Decline in Auto Prices Due to both Supply and Demand

“We are slashing price to make room for the new models!” is a common advertising phrase, implying that a decline in price is caused by an overlap selling of different model years of the same car. However, this assumption comes under attack in Prices, Production and Inventories over the Automotive Model Year by Adam Copeland, Wendy Dunn and George Hall. In order to supplement that aforementioned demand decline theory, the authors examine the impact inventory management has on the declining price of cars. Examining both inventory management and demand caused decline theory, Copeland et. al explain at which point in the product cycle each theory is more dominant and influential.

Using US retail transactions from a sample of dealerships that offered prices and sales distribution by car type and model year and total sales in North America by country, model and production, car type and model year, the authors first ascertain how price, production and inventory move over the product life. Five critical facts appear:

1. Average monthly decline in price for a typical new vehicle is 9.2% annually.
2. Average vintage sells for 16.7 months, meaning there is an overlap of model years for almost six months
3. When two model years of the same vintage have overlapping sales, the old vintage sells for 8.8% less than the new vintage.
4. Sales and inventories are hump shaped over the model year with average inventory/sales of 76 days
5. Holding all else constant, higher inventories are correlated with lower retail prices.

With this empirical data, the authors are able to create a market equilibrium and to find the demand curves for different cart types when model year overlap exists and how those demand curves shift during the model year. Cross-price elasticity assesses consumer preferences between different model years of the same car. The results of small cross-price elasticities indicate that consumers don’t consider different model years of the same car substitutes. When two model years are available, consumers are more sensitive to prices. This helps explain part of the demand decline during the second half of the product cycle as the new model year becomes available. During the second half of the model year is when the most significant shift in the demand curve occurs, going leftward, indicating decreased demand.

Assuming the demand curve as set, the authors create a model that allows automakers (OEMs) to maximize profits by changing production and inventory. While OEMs can only produce one car type at a time, inventory allows for the overlap selling of different model years. Because consumers wish to immediately drive away in their new car, dealerships must have a full inventory. To deal with the consumers’ demands, dealerships raise the price at the beginning of the product cycle in order to lower sales because the dealer hasn’t yet built any inventory and doesn’t have the ability to allow consumers to drive away in the desired car. As the dealer begins to build inventory in a “build-to-stock” inventory management, the supply curve shifts rightward during the early part of the product cycle as dealers get the cars they need to allow consumers the on-the-spot buy and receive deal they want.

Although dealers claim prices are lowered due to the introduction of a new model year, Copeland et. al discover that the build-to-stock inventory management actually contributes to the price decrease. With inventories increasing in the first six months of the product cycle, supply shift dictates the first price decline. However, in the second half of the product cycle, sales begin to decline and the new model year enters, leaving a demand shift to influence the price decline then. The price decline is a combination of inventory and consumer preferences.