Description –
The economic downturn of late 2008 presented numerous challenges to many businesses across a span of different industries. The auto industry was one area that was particularly affected mainly because they have been having so many problems in the years leading up to that point. The phrase “bigger is better” reflected the popularity of many vehicles sold throughout the 1990s and early into the new millennium. Big, hulking SUVs dominated the streets and highways in all parts of the country. This idea started to change as fuel prices started to rise. People then started to realize that the large cars they had taken such pride in at one time were becoming more and more expensive to own as it cost more to fuel and maintain them. The industry shifted to smaller, more fuel efficient models in order to save money.
Background – “Give me more. Bigger is always better. Everything is bigger in Texas.” Sentiments like these do well to describe the thinking of American’s as a culture. We like big houses, big meals, big TVs, and big cars. “The trend toward more powerful engines, the shift to trucks and greater luxury, offset the technical gains that we've made in fuel economy," said John DeCicco, a senior associate for the American Council for an Energy Efficient Economy, a nonprofit research group that has become a lonely voice of conservation these days. (Peters, 2005) Mr. DeCicco’s comments in an article written back in 1995 highlight the increased demand for large cars during that period. He states “Call it Cherokee madness or Bronco fever.” One symptom was that many drivers said they were not as concerned about the higher cost of driving. There was a shift in the use of rugged vehicles from just outings like camping trips, but also for regular daily tasks such as running errands and commuting to and from work. "I haven't looked at gas mileage in the last five years," said Richard Meyersburg, as he had his hulking Chevrolet Suburban filled with Exxon Plus, the middle grade of gasoline, at $1.31 a gallon at the Exxon station in Tenafly, N.J. "It gets us up to our house in Vermont on one tank load. That's my barometer." (Peters, 2005) This statement coming from a man that uses his Suburban, a utility vehicle with a V8 engine, to commute 10 miles to and from work. When looking at the price of fuel during this period, it makes some sense why many Americans did not worry about how much they spent. When looking at the price per barrel of oil through the 1990s into the early years of the 2000’s the trend for the most part was that prices were low, well under $40 per barrel. Reference the chart below.
*** Graph derived from US Government Accounting Office
You can see that after a spike in 1990, coinciding with the invasion of Kuwait that started Operation Desert Storm, that the price of oil held below that $40 per barrel price through the remainder of the decade. At one point, prices fell as low as $16 per barrel. How did this equate to the per gallon cost? The chard below derived from data acquired from the department of energy shows that costs held between $1 and $1.50 through 1999. This gave way to the rise in popularity of larger, more luxuriant, yet less fuel efficient vehicles such as the SUV.

*** Graph derived from US Government Accounting Office
SUVs (Sport Utility Vehicles) have been around for decades, but until the early 1990s they appealed mostly to outdoor enthusiasts who wanted the four-wheel drive capability typically offered in SUVs to access remote destinations. But after Ford Motor Co. introduced its popular Explorer in 1991, sales of SUVs skyrocketed, from less than a million a year to 3 million in 2002. In the past decade, SUVs — along with minivans — have essentially replaced the station wagon as the suburban car of choice in America. The SUV is available with engine sizes ranging from 1.6 to 6.5 liters, curb weights from about 2,700 pounds to over 5,500 pounds, and price ranges from under $14,000 to over $65,000 (1999 models). During the 1990s, sport utility vehicles became the fastest growing segment of the auto industry. In 1999, SUV sales reached almost 19% of the total light vehicle market and the mix of SUVs on the road was about 8.7%. (Davis, 2000) Some has called this popularity a passing fad, but the continued increases in SUV sales seem to indicate a more permanent trend. There were a number of factors that could best account for the rise in popularity of the SUV. These included: * a sign of economic wellbeing – the percentage of total household expenditures for vehicle purchases and fuel costs has remained almost constant, as the available income has increased in the 1990s, * a perception of safety – the size of the vehicle and its greater visibility give a perception of safety, and * “utility” – the average U.S. citizen is more mobile than ever; the SUV combines the hauling/towing power of a pickup truck with the roominess and seating capacity of a minivan.
This idea changed around 2003 as fuel prices started to rise drastically. Depending on where you lived, fuel prices continued to rise well past $3 per gallon in some areas. Suddenly demand for more fuel efficient models was on the rise and hybrid vehicles were among the most sought after. A hybrid electric vehicle (HEV) combines a conventional internal combustion engine (ICE) propulsion system with an electric propulsion system. (Szczesny, 2008) The presence of the electric powertrain is intended to achieve either better fuel economy than a conventional vehicle, or better performance. A variety of types of HEV exist, and the degree to which they function as EVs varies as well. The most common form of HEV is the hybrid electric car, although hybrid electric trucks (pickups and tractors) also exist.
