Reference no: EM131737188

Problem: ZERO-INTEREST RATE FINANCING FOR NEW MOTOR VEHICLES

In October 2001, the major automobile manufacturers advertised zero-interest rate financing to boost motor vehicle sales in the aftermath of the terrorist attacks of September 11th. The experiment was a resounding success - sales of new cars and light trucks rose from a seasonally adjusted annual rate of 16.1 million in the third quarter to a record 21.1 million in October. Sales then declined to 17.8 million in November, and 16.5 million in December, when the incentives were somewhat reduced although not entirely eliminated. In spite of the blaring headlines announcing ‘‘zero-interest rate financing,'' the truth is more prosaic.

According to the Federal Reserve Board, the average interest rate on new car loans in October dropped to 2.74% from an average of 6.0% in the previous quarter. Also, according to Fed statistics, the average amount financed per new car was $24,443, with an average maturity of 53.7 months. On that basis, the average monthly payment fell by about $9 per month, or about 2% of the total purchase price. Assuming that the Fed data are correct, it is interesting to note that the incentives provided by the auto companies were considerably less than implied in the advertisements. Taken at face value, these figures would suggest that a net reduction of approximately 2% in the price boosted sales by 5 16 , or more than 31% in October, implying a price elasticity of more than -15. Obviously that does not make any sense; the vast majority of increased purchases reflected timing adjustments rather than the decision to trade the car in more frequently or purchase more cars per household. Consumers reacted to what they perceived to be a ‘‘bargain.'' There are two other ways to look at this elasticity. First, we note that the 5.0 million annual rate increase in October would be equivalent to an actual increase of 417,000 cars sold if October were a normal month, but since sales are usually heavier in that month, the actual increase was about 500,000 cars.

One possibility is to assume that the extra 500,000 cars sold all represented permanent increases, in which case the implied elasticity is approximately -1.5. The other is to assume that most of the changes were temporary. That effect can be calculated by comparing sales in 2002 with those in 2001, and assuming that any shortfall in 2002 was borrowed from October 2001. Since there was no shortfall in 2002, we can assume the gains were permanent. That does not mean the average number of cars per person rose, but it does mean that people traded in their cars more frequently. Because dealers had an unusually large number of 2001 model cars and trucks left over because of the recession and the drop in sales after the terrorist attacks, some attention-grabbing method was needed to move those extra vehicles.7 Also, the ‘‘Big Three'' have contracts with the UAW, which essentially stipulate that production workers will receive almost all of their full salaries whether they are working or not, so the marginal cost of producing an extra vehicle is much smaller than would be calculated from the cost of labor and materials. Hence relative to the alternatives, the de facto 2% price reduction did not cost the automobile industry very much. It was a very clever merchandising approach, and presumably boosted sales far more than would have been the case had the auto industry merely announced an actual 2% price reduction.