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Micro Economic Dynamics of the Automotive Industry

The Volkswagen Group recently introduced its strategy for until the year 2025. The strategy also known as “Future Program Together” placed an emphasis on some key themes of Diversity of Brands,  Environmental Sustainability, and maintaining and improving Quality Standards. (Volkswagen AG, 2017) The group plans to gain leadership in electric vehicles by gaining costs advantages driven by high production volumes,  enhancing the after sales services that it must provide,  improving its baseline by reducing its operating margins by 6% in the given period. The Company also, plans to go deeper into markets that are not currently the stronghold of the Group i.e USA, China, India South America and Russia. (Volkswagen AG, 2017)

Given below, are the micro economics of the automotive cars. The Micro economic dynamics, although shaped by the macroeconomic conditions for the car industry as a whole, effect every manufacturer differently. For example, Volkswagen may have the capacity of specialization that Tesla Motors may not have. However, Tesla Motors with its base in the USA, may have fewer regulatory constraints such as environmental and workers law (Lipschultz, 2008) and hence, may be working in a more competitive environment. The micro economic dynamics for both firms will change.

The Volkswagen Group has production plants located all over the world. However the majority of the plants are concentrated in Europe. (European Automobile Manufacturers Association, 2017)

Automobile manufacturing typically has entry barriers in the form of large plant set up costs and fixed capital costs. In generally, any firm entering the automobile markets (car market included) must be able to commit to several years as gestation period and must be able to withstand losses. Cost minimization, is therefore, possible if economies of scale are achieved.  The auto industry is, generally, plagued with “escalating raw material prices, reduced automaker production and soaring benefits and labor costs.” (Carty, 2005)

Capital Costs are long run costs while wages and other operating costs are included in short run costs. (Samuelson & Nordhaus, 2004) The key managerial dilemma presents

Some types of costs that will be incurred, include:  (Sezemský, 2014) 

  • Overhead Costs
  • Indirect and Direct Personnel Costs or Costs Associated with labour
  • Material Costs
  • Other Costs of Production

An Automotive plant tends to have large production capacity (Sezemský, 2014) and typically tend to have “joint production” of various differentiated products. (Aryasri, 2007). Joint production implies that various types of cars from differentiated segments such as light utility vehicles, heavy vehicles etc. (European Automobile Manufacturers Association, 2017) are produced in one plant. Joint production helps achieves crucial economies of scale, which helps in cost reduction. (Aryasri, 2007)

An interpretation of Neo classical economics, the plant size cannot be increased or decreased in the short run.  (Samuelson & Nordhaus, 2004) Hence, profit maximization is not just about achieving economies of scale but also about achieving the right differentiation of product.  The Volkswagen Group alone produces petrol cars, cars with alternative fuel and diesel cars. In the past few years, automotive industry has been struggling due to this dynamic. Falling demand from consumers in the European Union implies that plants may soon have excess capacity. However, running plants with big sizes implies that fixed costs are high. Fixed costs shall be reduced in the long run by reducing the plant size.  

Manufacturing Costs and Size of Plants

Neo classical economists, in particular, believe that wages are flexible in the short run. This implies, that in the short run , the automobile manufacturer can simply increase its production by employing more workers provided it has a greater production capacity. However, increasing production capacity in the short run may not be possible. In the light of such a situation, investments in fixed capital may seem like a good idea. However, the creation of excess capacity creates problems as well. Excess production capacity implies that during periods of depressed demand, there may be excess production capacity and that is inefficient. (Samuelson & Nordhaus, 2004)

Handing out pink slips to employees may threaten a back lash from workers’ union and regulatory authorities alike. (Samuelson & Nordhaus, 2004) Hence, workers’ Unions are a key dynamic in the production of manufacturing of cars. Hence, improving labour productivity, in order to maximize profits, instead of cutting the number of workers employed is a good strategy for Volkwagen.

Typically, there are diminishing returns to labour and other variable costs. Thus, diminishing returns ultimately lead to high marginal costs, even if Average Total Costs decreases. Hence, an attempt to improve labour productivity will help decrease the Marginal Cost.