Demand and Supply – Demand is the rate at which consumers want to buy a product. Economic theory holds that demand consists of two factors: taste and ability to buy. Taste, which is the desire for a good, determines the willingness to buy the good at a specific price. Ability to buy means that to buy a good at specific price, an individual must possess sufficient wealth or income. Both factors of demand depend on the market price. When the market price for a product is high, the demand will be low. When price is low, demand is high. At very low prices, many consumers will be able to purchase a product. However, people usually want only so much of a good. Acquiring additional increments of a good or service in some time period will yield less and less satisfaction. Willingness and ability to supply goods determine the seller’s actions. At higher prices, more of the commodity will be available to the buyers. This is because the suppliers will be able to maintain a profit despite the higher costs of production that may result from short-term expansion of their capacity. In a real market, when the inventory is less than the desired inventory, manufacturers will raise both the supply of their product and its price. The short-term increase in supply causes manufacturing costs to rise, leading to a further increase in price. The price change in turn increases the desired rate of production. A similar effect occurs if inventory is too high. (Baye, 2009) SUV demand relates to the demand concept of substitution. Substitution theory states that as the price of one item increases, the demand for an alternate item (or substitute item) will increase. Consumers are replacing one item for another. Think of the price of fuel and the demand for SUVs. As the price of fuel increase, demand for less fuel efficient SUVs would decrease. At the same time, the demand for more fuel efficient vehicles increased. While not related to the direct cost of the SUV or hybrid vehicle individually, the relationship is there. In May of 2005, GM reported a strong (over 7 percent) decrease in sales of their SUV models. At the time, GM’s top sales analyst stated that the high gas prices were directly responsible for the sharp decrease in demand in the number of SUVs that Ford sold that April. (Peters, 2005) During this same period, Toyota reported that sales were up 21.3 percent on big gains in passenger car sales. This was led by the Prius, which is a gasoline-electricity hybrid. This is a slight alteration from the classic description of substitution in that the price of the vehicles themselves does not have as much of a direct impact upon the demand. In fact, the prices of hybrid models were between $4,000 and $7,500 more than their non-hybrid counterparts. (Peters, 2005) Despite this fact, Toyota had a particular problem with providing the appropriate supply to help meet demand. In 2005, roughly a year after Toyota reported their sales increase, they sold less of the same models than they did the year before. The blame was on supply shortages for sales declines on Toyota Prius and Honda Civic hybrids in April of 2005. “We sold down our inventory. We're down to a two-day supply," says Toyota U.S. President Jim Press. "The fact is demand has never been higher." The normal process was that Toyota would order the motors from the manufacturer and assemble them within here within the states. The shortfall came from Toyota’s inability to order the motors as fast as demand required. As a result, waits for a new Prius ran up to a couple of weeks at Rice Toyota in Greensboro, N.C., and up to four months at Toyota Santa Monica, Calif. (Woodyard, 2006)
Individual Behavior –
Consumers face trade-offs in their purchase decisions, since their income is limited and choices are numerous. In order to make choices, consumers must combine budget constraints (what they can afford), and preferences (what they would like to consume). If a consumer equally prefers two product bundles, then the consumer is indifferent between the two bundles. The consumer will get the same level of satisfaction (utility) from either combination of products. Graphically speaking, this is known as the indifference curve. This curve shows that all bundles are equally preferred, or have the same utility or same level of satisfaction. The slope of indifference curve is the rate at which a consumer is willing to trade one good for another, which is also known as the marginal rate of substitution (MRS). (Baye, 2009)
Think of the relationship between consumer preferences and their budget constraints as it related to hybrid cars. The relationship here is that consumers want to drive longer for the amount of money they are spending on gasoline. To properly display this, let’s setup a practical observance of facts. A basic 2010 Ford Expedition has a fuel capacity of 28 gallons. Ford specifications state that an Expedition can travel 14 miles per gallon (mpg) and up to 20 mpg on the freeway. (Ford Expedition Specifications, 2010) A 2010 Toyota Prius, on the other hand has a fuel capacity of 11.9 gallons and can travel an estimated 51 mpg in the city and 48 mpg. (Toyota Prius Specifications, 2010) Currently the least expensive price of gasoline in my local area is $2.59. If I were to fill up an Expedition, it would cost roughly $72.52. This would provide me roughly 392 city miles and 560 miles of freeway driving. By comparison, filling up a Prius would cost $30.82 and would give me 606 miles of city travel and 571 of freeway travel.
Graphically, this relationship between amount spent and mpg might look like the graph below. Along the left side is the fuel amount and along the bottom is overall mpg.

**Graph self generated
Note the diagonal line which represents the average consumer’s budget line. The graph represents the amount of gasoline that a consumer can purchase and the amount of mileage (MPG) that the can expect. The curved line, also known as an indifference curve that touches the budget line at point A represents the amount of gas and mileage that can be expected with an SUV. The indifference curve that touches the budget line at point B is the amount of gas and mileage that can be expected with a hybrid vehicle. Figuring that the budget line remains constant, as well as the price of gasoline remains unchanged, a consumer can see that they can get more mileage out of less gasoline needed. As the price of gasoline changes, it will adjust the budget line to turn either higher or lower. However, the relationship will remain the same among the two indifference curves.
