Monday, June 8, 2009

The Profitability of SUVs

James Kwak from The Baseline Scenario asks Why are SUVs more profitable?:

Many discussions of auto company economics include the assertion that SUVs and pickup trucks are more profitable than small cars, and so a shift from the former to the latter – as discussed by Felix Salmon, for example – will not be good for the auto companies, particularly GM and Chrysler (since they are in the news these days). I accept that as a historical statement, but I don’t understand why that is the case.

Textbook micro tells you that price equals marginal cost, so the gross margin on every product is zero; that’s clearly no help here. Profit margins should be higher in product segments with less competition, but basically every manufacturer makes a small, midsize, and large SUV, so I don’t think that’s the explanation.

He goes on to give several other reasons why SUVs might be more popular. There are a lot of good comments to the post and I found the exercise of answering the question very intellectually stimulating. Here is my response to the question why are SUVs more profitable?:

The answer to the question has a lot to due with consumer preference. SUV’s are, in a low cost of fuel environment, preferred to cars. The only reason people would rather buy a Civic than a truck/SUV is the low cost of a Civic. A minority would buy the Civic due to environmental reasons but most people won’t sacrifice comfort for the environment. SUV’s fit more people/stuff, make people feel powerful when they are able to look down on cars, and are safer (or at least perceived to be) in case of an accident. Car companies realize this so, since building cars has a high barrier to entry, the existing competitors compete on features rather than price for SUV’s and compete on price rather than features for small cars. This is one reason why Japanese automakers were late introducing multiple models of SUV’s. They had to understand the design aesthetic and features that Americans required for SUV’s and build the capabilities to meet the requirement whereas with a small car they could use their low cost advantage to profitably sell small cars and gain acceptance in the marketplace.

With their low cost structures, why didn’t the Japanese manufacturers lower prices on SUV’s to further pressure domestic manufacturers? The Japanese manufacturers probably realized that the domestic manufacturers didn’t want to risk lowering prices on SUV’s and not seeing a subsequent uptick in sales because the domestics had to make up the money they were losing on the small cars required by the CAFÉ standards. Thus the number of competitors that could compete on price was essentially cut from 6 to 3. With rebates an accepted practice in the car industry, Honda, Toyota, and Nissan could just start offering rebates if there was any real pricing pressure. Combined with the fact that until the past year or so foreign manufacturers did not have excess SUV manufacturing capacity, there was no real incentive to cut prices. Brands such as Hyundai are starting to build quality cars and gain a good reputation so it will be interesting to see if the profit margins continue to stay high.

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