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

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

2. 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

3. Market Shares (cars):

4. Market Shares (cars and trucks):

5. Car/Truck sales 2000 to 2005:

6. Techniques for moving inventory: • Interest-rate incentives • Cash-back incentives • Employee-pricing incentives • Leasing incentives • Value pricing

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

8. 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

9. 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)

10. Historical Trends in Leasing Shares

11. 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

12. 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

13. 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

14. Indirect Utility Function (for consumer i) Vm|am = Indirect utility of vehicle m conditioned on acquisition methodam BLm = Brand Loyalty to m BPm = Brand Preference to m Xm = Vector of attributes of m Z =Vector of consumer attributes

15. 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)

16. 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

17. 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

18. Model Structure

19. Nested Logit Formulation: Conditional type-choice models

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

21. Nested Logit Formulation: Unconditional Cash/Non-Cash Model

22. 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

23. 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)(+)

24. 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) (-)

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

26. 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

27. 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

28. 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

29. 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)

30. 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

31. What has driven growth in leasing? • Income of top 5% of households grew 17% from 1990-95 (compared to median income stagnation)

32. 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

33. 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)

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

35. 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%

36. Total Actual vs. Predicted Lease Shares

37. 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

38. 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