Volkswagen Group produces a total of 43000 vehicles per day (counted as per day every week day). (Volkswagen AG, 2017) This level of production is possible because he Volkswagen group offers several differentiated product. Joint production helps Volkswagen achieve economies of scale. (Aryasri, 2007) The managerial decision of producing electric cars and offering a competitively priced Tesla is  “joint production” , the costs of production costs of production can be minimized and help insure against shifts in consumer preference. On the other hand, companies such as Tesla Motors that have relatively less product differentiation would tend to have a relatively more elasticity of demand. In simple words, Volkswagen product may not be affected greatly if the price of a single model is increased. On the other hand, if the demand for the electric vehicle of Tesla Motors decreases as consumers shift preferences, Tesla motors may be priced out of the market.

As, the returns to every additional output decrease but the increase in plant since brings the average costs down, the average cost curve decreases but marginal cost curve becomes U shaped i.e. it decreases and then increases.

Consumers tend to look for the relative benefits offered while selecting heavy investment like cars. (Welch, 2010) Additionally, (Welch, 2010) believes that consumers tend to select based on the ranking of costs i.e consumers tend to select less based on the absolute cost and tend to make purchasing decisions based on the cost in relation to another similar product and that the marketing of the automotive industry must take all these behavioral tendencies of the consumers in the mind. Hence, the price of any car is a big determinant in the elasticity of a product.  The car market is fragmented with several companies operating the market. (European Automobile Manufacturers Association, 2017)  Any model of a car has several substitutes , which makes the elasticity of demand for any car product is high.

Wages and Labour Productivity

 In order for consumers to select a particular model of a car over other model of cars, the diesel cars must offer significantly higher benefits than electric cars. These cars do not just include cars in similar category that are manufactured by other companies but also the petrol version cars of the same model. Additionally, car manufacturers must now also be able to provide alternative fuel cars such as electric cars or hybrid cars.  In case, subsidies on fuel are removed, the costs of operating diesel and fossil cars will rise significantly.  This is seen as a significant concern. Commercial car owners can produce cars by varying the engine of the car. (Chrisafis & Vaughan, 2017) Consumers are able to choose between the petrol and diesel cars and electric cars. Hence, petrol and diesel cars and electric combustion cars are close substitutes. (Gravelle and Rees 2005) As demand for electric combustion engine vehicles increases, average costs of such cars will reduce and the prices of electric vehicles and petrol and diesel run vehicles will ultimately converge. If electric cars were to be subsidized, then diesel cars must be competitively priced to match the lower costs of the electric cars.  

The percentage decrease in the demand by the consumer to every percentage increase in the price of the car is called the price elasticity of the car. (Samuelson & Nordhaus, 2004) “The determinants of elasticity include the number and closeness of substitutes and relative degree of significance in the consumer’s budget.” (Lipschultz, 2008)

Given the increasing wages as well as capital costs, the prices of Volkswagen may increase. This implies that for every increase in cost, the decrease in demand will be high. (Samuelson & Nordhaus, 2004) An additional factor to owning a car is the cost of running a car. An increase in the prices of fuel may, to some extent, affect the demand for cars that run on fossil fuels. However, it remains to be seen on how much of a consideration is given to the running of a car.

Chief among the determinants of the elasticity of the demands for cars is the price is elasticity of cars. “Price elasticity of demand also bears consideration in analyzing the behavior of the market. Given the nature of the automobile market, in which products, and perhaps more significantly their substitutes, often change significantly as often as their prices do, elasticity must be calculated among similar products within a time period, rather than between the same product in different time periods.” (Lipschultz, 2008)

Conclusion 

There are several dynamics at the micro economic and macroeconomic level that would affect the demand well as supply of cars for Volkswagen. These dynamics govern the several managerial decisions for the automotive industry such as determination of the output including the output quantities of every differentiated product (diesel versus electric car) that must be produced. At the macroeconomic level, policies by various countries especially the European Union are the chief determinants and consumer demand for diesel as well as electric cars are given. These policies, in general, include the provision of subsidies for electric cars by government, especially in the European Union and phasing out subsidies for fossil fuels such as diesel. (Worall & Runkel, 2017)

