I spent an entire summer selling cars (July 4th is a good weekend to buy cars). I sold Hyundais, at a local dealership in Kentucky. I really enjoyed it, but it was a big time investment. I was on the car lot all the time – morning, night, weekends, weekdays – selling, selling, selling.
I learned a lot about myself during that time. I am an INTJ (fellow introverts, hello!) and I was pushed OUT of my comfort zone. I had to go up to people… shake their hand… and talk to them… everyday, for hours. I quickly realized that I would have to adapt.
Car sales is economics (everything is). It is one of the few businesses that still uses the negotiation technique, rather than listing a set price that customers can buy at (usually). The entire business is focused on one goal: get that customer in a car.
In economics, one of the first things that we are taught is that incentives matter. People have to be enticed to do things – otherwise, they won’t do them. It’s the same in car sales – you have to incentivize people to purchase your product.
In car sales, this is achieved through bargaining. The goal is for both parties to be better off – utility for everyone: dealership gets some profit, and the customer gets a car.
However, there are conflicting interests.
The Process of Negotiation
This creates the “Zone of Possible Agreement”:
As you can see, a seller wouldn’t sell a particular car for less than $13,000, but the buyer won’t buy for more than $16,000. So the space of bargaining is separated by the reservation points of both the buyer and the seller (between 13k and 16k). If the reservation point of the seller was the same as the the target price of the seller, there could never be an agreement.
But because in car sales, we know that we hardly ever get people to agree to our target price, so we always have a reservation point that is relatively reasonable.
But there is also asymmetric information in car sales – the dealer and the salesperson know more about the process than the customer does, and this can be leverage in the sales process. This also tends to be the reason that people dislike car salespeople.
But this asymmetric information often leads to expensive bargaining costs and inefficiencies. People get upset, they leave, and that’s tough on both the customer and salesperson.
The customer then has to continue their hunt for a car, which increases their search costs, and the dealership loses out on a sale, which reduces revenue.
But in the long run, car sales operate the way that they do because of elasticity. The law of supply and demand is as follows – there is an equilibrium price that is satisfied for both buyers and sellers.
Elasticity measures the size of response to this price change. Because car buyers spend a large portion of their income on cars, they are more responsive to price changes. Despite there being substitutes for cars (buses, bikes, walking) most cities in the United States require some sort of personal automobile to really thrive (read my rideshare report for an in-depth look at this).
In the short run, the demand for cars are elastic. People are very responsive to changes in price, and will postpone their purchase until they feel like they can get a better deal. In the long run, car sales become inelastic – that is because when the family van does finally run down into the ground, buying a new car becomes essential.
But seller responsiveness to price changes depends on four things:
- Storage Costs
- Adaptability of Production Process
- Resources Costs
The cost of storing goods impacts the firm’s responsiveness to a change in price, because if goods are expensive to store (like cars are) the dealership is going to be less responsive, because they want to offload product.
Time is also very important – in the short run, car dealerships are limited to the current amount of inventory that they have on the lot due to purchasing constraints, and the primary goal is to offload it quickly. The more time that they have, the more that they can respond to price changes.
If the production process can be easily changed, then the size of the firm’s response will be smaller than it would be if it took forever to readjust things. For cars, it tends to be a matter of economies of scale – how can they apply existing infrastructure to build out the vehicles?
Finally, if resource costs are high (think aluminum, glass, rubber etc), then the cost of increasing output would be expensive as well, and impacts price.
For a car dealership / manufacturer, all of these things are expensive. The production process is not that adaptable (or something that they directly control), and the resource costs for most cars tends to be pretty high. That reduces the flexibility of the dealership’s response to a price change.
Overall, the price elasticity of supply in the automotive world tends to be pretty low. Because of the high costs of production, and the high costs of the materials that go into production, coupled with the storage costs, makes it so car dealerships don’t have much flexibility to respond to prices. In the long run, they are a bit more responsive because they have more time to make changes, but the response to price changes tends to be pretty inelastic.