Government Intervention and Production Costs–
The government has made a number of efforts to help improve fuel efficiency. This started in 2005 with the Bush administration’s recommendation to overhaul the fuel economy standards that businesses must comply with. These mandates put into effect six rules for mpg requirements. (Szczesny, 2005) These rules were met with a lot of criticism by experts because of the sliding scale nature for light trucks, vans, and SUVs. Groups like the Sierra Club say the rules would have the perverse effect of encouraging carmakers to bulk up vehicles so they would fall under more lenient m.p.g. standards. Automakers such as Ford and GM might even be tempted to give up building small cars altogether because they would no longer need them to improve their overall fuel-efficiency numbers. In 2008, the US Department of Transportation proposed to increase the minimum mpg ratio for both passenger vehicles and light trucks would have to increase by 4.5 percent each year over a five-year period ending in 2015. (Szczesny, 2008) This was considered an ambitious proposal seeing that the current proposal made by congress was only a 3.3 percent increase in mpg. The DOT’s proposal would boost the fuel-economy standard for passenger cars from the current 27.5 miles per gallon to 35.7 miles per gallon by 2015. For light trucks, the DOT proposal calls for an increase from 23.5 miles per gallon in 2010 to 28.6 miles per gallon in 2015. (Guilford, 2010)
Government intervention such as this would have a great affect upon how a company would operate. It lays out goals that mangers must comply with otherwise they would be imposed a fine. In order for them to comply with the new rules they will need to depend upon new and unfamiliar technology. However, most automakers would look at this situation summarized by the statement "technology costs money." In order for an auto company to change their inventory, some of the factors involved would include finding ways to reduce overall vehicle weight as well as the developing and producing a newer engine. There are a number of different types to include gasoline-electric hybrid, fully electric, and alternative fuel types such as biodeisel. These costs can add up in terms of average total costs as well as marginal costs depending upon the route they take. The concern that many automakers have is that the increased production costs would need to be passed on to consumer which may hurt demand. The EPA has said that technology required for fuel economy improvements will raise vehicle prices an average of $1,300 by the 2016 model year. Sandra Stojkovski, president of See More Systems consulting firm think that estimate undershoots the actual costs. Her estimates place the sticker of a compact car will go up $1,800 to $2,000. She also thinks that price of a mid-sized car is likely to increase $4,500 to $6,000. Lastly, she states that outfitting a full-sized pickup with a diesel, rather than a gasoline-powered V-8, and other new equipment could cost as much as $9,000. (Guilford, 2010)
Conclusion – The steps that are being taken to make the vehicles we drive more fuel efficient will have a big impact upon our lifestyle as well as our economy. The managers within the auto industry need to understand both the factors that have driven these changes, and the affects that these changes will have upon both the economy as well as the industry. Right now, hybrid cars are leading the change with its popularity. However, its creation has created an arms race among manufacturers to design the most advanced hybrid technology. No matter the engine type, this same pursuit must be taken across the board with all managers.
References –
Baye, Michael R. (2009). Managerial Economics and Business Strategy 6th Ed. McGraw-Hill Irwin

Davis, Stacy and Truett, Lorena. (2000) An Analysis of the Impact of Sport Utility Vehicles. Center for Transportation Analyisis. Published August 2009. Accessed 9 May 2010
Guilford, D. (2010). For new CAFE, automakers place high-stakes tech bets. Automotive News, 84(6404), 1-25. Retrieved from Business Source Premier database
Ford Expedition and Expedition EL Specifications (2010). Ford Vehicles Online. Accessed on 11 May 2010. http://www.fordvehicles.com/services/cars-proxy/NGBS/Nameplate_SpecificationLiteDoc/Nameplate_SpecificationLiteDoc_8801EF28-3EBE-B257-A941-FCEDA941FCED.pdf
Motor Fuels: Understanding the Factors That Influence the Retail Price of Gasoline. US Government Accounting Office. Published May 2005. Accessed 9 May 2010
Peters, Jeremy (2005). Car sales in the U.S. show SUVs lose appeal. The New York Times Online. Published 5 May 2005. Accessed 8 May 2009. http://www.nytimes.com/2005/05/04/business/worldbusiness/04iht-auto.html?_r=1&scp=9&sq=Demand%20for%20SUVs&st=cse
Salpukas, Agis (1995). As Rugged Vehicles Take to the Streets, Gas Prices Take Off. The New York Times Online. Accessed 8 May 2009. http://www.nytimes.com/1995/06/25/us/as-rugged-vehicles-take-to-the-streets-gas-prices-take-off.html?scp=32&sq=gas+prices&st=nyt
Szczesny, Joseph. (2005) Fuel Efficiency: Target: Guzzlers. Time Magazine Online. Accessed on 12 May 2010. Published 29 Aug 2005. http://www.time.com/time/magazine/article/0,9171,1098934,00.html
Szczesny, Joseph. (2008) Washington to Shrink US Cars? Time Magazine Online. Accessed on 12 May 2010. Published 23 Apr 2008. http://www.time.com/time/nation/article/0,8599,1734637,00.html
Toyota Prius Specifications (2010). Toyota Online. Accessed 11 May 2010. http://www.toyota.com/prius-hybrid/features.html
Woodyard, Chris (2006). Lack of Supply Reduces Hybrid Sales. USA Today Online. Published 9 September 2006. http://www.usatoday.com/money/autos/2006-05-09-hybrid-shortage-usat_x.htm