Joint Production and Plant Size

The car market can be categorized an Oligopoly since the total number of car manufacturers worldwide is relatively. (Samuelson & Nordhaus, 2004) However, the car market is If the car market is categorized as an oligopoly, then both product differentiation and advertising are crucial factors. In light of such evidence,  the decision to add an entire array of differentiated products by Volkwagen, is a step in the right direction. According to another car manufacturer, “The Company’s future success depends on its ability to satisfy changing customer demands by offering innovative products in a timely manner and maintaining such products’ competitiveness and quality” (Tata Motors Ltd.)

The decision to include an entire array of electric vehicles is also an important one.  It is expected that the  rice of an electric vehicle may be lowered due to policy incentives.  “Incentives for electrically-chargeable vehicles are now applied in many European countries. The incentives mainly consist of tax reductions and exemptions, as in countries such as Austria or Germany, and bonus payments and premiums for the buyers of electric vehicles in France and the UK.” (European Automobile Manufacturers Association, 2017)

The Volkswagen management is, also, correct in stating that Volkswagen will compete with innovation of Tesla Motors by way of price leadership. The investment made in capital so far may pay off as it may help Volkswagen achieve economies of scale. “Fortunately, current manufacturers in the industry face relatively low pressure from the possibility of new entrants and from substitutes. Automobile manufacturing requires large upfront costs and typically absorbing years of substantial losses before earning profits. While Tesla Motors has shown that driven companies can insert themselves, the company’s history also underscores the difficulty of new entrants obtaining sizable market shares.” (Pratt, 2015)

Volkswagen and other markets leaders are perfectly poised to leverage their share of markets , the fragmentation of the car industry. While Tesla may gain some profits due to innovation, volume based competitiveness will ensure that Volkswagen and European automakers stay in the competition due to the price advantage. According to the information given, both the fixed costs and capital costs of electric vehicles are set to be lower in the future. Given the two price equations, it is clear that the operating costs of electric car are reduced by 50%when the sales enter a high growth stage. On the other hand, the fixed costs will be reduced by 30%. Hence, investment in electric cars and hybrid electric cars is a necessary and important decision by the Volkswagen Group.

The Gross Domestic Product of the Europe -15, the Private Consumption of the nationals of EU-15 helps understand the top line if the expected demand from the Western European Countries or the EU-15 countries, in this case.  Trade between these countries is not hampered by regulations due to the presence of the European Union. However, some challenges may be presented due to the changing macro economic environment. The macro economic environment shapes the auto industry in several ways.

As shown above, factors contributing to unemployment are increasing and several countries are showing concerns regarding the same. The automotive industry is a source of employment in several countries and exports from Germany threaten the local auto industry. (Fahmy, 2017).   Chief among such countries is Britain, a leading importer of Volkswagen cars. Brexit has had an impact in the form of the deletion of free access to a key market like Great Britain. (Fahmy, 2017) There may be some challenges in the form of non-tariff and tariff barriers due to this fact. The introduction of non-tariff barriers may raise costs. Given that the elasticity of demand for cars is high, and Volkswagen may have to take the price and absorb them which will lower the margins further and puts the firm in a situation where it may be priced out of the competitive car market.  

Consumer Preferences and Elasticity of Demand

President Macron of France announced in July 2017 that France was looking at phasing out its petrol and diesel vehicles by the year 2040. (Chrisafis & Vaughan, 2017) This announcement came in the wake the Paris Climate Agreement to which France is a signatory party. Similarly, many European countries may want to phase out the more polluting cars, in favour of hybrid or diesel vehicles due to commitments made in the Paris Climate Agreement.  (United Nations Framework Convention For Climate Change 2017). The increase in the number of sales of hybrid vehicles and the decrease in the number of diesel cars seems to be in line with the same.

