# Microeconomics: Theory Through Applications, v. 1.0

by Russell Cooper and A. Andrew John

## 16.2 Supply of Cars

### Learning Objectives

1. What factors determine the price of a car?
2. How do car manufacturers compete beyond their choice of price?
3. What factors influence the choices that automobile producers make about the location of their production?

If you walk around the streets of your town, you could conduct a survey of the cars you see. For each car, you could make your best guess as to the answers to the following questions:

• What was the sticker price of the car when it was first sold?
• How old is the car?
• What is the car’s estimated value now?
• What are the car’s most important features?
• Which company produced the car?
• Is the car manufacturer a US company or a foreign company?
• In which country was the car assembled?
• At which manufacturing plant was the car assembled?

We start with the price of a car. We then look at other aspects of the production decision, such as the key attributes of the car and the choice of production location.

## Car Prices

The basic rule for pricing is as follows: set the price so that

marginal cost = marginal revenue.

This rule was explained and developed in Chapter 6 "Where Do Prices Come From?". Marginal cost is the extra cost incurred by producing an additional unit, and marginal revenue is the extra revenue earned by producing an additional unit. To understand how this rule applies to cars, we need to look more carefully at both the costs of production and the demand for cars.

## Marginal Cost

Cars are produced in automobile assembly plants using a variety of inputs, such as steel, rubber, glass, and labor. Lying behind the assembly of the car is an organization that engineered the car and designed the production process. At one level, there is nothing special about the cost structure for car production. We can decompose costs into three components: entry costs, fixed operating costs, and variable costs. We explained these notions of cost in Chapter 8 "Growing Jobs".

• Entry costs are incurred prior to production. For cars, the most significant entry costs are design costs and the costs of establishing the production line. Many of these expenses are incurred in the research and development stage of the product. Once the car has been designed, the production line must be organized to manufacture the car efficiently. Finally, specialized machinery must be ordered or custom built for the production line. All of these expenses are incurred before a single car can be produced.
• Fixed operating costs include the costs of managing the automobile plant. Think of these as the costs of the various divisions of the plant not directly engaged in production: the operations department, the human resources department, and so on. These costs are the same no matter how many automobiles are being produced.
• Variable costs depend on the number of cars being produced. To build more cars, the firm must hire more labor. If the firm wants to produce fewer cars, it needs to buy less steel. These and other variable costs fluctuate according to the number of cars rolling off the production line.

By definition, entry costs and fixed operating costs are the same no matter how many cars are produced. The only costs that matter for the pricing decision are the firm’s variable costs. Managers in auto plants must do their best to determine how much these variable costs change when they produce one extra vehicle. In other words, they need an estimate of the marginal cost of production.

You can review different cost definitions and the definition of marginal revenue in the toolkit.

The history of automobile manufacture reveals that costs of production change over time. Technological progress is visible as we compare production processes at different dates. Ford’s move to mass production was key to its success in the early 1900s because this new production method reduced costs substantially. Meanwhile, modern, highly automated, capital-intensive production facilities make those Ford production techniques seem primitive.

Even today, however, the labor input into the production process differs across producers. A recent report compared the labor hours required to produce a car at different manufacturing facilities.See Gary S. Vasilash, “Assembly Plants: How They Compare,” Automotive Manufacturing & Production, August 1997, accessed March 14, 2011, http://findarticles.com/p/articles/mi_m0FWH/is_n8_v109/ai_20855370/pg_2. For 2006, a Nissan plant in Smyrna, Tennessee, required 28.32 labor hours to produce one vehicle. A Toyota plant was next at 29.54 hours. In contrast, a General Motors (GM) car required 44.59 hours of labor input. Thus GM is using a much more labor-intensive method of production than Toyota or Nissan, whose facilities are more automated. These are not exactly measures of marginal cost because they measure average labor hours rather than the labor hours required to produce one extra car. Still, it is very likely that the GM plant has a higher marginal cost than the Nissan plant.

