Tom Klitgaard

English

Research Papers in Economics

The story in reverse could be told ifthe
sticker prices ofcars were to decline. The
rational consumer might believe that prices
will drop further and postpone any pur-
chases. Forthe auto industry, such con-
sumer behavior in the aggregate would only
But ifall that matters is the effective price,
why not just lower the list price instead of
usingeither ofthese two types ofdiscounts?
Part ofthe answer is that both the consumer
and the firm base theirdecisionson expecta-
tions offuture events. Reduction in the list
price (as opposed to rebates) couId lead the
public to expectadditional pricecuttingand
cause consumers to defer their purchases.
During the 1978-80 surge in inflation, con-
sumers used the experience ofrising prices
to anticipate continued inflation. They
tended to adopt a buy-now strategy out of
fear that they wouId notbe abletoafford the
purchase later on. This reaction may even
have been strongenough to generate further
inflationary momentum.
In present value terms, cash rebates or low
loan rates can be eqUivalent. The consumer
is assumed to care principally about the
effective price ofthe car, i.e., the amount of
money,all things considered, thatonehas to
pay for the automobile. For example, con-
sider a $10,000 car that is to be financed
with a 25 percent down payment. A 36-
month loan at 12 percent on $7,500 will
have finance charges totalling $1 ,470, and
monthly payments of$249. In the same
case, but with a loan rate of 16 percent, a
rebate of roughly $400 would lead to the
same monthly payments. (Because interest
is tax-deductible ifitemized, the two
programs have potentially different tax con-
sequences. The after-tax cost would depend
on the proportion ofpayment counted as
interest.)
companies, extended their programs to all
new cars.
The domestic auto industry has been in a
slump for the past few years due to higher
gas prices, import competition and aweak
economy. In efforts to increase car sales, the
industry has periodically offered incentive
programs which, while successful in man-
aging inventories, have primed consumer
expectations ofrenewed promotional dis-
counts. The public now reasonably expects
auto companies to continue to offer price
incentives until there is a significant im-
provement in the demand fortheirproducts.
Recently, the industry has changed the form
of its promotions from rebates to subsidized
credit. Finance rates, sometimes three to
four percentage points below the average
bank rate, are now the mechanism used to
lowerthe effective costofan automobile to
the consumer. Since both types ofpromo-
tions are equallycapableofloweringcosts it
is an interesting question as to the rationale
behind the switch. This Letter suggests a
numberofpossible answers to why cheap
credit was chosen. Expectations ofthe
economy's future, a more favorable incen-
tive structure, better current accounting
profits, and the potential for increases in
market share ofthe industry's finance cor-
porations are possible considerations used
by those responsible for the change.
Temporary discounts
Toward the end oflast year, the large auto-
makers, possiblydiscouraged by theirrebate
program, announced that there would be'
little or no change in the prices ofnew
models. The unfortunate effect ofthe
announcement was to lower the sales of
1982 model cars dramatically as the public
could expect to buy a 1983 model forthe
same price. To combat this drop in sales,
the automakers set up programs ofdiscount
financing on 1982 cars. The programs
proved to be very successful and, at the
beginning of 1983, the big four U.S. auto
manufacturers, alongwith many foreign
April 15, 1983
The Whys of Automobile Discounts
1Opinions exprt'ssed in this nt'\v~;l('llc·r elf.) not
necessarilv retlcct the vic\v~ 01 the mafldgcflwnt
of the Fedpral Reserve Bank of San Francisco,
or uf the Board of Covernors of the' "Federal
Reserve Systel11.
increase the pressure for further price cuts.
Thus, maintaining stable list prices while
using temporary discounts to encourage
sales is one way for the industry to wait out
its slump.
Changing the risks
Rebates filled the role ofa temporary price
discount until recently when firms began to
offer financing at rates substantially below
those ofbanks. The choice may partly be
related to the industry's expectations ofthe
economy's future. If it believes that the
demand for cars will increase and that
interest rates will decline, then it may try
to profit by gambling against the maturity
structure ofinterest rates.
The low finance-rate programs usually
require the purchaser to use a finance
corporation wholly owned by the auto
company. The healthierofthese finance
companies are able to bypass banks and
obtain funds directly in the capital markets.
Theoretically they can acquire short-term
funds through instruments such as commer-
cial paper and then, by mismatching the
maturities oftheir assets and liabilities,
benefit from falling rates in the three or four
years during which the customer pays back
his fixed-rate loan.
Such programs accentuate the risk for the
industry ofa change in interest rates. A rise
in interest rates would not only increase the
costs of th is promotion over the next few
years, it would also hurt car sales when the
promotion ends. On the other hand, adrop
in rates that increases the demand for cars
would be more profitable over time as the
industry sells more cars while funding pre-
vious promotions with cheaper borrowing.
Current earnings
The industry mayalso be trying to lessen the
effects discounts have on current earnings.
Below-market loans and other long-lasting
discount schemes, such as extended war-
ranties, tend to spread the costs ofdiscounts
over a numberofyears. When the duration
2
of warranty protection is extended, the cost
to the consumer ofowning the car is
lowered while the cost to the company of
selling the car is increased. However, the
company's cost is spread out over the term
of the below-market loan or the additional
warranty period and neither falls in the
current accounting period nor is directly
observable. Thus, the industry's current