In addition, many countries in the Western Europe may reduce the subsidies available for fossil fuels. This implies that the costs of ownership, not just the cost of purchase of vehicles may increase for the consumers. Thus, Volkswagen may not just have to provide better and more environmentally sustainable alternatives but also more fuel efficient cars. (Worall & Runkel, 2017)

Incentives to Electric Vehicles are different in different countries. Hence, the pricing for every country may be different. This poses challenges to the management of the Company.

The Private Consumption in the European market and the Real GDP seems to have been growing for a long time and are apparently peaking. This implies that the growth for Volkswagen cars may also peak. The European Automobile Manufacturers Association recently announced that the demand for sales of cars was peaking in the European 15 or the Western European countries. (European Automobile Manufacturers Association, 2017)

The roadmap of the Company is to increase the number of electric vehicles by achieving price competitiveness. (Volkswagen AG, 2017) However, price competitiveness may not be achieved if the production of the Company is fragmented.

Aryasri, A. R. (2007). Managerial Economics And Financial Analysis (Third Edition ed.). (T. K. Maji, Ed.) New Delhi: Tata McGraw Hill Publishing Company Limited.

Carty, S. S. (2005, October 11). Delphi's Chapter 11 filing pushes GM closer to brink. USA Today .

European Automobile Manufacturers Association. (2017, December). Electric Vehicle Incentives. Retrieved December 22, 2017, from EAMA: https://www.acea.be/industry-topics/tag/category/electric-vehicles-incentives

European Automobile Manufacturers Association. (2017). Statistics. Retrieved December 23, 2017, from European Automobile Manufacturers Association: https://www.acea.be/statistics

Fahmy, D. (2017, July 14). Europe Car-Sales Growth Slows on Brexit as Market Nears Peak. Retrieved December 22, 2017, from Bloomberg: https://www.bloomberg.com/news/articles/2017-07-14/europe-car-sales-growth-slows-on-brexit-effect-amid-market-peak

Lipschultz, J. T. (2008). A Microeconomic Analysis of the Full-Size Automobile Market. Economics & Business Journal: Inquiries & Perspectives , 152-163.

Pratt, B. (2015). Case Analysis: Volkswagen Group. Retrieved December 23, 2017, from University of California, Santa Cruz: https://people.ucsc.edu/~brpratt/Courses/ECON136Su15/

Samuelson, P., & Nordhaus, W. (2004). Economics: Seventeenth edition. New Delhi: Tata McGraw Hill.

Samuelson, P., & Nordhaus, W. (2004). Economics: Seventeenth edition (17th ed.). New Delhi: Tata McGraw Hill.

Sezemský, O. (2014). Determinants of Production and Sales in Automotive Industry: Evidence from ŠKODA AUTO. 

Tata Motors Ltd. (n.d.). MANAGEMENT DISCUSSION AND ANALYSIS: 71st Annual Report 2015-16. Retrieved from https://www.tatamotors.com/investors/financials/71-ar-html/pdf/Management-Discussion-Analysis.pdf

United Nations Framework Convention For Climate Change. (2017, June 20). The Paris Agreement. Retrieved October 10, 2017, from www.unfccc.int/paris_agreement

Volkswagen AG. (2017). Goals and Strategies. Retrieved December 22, 2017, from The Volkwagen Group: https://annualreport2016.volkswagenag.com/group-management-report/goals-and-strategies.html

Volkswagen AG. (2017, November 22). News: TRANSFORM 2025+ Volkswagen presents its strategy for the next decade. Retrieved December 22, 2017, from Volkswagen: https://www.volkswagenag.com/en/news/2016/11/transform-2025.html

Welch, N. (2010, February). A Marketer's Guide to Behavioural Economics. Retrieved December 21, 2017, from McKinsey Quarterly: https:/www/Mckinsey.com/busines-functions/marketing-and-sales/A-marketers-guide-to-behavioural-economics

Worall, L., & Runkel, M. (2017). PhaseOut 2020: Monitoring Europe's Fuel Subsidies: France. Belgium; London: Climate Action Networl Europe; Overseas Development Institute.

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