The Automotive Industry and the Dynamics of Consumer Demand: The case of automobile leasing Fred Mannering

The sad state of US automakers:  Declining market share  Non-competitive products  Retirement /health care liabilities  The supply-chain squeeze  Undesirable product mix  Reliance on high profit SUV/Trucks

Market Shares (cars):

Market Shares (cars and trucks):

Car/Truck sales 2000 to 2005:

Techniques for moving inventory:  Interest-rate incentives  Cash-back incentives  Employee-pricing incentives  Leasing incentives  Value pricing

Outline:  Background on leasing growth  Structure of the leasing-demand model  Data  Leasing-model estimation results  Profit maximizing industry model  Implications of findings

Why has leasing grown?  Leasing is the correct economic decision  Manufacturers prefer and have promoted leasing  New vehicles have become too expensive to buy  Consumers do not want to hassle with vehicle disposal  Leasing allows consumers to upgrade their vehicles  Leasing offers protection against reliability risks

Recent car add promoting leasing:  Drive new every 3 years  Never have negative equity  Never have a trade-in hassle  Always in warranty  Guaranteed purchase price  Gap protection (many leases cover difference between amount owed and vehicle value in case of total loss)

Historical Trends in Leasing Shares

Leasing growth – Study Approach:  Based on Mannering/Winston/Starkey  Survey consumers’ vehicle ownership history and acquisition methods (cash, finance, or lease)  Estimate a disaggregate econometric model of acquisition method and vehicle type choice  Develop a profit-maximizing model of manufacturer behavior and forecast future trends in vehicle leasing

Data:  654 households buying new cars and light trucks in 1993, 1994, 1995  National household panel (National Family Opinion, Inc.)  Vehicle attribute data from various sources

Disaggregate Vehicle-Choice Modeling  Utility maximizing model of the types of vehicles to own  Numerous applications since the late 1970s addressing a variety of vehicle related issues  Most often multinomial logit or nested logit to take advantage of consistent parameter estimates when sub-sampling alternatives

Indirect Utility Function ( for consumer i ) V m|am = Indirect utility of vehicle m conditioned on acquisition method am BL m = Brand Loyalty to m BP m = Brand Preference to m X m = Vector of attributes of m Z = Vector of consumer attributes

Advantages of Disaggregate Modeling:  Can account for high level of detail in vehicle attributes and consumer characteristics  Can draw inferences from marginal rates of substitution and elasticities  Can compute changes in consumer welfare (Small/Rosen 1981 Econometrica)

Potential modeling problems:  IIA violations if a logit model is used – can be tested and resolved with nesting  Accounting for Brand Loyalty – Lagged variables give issues of state dependence vs. unobserved heterogeneity  Price elasticities can be problematic in the presence of unobserved heterogeneity

Past brand loyalty measures:  Accumulated mileage on same-make vehicle (Mannering/Winston, 1985 Rand paper)  Number of consecutive same-make purchases (Mannering/Winston, 1991 Brookings microeconomics paper)  Previous same-make purchase

Model Structure

Nested Logit Formulation: Conditional type-choice models

Nested Logit Formulation: Finance/Lease Model (conditioned on choice of non-cash)

Nested Logit Formulation: Unconditional Cash/Non-Cash Model

Conditional Type-Choice Models: Variables Common to lease, finance and cash models:  Horsepower, turning radius, consumer reports’ repair index, expected operating costs, vehicle class indicators, brand preference variables, price, passenger airbag

Conditional Type-Choice Model - Lease:  Expected residual value after 3 years (+)  Loyalty (number of previous repeat purchases of the same brand) (+)  Loyalty (number of previous repeat leases of the same brand) (+)

Conditional Type-Choice Model – Finance:  Expected residual value after 3 years (+)  Loyalty (number of previous repeat purchases of the same brand) (+)  Loyalty (number of previous repeat leases of the same brand) (-)

Conditional Type-Choice Model - Cash:  Expected residual value after 3 years (+)  Loyalty (number of previous repeat purchases of the same brand) (+)

Findings suggesting upgrading:  Willingness to pay for luxury items higher in lease model than finance model (determined from MRSs) – more on this later  Negative lease loyalty in finance model

Conditional Acquisition Model - Lease/Finance:  Higher income, higher debt, higher education all increase propensity to lease  Expected miles driven over 12,000 decreases propensity to lease

Acquisition Model – Cash/Non-Cash:  Higher education and owning a home increase propensity to pay cash  Higher debt and annual miles driven decrease propensity to pay cash

Elasticities and Willingness to Pay  Income elasticity of leasing increases with income (0.82 at $75K, 1.43 at $125K)  People who lease have higher willingness to pay for luxury items (horsepower, vehicle size, passenger- side airbags)

What has driven growth in leasing?  Vehicle upgrading behavior and large real income growth in upper income groups  Close-end leases and other improvements in leasing contracts (model year indicators)  Habitual behavior/familiarity

What has driven growth in leasing?  Income of top 5% of households grew 17% from (compared to median income stagnation)

Alternate explanations:  Changes in new vehicle prices – negligible in real dollars  Changes in vehicle quality – improving quality so leasing not likely being used to minimize uncertainty  Dealer’s behavior – no evidence  Tax advantages – none to speak of  Vehicle usage – increasing, so mileage limits remained a leasing barrier

Profit maximizing industry model:  Manufacturers set differential leasing and purchase prices to maximize profits  Profits maximized on a 3-year discounted time horizon (current prices affect future profits through brand loyalty and acquisition method)

Profit maximizing industry model (continued):  Manufacturers behave in a Cournot- Nash fashion (other manufacturers’ prices given)  Forecasts made from 1996 to 2004

Forecasting results:  Manufacturers should have raised their real lease prices an average of 17% by 2005 (assuming real cash/finance prices remain constant)  Average percent increase: GM 16%, Ford 21%, Chrysler 14%, Honda 16%, Nissan 21%, Toyota 14%, European 23%

Total Actual vs. Predicted Lease Shares

Summary:  Acquisition method and vehicle type choice can not be viewed separately  Growth in leasing has been fueled combination of factors - models suggest upgrading and income growth  Market dynamics indicate that leasing will not grow significantly in the future

Short-term strategies for US manufacturers moving product:  Leasing incentives? Downside risk on residual values  Rebates/incentives? Risk consumer burnout  Value pricing? Cold consumer response so far  Hope for favorable macroeconomics? Cheap fuel, low interest rates