Mike Stevens | Mar 5, 2009

Right then, who’s up for an experiment in the name of scientific discovery and intellectual edification? Come on.

It really is uncomplicated - all you need is a rubber band (and you can nick one of those from just about any unsuspecting schoolgirl).

Step 1: Double up the rubber band to give it some strength and stretch it till it’s taut; pull it right back till it’s ready to snap.

Step 2: Find a nice fleshy part of your body. A cheek or the inside of your thigh will suffice quite nicely for this experiment.

Step 3: Be strong now. Bring your loaded rubber band as close to the skin as possible. And fire.

The pain you have just felt is what an economist would call an ‘elastic’ response. Hurts doesn’t it? Elastic responses are that way – very sensitive.

Now if you were tempted to cheat at the last moment and failed to stretch the band like I had instructed, the resulting thwack would have left you with considerably less pain. That would have been an ‘inelastic’ response.

Naturally I jest, but the point I want to make is rather germane to what is happening in the automobile now, and, indeed, what I see happening in the near future.

Here is the idea in a nutshell: The ‘income elasticity of demand’ for cars will dictate car design, the portfolio of cars that manufacturers offer, the way they are marketed and the course of technological evolution.

Now let’s break it down. The ‘income elasticity of demand’ is a measure that essentially tells us how the demand for cars behaves when incomes change.

If it is positive it would suggest that increasing incomes lead to an increase in demand for cars. If it is positive as well as large, it would be a luxury item because people buy disproportionately more luxuries when they are wealthier.

aussie-money1

However, the converse holds true for such items when their incomes fall. Their demand also falls disproportionately compared to the fall in income. Response to luxuries is elastic.

Let’s take manufacturers (divorced from parent companies) that exclusively produce luxury cars. Maserati, Ferrari, Bentley, Lamborghini, Rolls Royce and Maybach will suffice for our example. And let’s consider the US market where the recession’s impact on the automobile industry is most palpable. In the year to February the recession hit these luxury manufacturers, without exception, disproportionately more than the overall segment of passenger cars.

Ferrari and Rolls were the best performers of the lot and Maybach and Lamborghini suffered the worst. But, they all suffered off-the-bottom-end-of-the-charts sales figures that outstripped the already alarming YTD -37.4 percent dip in sales for passenger cars taken as a whole.

Each one suffered the sting of a tightly wound up rubber band.

Not so with regular goods and, especially, necessities. Naturally their demand increases and decreases with income changes too, but rather more conservatively compared to luxury goods.

Let us just take manufacturers that exclusively produce cars that can be classified as largely ‘necessities’. Kia and Hyundai both registered modest but, crucially, positive growth in their sales in the US bucking the negative trend.

Even Volkswagen, which admittedly hardly offers up only necessities, ‘enjoyed’ negative growth that was barely half the pathetic performance of the entire segment.

bentley_continental_gt_diamond_seriesNow we come to the idea of the portfolio of cars manufacturers offer. This discrepancy between luxury cars and necessary ones is further exaggerated by the fact that there is a pecking order in cars and therefore every car suffers from the ‘inferior good’ problem.

As incomes rise and consumers buy cars higher up on their desirable cars list, sales of the ones that they abandon suffer since they are ‘inferior’.

While it is true that one man’s inferior car is another man’s luxury, no manufacturer wants to be placing products in that blackhole where income rises see consumers buying cars that are clearly superior to their model.

Conversely when incomes are falling and consumers are moving down their list, manufacturers want to be able to cater to their more modest needs too.

This is where the portfolio of cars on offer is crucial. Porsche is a good example in this regard and it was able to do somewhat better than average in the past year in spite of its image as a luxury brand.

From the Boxster to the GT2 the range is so finely segmented (and getting increasingly more so) that sales are much less susceptible to being decimated by changes in consumer income. Especially when you consider that its 911 advertisements in magazines these days seem to be touting emissions and economy stats much more frequently than 0-60 and 400m times.

Generally, income elasticity to demand for fuel is less elastic than to cars, which means that marketing a range of cars that uses less of the stuff reduces the ‘income elasticity’ consumers would have to the cars as well.

Simple logic really.

citroen_4007I read an article recently that fawned over the brilliance of the mainstream French manufacturers in these times. It averred that they offer sensibly sized, excitingly designed, emotively inspired cars that are also efficient and economical.

I see exactly where that sentiment is coming from, but it misses the point. The reason they have done relatively well is less attributable to their philosophy and more to the simple fact that they (chiefly) populate that spectrum of the market where declines in incomes are less painful but increases in it would be.

Even Smart, after all, was the star student in the US class of 2008 – actually it was rather like Einstein would be in a classroom full of inebriated apes. It recorded a more than 80 percent growth in sales YTD where the next best was Hyundai with less than 4.5 percent.

The message is simply that income elasticity works both ways.

It is easy for any given manufacturer to look good when the income trend is such that hordes of consumers are abandoning rivals and running into its showrooms.

The real trick is to prevent them from buggering off when the trend reverses. Subcompact car offerings from Audi, BMW, Alfa, Ford, Toyota, Mitsubishi and Nissan is less simply a sign of times and more a proof that it is actually diversification that eases the pain of a rubber band that can be stretched both ways.

Source for data: Motor Intelligence

Prateek is a Lecturer at the Deakin Business School in Melbourne

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