lower labor costs in foreign countries increased competition in USA auto makers which encouraged them to cut down the prices of vehicles. On the other hand, certain economic influences may lead to the shrinking of automobile industry. Increase in over all tax rates reduces consumption and demand declines. Also, imposition of high level of taxes on automobile makers means higher cost of production and higher selling prices for the consumers which affects consumer choice and forces them to look for alternative modes of transportation for example, public transportation. An increase in fuel costs and other raw materials of automobile industry leads to the same outcome. Many US auto makers are suffering losses in the face of competition from foreign auto makers operating in low wage countries. Such foreign companies benefit as they can pass on the advantage of lower wage costs to the consumers in shape of lower prices. Hence, demand in US has shifted from local US automobiles to foreign produced inexpensive automobiles, leading to market shrinking. It is thus obvious that the success of automobile industry depends on the economy and economic influences. Bibliography Anderson, P.L., McLellan, R.D., Overton, J.P. & Gary, L.W. (1997). Price Elasticity of Demand. From Website: http://www.mackinac.org/article.aspx?ID=1247 Angelina. (2008). The Automotive Industry-Research Essay. Article id= 1256974. from Website: http://www.associatedcontent.com Domansky, L.R. & Williams, L.V. (2006). Automobile Industry: Current Issues. Nova Publishers. Encarta Online Encyclopedia. (2009). Automobile Industry. from Official Website: http://encarta.msn.com/encyclopedia_761563934/automobile_industry.html Jones, R. (2007). Credit crunch cools demand for automobiles. from Official Website: http://www.msnbc.msn.com/id/20393888 Papatheodorou, Y. & Harris, M. (2009). Industry Week: The Automotive Industry: Economic Impact and Location Issues. from Website: www.industryweek.com. Article id= 13363 VDA. (2008). Demand for automobiles declining worldwide. from Website: www.vda.de/en/meldungen/news/20081104.html Read More