earnings do not suffenhe sharp drop that
occurs when the full discount is given up
front, as is the case with rebates.
In theory, smoother accounting profits from
subsidized credit will not fool the capital
market when itvalues equity ordebt issues.
Nevertheless, the widespread efforts ofcor-
porations to raise accounting earnings ..
duringeconomic slumps suggest that the
effect on current earnings may be an addi-
tionaI reason for the switch from rebates to
subsidized financing.
Incentive structures
In general, rebates were applied to the base
cost ofselected models and increased in
step-wise fashion without consideration of
the options chosen. The use ofsubsidized
credit, however, alters the incentive struc-
ture by loweringcosts at the margin for the
consumerwho is thinkingofaddingoptions.
This can work to the advantage ofthe car
manufacturer, even though the dollar value
of the discount increases with the pur-
chasing price, because the industry uses a
much greatermark-upovercastsforoptions
than they do for the basic model. The profit
on a sale is therefore directly related to the
numberofoptions included. Ifthis new in-
centive is successful in increasing the saleof
cars with more options, then the industry
will most likely benefit more from discount
financing than from rebates.
Marketingof auto finance corporations
It is also possible that, in addition to selling
more cars, discount financing will increase
the market share offinance corporations
owned by the auto manufacturers and
thereby enable them to be more profitablesubsidiaries at market-determined rates in
the future.
Nottoo many years ago, the market for auto
loans was dominated by commercial banks.
But, as seen in Chart I, the banks' market
share has narrowed recently. At the end of
1978, banks had three times as much out-
standing consumer credit as finance com-
panies, a difference of$40 billion. By the
end of 1982, the differences had shrunk;
banks were still ahead, but at only $59 bil-
lion to $49 billion. (Unfortunately, the data
do not distinguish among types offinance
companies. Still, indications are that the car
loan market is strongly dominated by auto
company finance corporations.) From Chart
II, which uses the average bank carloan rate
for comparison, it is apparent that
auto-owned finance corporations have been
aggressive in pricing their loans even
during periods without low finance-rate
promotions.
Auto company finance corporations have,
in the past, seemed toexist mainlyto prevent
credit shortages from hurting sales. Now,
during difficulttimes, car manufacturers are
looking to increase the earnings potential of
all their various operations. The offering of
relatively cheap credit serves an auxiliary
function as a promotional scheme to in-
crease the market share oftheir finance
corporations in competition with commer-
cial banks.
Chart I
OUTSTANDING AUTO LOANS
.Even when not offering promotions, auto
companies have certain advantages in the
auto loan market. The marginal costs of
running such operations is minimal, while
their ability to sell repossessed cars means
they can recover more ofthe value ofa bad
loan than can other institutions. They there-
fore face less risk in making a loan. Further-
more, cheap creditattracts peopletoan auto
company finance corporation, and allows
these corporations to sell the public on the
qualityof their service. It creates the poten-
tial for auto buyers to return in the future
when the promotion is longover and rates
fall back into line with the market.
Conclusion
The aulo industry has struggled for the last
few years to cut costs and improve its prod-
ucts while waiting for an upswing in the
demand for cars. In the interim, they have
had to resort to discounts in order to main-
tain sales. This Letter has looked at why
cheap credit rather than rebates might be a
more desirable form ofdiscount from the
industry's perspective. For instance, in
theory, discounts of low finance rates given
in January are now costing auto companies
less than rebates wouId have because of the
drop in interest rates. The course ofevents
has so far made using low finance rates
appear a wise choice.
Tom Klitgaard
Chart II
FINANCE RATES
15
11
0 1 " I", I",I", I", I
1978 1979 1980 1981 1982
12
13
14
18
17
Percent
18
3
1982 1979 1980 1981
~Bank
$BlIIlons
80
70
60
50
40
30
20
10
0
1978UOlgU!LjSE'M • LjE'ln • uog~uo • epeAaN • 0Ljepi
HE'M!?H .". !?!uJo)!le:> euozpv. e>js!?]\!
<\j)~~Y~Iill~JI~.· Iill~CS
~<\j) ~Iill~cm
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:jl \1Jl ~)\)llli:jlJl 'S/<dl«ilCOJ \\{(;:)lJI 'S/«il~ «ilCQI
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
3/30/83
Change
from
3/23/83
Change from
year ago
Dollar Percent
Loans (gross, adjusted) and investments* 163,185 470 4,395 2.8
Loans (gross, adjusted) - total# 142,089 429 4,626 3.4
Commercial and industrial 45,163 97 1,920 4.4
Real estate 57,146 - 89 280 05
Loans to individuals 23,456 53 262 1.1
Securities loans 2,021 129 371 22.5
U.S. Treasury securities'" 8,137 41 1,943 31.4
Other securities" 12,958 0 - 2,174 - 14.4
Demand deposits - total# 40,039 1,627 - 468 - 1.2
Demand deposits - adjusted 28,211 1,110 266 1.0
Savings deposits - total 65,273 187 34,061 109.1
Time deposits - total# 67,894 - 377 - 23,623 - 25.8
Individuals, part. & corp. 60,507 - 223 - 21,836 - 26.5
(Large negotiable CD's) 21,235 - 314 - 12,900 - 37.8
Weekly Averages
of Daily Figures
Member Bank Reserve Position
Excess Reserves (+)/Deficiency(-)
Borrowings
Net free reserves (+)/Net borrowed{-)
Weekended
3/30/83
'88
67
21
Weekended
3/23/83
107
31
76
Comparable
year~ago period
95
103
7
:I< Excludes trading account securities.
# Includes items not shown separately.
Editorial comments mayhe addressed to the editor (Gregory Tong) or to the author ....Free copies of
this and other Federal Reserve publications can be obtained by calling or writing the Public Infor~
mation Section, Federal Reserve Bank of San Frandsco, P.O. Box 7702, San Frandsco 94120. Phone
(415) 974-2246.

The whys of automobile discounts

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The whys of automobile discounts

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