The Opportunity Costs of Car Sales
Car sales have been down YTD due to the pandemic, tighter budgets, and less driving, as shown below. The average YTD change is -25.031%. Compared to this month last year, sales are down an average of -18% with Lincoln (?), Mazda, and Volvo in the green.
When I sold cars back in June – August 2017, June was a tough month. When you sell cars, you need customers, and for whatever reason, no one wanted a car that month.
There was an opportunity cost – every second that you go after one customer, you potentially lose other deals. As a salesperson, I had a unique relationship with this – I would spend hours with a customer, only to have them say “Thanks for all the information!” and then walk off the lot, and go buy somewhere else.
That was lost hours for me and the company, and a lost opportunity for me to spend time with another customer.
I had to begin conversations by ranking my customers in order of cost – that is, who would hold the least amount of opportunity cost for me – who seemed the most likely to buy? I would ask customers, “do you plan on purchasing a vehicle today or within the next month?” and depending on their answer, as well as their time frame, would depend how much of my time I would allocate to them on that day.
Of course, I would make time for those who had questions or were out of the time frame too.
The store had to do the same thing with designing marketing materials – ~$600 per unit spend.
Most of the time, customers were concerned with three things: price, performance, or plush (car aesthetics).
- Price is how much the car costs – a lot of people are concerned with price. Car dealerships can incentivize sales by offering low rates of interest, low monthly payments, or a low down payment – or taking the overall price down.
- Performance is harder to incentivize, and not as many people are interested in this aspect (at least for Hyundai’s). This is essentially how fast the car goes, and other specs. If this was a key interest for a customer, we could offer a free fuel economy upgrade or engine inspection to help the purchase.
- Finally, the plush or the luxury of the car. In every car, there are base models, and customers can upgrade from there. If a customer wants more features, you have to pay more, but a lot of people do like the heated seats or automatic dimming lights.
Our advertisements and resources were designed around this. How do we incentivize customers on price, performance, and plush?
There is a model of consumer preferences that are built in here:
Transitivity: if a customer preferred a Hyundai Santa Fe over a Hyundai Tucson, and a Hyundai Tucson over a Hyundai Accent, then a customer would prefer a Santa Fe over an Accent
Completeness: Customer is capable of determining a preference or indifference for all bundles
Non-satiation: they normally would prefer a car with more features than a car with less features if the cars were the same price (in some cases, however, this was not true)
We want to get customers to their highest indifference curve. We had to show them how they could get the greatest amount of utility to get to that indifference curve inside their personal budget constraint. This is determined by the tangency of the indifference curve to the budget line.
To get to that point of tangency, we had to, in theory, figure out the customer’s marginal rate of substitution. So considering “All Other Goods” versus “Cars” it was very important to find out how much a customer’s tradeoff preference.
Basically, we had to find out their budget and make sure we didn’t put them on a car that was too expensive or too fancy or too inexpensive or too old.
Most customers come in knowing what kind of car they want, but a lot of times it is outside their personal budget constraint. It was important to keep customers on that constraint (back down to reasonable prices), otherwise, they wouldn’t be able to purchase the vehicle from a lack of resources.
The automobile industry qualifies as an oligopoly according to Ricardo Falter’s “The Effects of Oligopoly in the US Automobile Sector on Pricing and Development”. Essentially this means that there are a limited number of sellers. The product that the sellers are selling are essentially the same – automobiles.
The automobile industry is actually a great example of an impure oligopoly. There is a lack of competition across the board, as the product they sell doesn’t have many substitutes, and there is a fair amount of product differentiation.
Final Thoughts: Car Sales are Changing
My 2017 summer was an analysis of the ‘science of car sales’ for me. I was an introverted finance nerd, trying to sort out how to talk to people about one of the most important purchases of their lives. It was a privilege to learn, and framing it in my econ brain helped me quite a bit.
Overall, selling cars is complicated. The industry is changing (carvana, uber/lyft as subs), so the whole process of negotiation is changing too (especially with Kelley Blue Book and other forms of information transparency). It will be interesting to see how dynamics continue to evolve, and if the above factors remain in place for much longer.