Car markets

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Markets are generally thought to work well. Changes in the relative prices of goods serve to create signals and incentives to which firms and consumers respond, allocating resources to where they produce the most utility. I These principles can easily be applied to car markets. At the time of the extracts, for example, there was a large drop in the market for new cars, especially luxury ones, due to the global economic downturn. New cars are a normal good, such as a decline in income sees a fall in demand for them.

More than that, they are likely to be income elastic, with demand falling more than proportionately in response to any fall in income. This is because consumers can keep their existing cars for longer, or turn to public transport, in order to spend more of their limited income on necessities during difficult periods. This effect was reinforced during the economic downturn by a lack of availability of credit with which to finance car purchases.

It is part of the way that markets work to allocate resources that the excess supply created should put downward pressure on price, reducing the price of cars relative to other goods, and also reducing the profit margin on each car supplied for a given cost of production. This incentivises producers to cut back on car production, with resultant job losses in the industry. I It is also a knock-on effect that prices of used cars, a substitute for new cars, should fall during such a period.

As downward pressure on the price of new cars leads to an extension of demand for them, the demand for used cars will fall at each and every price level, leading to a price fall to enable the market to clear. The process above describes the smooth working of a market, and for government intervention to be justified in the car market, there would have to be market failures present. It is possible to argue that the unemployment generated in the car industry during the global downturn is a market failure requiring intervention.

The downturn may be only part of the business cycle, but those rendered unemployed are likely to suffer from dwindling skill levels if their human capital is not in day-to-day use. There are potentially serious equity considerations, and the plight of those made unemployed deserves consideration. It may be difficult to bring capital resources back into use after a long period of time as well, so cyclical effects on the car industry and those employed in it may become permanent effects.

This can be damaging to macroeconomic performance and especially damaging to regional economies in areas where the car industry is based. These regional economies may suffer downwards multiplier effects and serious economic problems. A second likely failure involving car markets relates to the negative externalities that are generated by private cars, especially fossil fuelled ones. The burning of fossil fuels by cars generates costs to third parties through carbon dioxide emissions and a contribution to global warming, as well as by generating air pollution.

Those who suffer the effects have no way of using the market to charge those who have caused their suffering, and therefore are not compensated. The result is a misallocation of resources through an over-production of fossil-fuelled cars, and a deadweight welfare loss. This is illustrated in the diagram below. The market may lead to an over-production of fossil-fuelled cars There is enough evidence of market failure to support some sort of government intervention in car markets.

Negative externalities are notoriously difficult to measure, because they are not priced in markets, but those associated with global warming appear likely to be large. On this basis, there should be some government support for substitutes to conventional engines, such as electric cars. At the moment these are too expensive, and as the extract notes “competitive pricing requires manufacturers to benefit from economies of scale”. Governments support could build the size of the market for electric cars, allowing reductions in the unit cost of production and hence lower prices.

Despite the expense to the government, this could be done through a subsidy for electric cars. Alternatively, governments could consider a less direct intervention, by taxing fossil fuels such as petrol more heavily. It is stated in the extract that “when UK petrol prices soared to ? 1. 20 demand for Toyota’s market leading Prius surged”. In this way, a higher petrol tax could be effective in enlarging the size of the market for electric cars, with the additional benefit of generating increased tax revenue for the government.

It may turn out that the consumers would be less sensitive to petrol price increases at times when the economy was stronger, but equally at such a time they would be better places to afford the purchase of electric cars. Such interventions to support the production of environmentally friendly cars would be most effective if some international co-ordination could be achieved. The warming of the climate is by its nature a global problem, and there is only so much that any individual country can to prevent it. In 2011, the UK introduced a subsidy of ? 5000 on each electric car supplied.

Data on the effectiveness of this in promoting sales should shortly be available and this could be used by both the UK and other governments to assess how much more needs to be done in order to encourage the market. It must be acknowledged that despite the strong case for intervention, there is some risk of government failure. The article says in relation to Barack Obama’s support for electric cars that the “bet is risky”. It would be possible to spend considerable amounts on subsidy without succeeding in enlarging the market to the sort of size where economies of scale would enable it to thrive.

The case for intervention in car markets for failures relating to a lack of equity is not as clear cut as the case for supporting environmentally friendly cars. It might be justified to support the car industry through short term difficulties as long as the market is commercially viable in the long term, which may well be the case given the UK’s relatively flexible labour market and pool of skilled workers, which has attracted significant foreign direct investment into the UK car industry in recent years.

For any parts of the industry which cannot compete effectively, the money would perhaps be better channelled into funding education and training to increase the mobility of workers and help them find employment elsewhere in the economy. While recent events in car markets can be interpreted as the functions of the market mechanism working to allocate resources efficiently, we have shown that there is a strong case for some sort of intervention, especially to encourage the transition from conventional engines to more environmentally friendly alternatives.

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