Question

GM broke a lot of its old rules/business strategy when it started selling its line of Saturn cars in 1991. Until 1991, GM was losing business and profits to other auto manufacturing.
[A] Starting up the Saturn line was a major risk; GM spends an estimated $5bn to get Saturn going. GM built a new plant that uses modern technology and a team approach and other Japanese-style management methods to assemble cars. The Saturn plant produces relatively few models, and its sharing of engines and other major parts reduces production costs.
[B] In building its new plant and designing its new car, GM had to take into account the federal government’s emissions standards and other pollution regulations.
Some industry experts believe that GM lost $500M a year in the first few years because it could not make enough cars to cover its investment.
GM does not sell Saturn the way it sells its other cars. Its most striking marketing innovation was the ‘no-dicker sticker’. Saturn dealers charge a fixed price for a car.
Now, information about dealers’ costs is available on the Internet. Using such information, some consumers can strike better deals than they could previously.
[C] Noting that consumers became richer and were switching to larger cars at the expense of smaller cars, Saturn decided in 1999 to extend its line to include full-size cars and sport utility vehicles.
Other dealers and auto manufacturers did not stand still. When GM drops its wholesale price, Ford and Honda respond to prevent the loss of sales and profits. When GM started selling Saturns and some of its other cars at fixed prices, Ford began using fixed prices on two of its vehicles
Question 1. Information [A] indicates that a large amount of investment is usually required to produce a car. Mr Smith studied 2002IBA and understands that the M. Porter’s Five Force Model is important to analyse profitability at industry level. Using the Five Forces Model, he argues that the required large amount of investments in the car industry is a positive factor affecting profitability because it increases availability of substitutes. Do you agree or not. Explain.

Question 2: The information [B] indicates government strengthened pollution regulations. Do you believe this strengthened regulation will directly affect the demand curve or the supply curve? Explain what the new equilibrium price as a result of the regulations is

Question 3: Information [C] indicates that demand for large-sized cars increased along the increased consumer income. Consumers became wealthier because of the IT-led economy boom in the 1990s. Do you believe large-sized car in this case is an inferior good? Explain.

Answer 1

Answer 1

M. Porter's five force model is used to analyse competition in an industry and therefore it's profitability. An industry whose profitability will be close to zero ( perfect competition) will be an unattractive industry and an industry whose profitability will be high will be an attractive industry as per this five force model. These five forces help to determine the profitability of an industry. The five forces as per M. Porter which help to assess profitability are:

a) Threat from new entrants

b) Threat from new products (substitutes)

c) Threat from rivals

d) Bargaining power of customers

e) Bargaining power of suppliers

Mr. Smith after understanding this M. Porter's five forces framework argues that the required large amount of investment in the car industry is a positive factor affecting profitability because it increases availability of substitutes.

A substitute is basically a product which is produced using some different technology but which is used to satisfy same needs. For ex. Pen and Pencil can be considered as close substitutes as both are used for writing.

Now, considering the given situation, whether the increase in availability of subsitutes which arises because of large investment by GM will be a positive factor affecting profitability or not will depend on the following factors:

a) Brand loyalty/Buyer's propensity to substitute - If the consumers have a low propensity to substitute or are loyal towards one particular brand then availability of new subsitutes might still not lead to consumption of new substitutes in which case the imcreased investment might not actually lead to increase profitability.

b) Relative price of substitutes - If the new substitutes are relatively cheaper than the already existing products then it might influence potential customers to buy that product.

c) Switching costs - If the switching costs of the consumer are small in terms of money, time and other factors then the buyer might switch to the new substitutes. For ex, if switching from local cable tv network to DTH does not involve major costs then comsumers might decide to switch.

d) Availability of close substitutes - if close substitutes are easily available in the market then there are greater chances of buyers switching to the substitutes.

e) Product differentiation - if the buyers have a perception that the substitute products available in the market are well differentiated, then they might switch to the substitute if they believe that the substitute is better than the previously available products.

So all these factors need to be studied well before concluding that just the availability of larger substitutes would increase the profitability of an industry. If the research about all these factors indicates that the potential buyers will be willing to buy the new substitute and there would be a good market for that product only then it can be said that the investment would increase the profitability of the industry as per the M. Porter's five factor framework.

Answer 2

The strengthening of pollution regulation by the government will directly affect the supply curve of the cars as following the stricter regulations would increase the costs of production of the cars as does any regulation. This increased cost would discourage the producers to supply more cars unless the price rises vis-a-vis as it will decrease the profits of the car manufacturers. The new equilibrium price as a result of stronger government regulation should be above the equilibrium price that existed before the regulation since now the cost of production has gone up. But now since buyers have better information about the costs of the producers and are able to better strike the deal so the actual equilibrium price will depend on who has higher bargaining power, whether its the buyers or the sellers who have better bargaining power. If the powers would have more bargaining power then it might actually lead to a fall in equilibrium prices which would further discourage the suppliers to increase the supply as on one side costs will be gone up due to increased regulation and on the other side prices would be fallen so their profit margin would decrease. But it is also given in the question that Saturn charges a fixed price so it might also happen that there is no change in the equilibrium price.

Answer 3

An inferior good is a good whose consumption decreases with an increase in income and increases with a decrease in income. For example, some kind of coarse grains are considered as inferior goods as their consumption decreases with an increase in income. People tend to switch to better quality grains as their income increases and decrease the consumption of coarse grains.

As per the given information the demand for large sized cars increased as the consumers became wealthier i.e. as their incomes increased they started demanding more of large sized cars so large sized cars are not inferior goods, instead they are normal goods.

Normal goods are the goods whose consumption increases with an increase in income. Here the demand for large sized goods increased with an increase in income so large sized goods are normal goods.