## Marginal Revenue

We can take marginal revenue = marginal cost and rewrite it as a markup pricing formula:

price = (1 + markup) × marginal cost.

For example, if the marginal cost of producing the last unit is $30,000 and the markup is 0.50 (50 percent), then the firm sets a price of$45,000. For a given value of marginal cost, a higher markup translates into a higher price. And for a given markup, higher marginal cost translates into a higher price. The markup depends on the own-price elasticity of demand.

Suppose a firm has a lot of market power. This means it can increase its price with relatively small changes in the quantity demanded: that is, demand is inelastic so −(elasticity of demand) is small. In this case, a firm will choose a large markup. If demand is more elastic, a firm will choose a smaller markup.

You can review the definition and measurement of own-price elasticity of demand and markup pricing in the toolkit.

The markup pricing equations seem easy to implement, at least in principle. For an automobile producer, pricing is actually quite complex. There are several reasons for this:

• With something as complicated as an automobile, the calculation of marginal cost is not straightforward. The operations department must determine how much additional labor and raw materials are needed to produce exactly one more car.
• Extensive market research and a certain amount of careful experimentation may be required to find the elasticity of demand. Remember that we saw that a household’s decision about whether to buy a car depends on many different factors, including income, interest rates, the current and expected price of gasoline, the price of public transportation, and so on.
• The price elasticity of demand depends on the decisions of other producers. We discussed this idea in Chapter 14 "Busting Up Monopolies". When there is a relatively small number of suppliers, firms have to keep a close eye on the strategies of their competitors. For example, if other producers increase the prices of their cars, then you can expect households to substitute toward purchasing your car. The demand curve for your car will shift to the right. This is good news. But to determine whether to change your own price in response, you have to determine the elasticity of the demand curve for your product, given the new prices set by the other producers. You also have to worry about whether changes in your price will in turn lead other producers to change their prices again.
• Automobile producers manufacture many different models of vehicles. In effect, they compete with themselves as well as with other producers. If Ford cuts the price of, say, a Thunderbird, then the demand curve for other Ford vehicles will shift to the left as at least some potential buyers now choose the Thunderbird ahead of other Ford products. Ford must take into account how its various pricing decisions interact.
• As we explained earlier, an automobile can be thought of as a “bundle of attributes,” such as performance, style, color, and so on. The valuation that a potential buyer places on a car depends on the buyer’s valuations of these various attributes. Thus when manufacturers want to assess how much a car is worth to potential buyers, they really need to determine how much each attribute might be worth. Sophisticated statistical techniques are used to develop these numbers, and this information is used in both the pricing of vehicles and the decisions about which attributes to include in new models, which to exclude, and which to have as available options.

Pricing is only one of many decisions made by car producers. They make other key choices as well. Two of the most significant are design changes when they introduce new models and the decision about where to locate their production facilities. We turn to these next.

## Model Introductions

A century has passed since Henry Ford introduced one of the most famous automobiles ever: the Ford Model T.For details on the history of the Model T, see The Henry Ford Museum website, “The Model T,” accessed March 2011, http://www.thehenryford.org/exhibits/showroom/1908/model.t.html. This car remained in production for almost two decades, with 15 million automobiles produced. There were two versions of the Model T: a car and a truck. Otherwise, there were very few changes made to the vehicle design throughout its years of production. Famously, Henry Ford is claimed to have said, “You can paint it any color, so long as it’s black.”

In July 2008, 59 different vehicles were listed on the Ford website, including an entire family of brands: Ford, Land Rover, Lincoln, Mercury, Mazda, and Jaguar. In other words, Ford produced an immense variety of vehicles—available in more than one color. The same is true of other automobile producers. And, of course, such product variety means more than just a large number of models: any particular model may be available with all sorts of different styling, performance, and features. Interestingly, a visit to the Ford website in 2011 yields a different picture. There are Ford vehicles available, but the other brands are gone. Both Jaguar and Land Rover were sold by Ford in 2008, partly in response to the financial crisis. Over time, companies decide both to introduce and to remove models from their range of offerings.

Cars are not the only products that display such diversity. You can buy many different kinds of laptop computers, breakfast cereals, or mobile phones, for example. As economies grow and develop, we typically see an increasing variety of goods available. But product variety is particularly noticeable with cars because automobile producers come out with new models each year.

New model introductions began early in the history of the automobile. In the 1920s, Ford faced stiff competition from other producers, particularly GM. In the mid-1920s, under the leadership of company president Alfred Sloan, GM had adopted a strategy of introducing new models.This discussion draws on the history of automobiles at David Gartman, “Tough Guys and Pretty Boys The Cultural Antagonisms of Engineering and Aesthetics in Automotive History,” Automobile in American Life and Society, accessed March 14, 2011, http://www.autolife.umd.umich.edu/Design/Gartman/D_Casestudy/D_Casestudy3.htm. In part, the strategy came from recognizing that automobiles were durable goods that households kept for many years. The introduction of new models was a strategy to motivate the exchange of old for new cars. This strategy worked. Ford’s sales of the Model T fell off and, at the end of the decade, Ford also adopted the strategy of model turnover.

The tactic remains in place today. Each year, car companies introduce new models. In some years, they make radical changes, while in other years new cars do not deviate much from previous models. The design and production of new models is one element of the competition among automobile producers. Although we often emphasize price competition, producers also compete in terms of the attributes of their models. Thus competition is very complex.

## Plant Location

You have probably given little thought to why firms build factories in one location rather than another. But imagine for a moment that you must decide where to construct a new automobile plant. What kinds of factors might influence your decision?

You would certainly think about the cost of your inputs—that is, the items you need to manufacture new vehicles. Cars require substantial amounts of raw materials, such as steel, that have to be brought to your factory. If those inputs have to be brought in from a long way away, then your inputs will be more expensive. These costs depend also on the local infrastructure: are there good road and rail links to your prospective site? Another input, of course, is labor. Ideally, you want to locate your factory where labor is cheap but also sufficiently skilled for the positions you need to fill.

Once you have manufactured the cars, you have to get them to their final destinations: dealers throughout the country or even throughout the world. Because cars are large and heavy, they are expensive to ship to other locations. Thus, other things being equal, you would also like to locate your manufacturing site near your final demand. Of course, producers must usually serve many markets from a single plant.

Where you ultimately choose to locate the plant will depend on the costs of transporting both inputs and output. If your inputs are very costly to transport, then you will produce near the source of inputs and ship your finished goods to your markets. Alternatively, if your inputs are easy to transport but your output is costly to ship, then you might locate your production near some of your markets. You might even consider multiple production plants to lower the costs of transporting the final good.

You also care about local policies, such as the level of taxes. Countries, states, regions, and cities often compete to attract factories. They do so because a factory brings with it jobs and greater prosperity for a region. In some places in the world, you also have to worry about whether your property rights are well protected. If you set up a factory in the United States, you can be reasonably confident that the government will not try to confiscate either your capital or profits. In some other countries, however, you may justifiably be concerned for the safety of your assets.

The automobile industry in the United States was initially located in and around Detroit. This was partly due to the fact that access to the Great Lakes provided low-cost transportation of the necessary inputs into the production process. As time passed, plants began to appear outside the Detroit area, particularly in the southern part of the United States.

One of the factors motivating these location decisions was labor costs. The automobile plants in and around Detroit were dominated by a union, the United Auto Workers (http://www.uaw.org/node/39), which was formed near the end of the Great Depression. In the short run, firms must negotiate with the unions that represent its workers. In the longer run, though, firms have other options. One of them is to locate plants in areas with cheaper labor costs. Over time, firms have indeed shifted some of their production facilities to other parts of the United States and other countries around the world where labor is cheaper.

### Key Takeaways

• The price of a car is a markup over the marginal cost of production. The markup depends on the elasticity of demand.
• Car producers compete by introducing new models.
• Plant location choices are made in an effort to reduce the costs of production as well as the costs of transporting intermediate goods to a plant and finished goods to the market.