Vehicle purchases, leasing, and replacement demand: evidence from the Federal Reserve's Survey of Consumer Finances

Business Economics, April, 2004 by Ana Aizcorbe, Martha Starr, James T. Hickman

The motor vehicle industry has undergone important changes in recent years, including a shift in production from autos to light trucks and growth of vehicle leasing. This paper uses household-level data from the Federal Reserve's Survey of Consumer Finances to document changes in households' acquisitions and financing of motor vehicles from 1989 to 2001. We examine what types of vehicles households had, what financing arrangements were used to acquire them, and how vehicle holdings vary with such household characteristics as income, age, wealth, and creditworthiness. The data provide useful insights into the determinants of replacement demand and the use of alternative financing arrangements like leasing.

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The motor vehicle sector plays a significant role in the United States economy. Although it accounts for a relatively small share of U.S. gross domestic product (under four percent in the past 15 years), fluctuations in its output contribute importantly to swings in aggregate output, as shown in Figures 1a and 1b. Thus, developments in the motor vehicle industry are carefully watched in part because of their macroeconomic implications.

The motor vehicle industry has some notable features that must be taken into consideration in its analysis. On the demand side, vehicle ownership among U.S. households is high and relatively stable, so that most demand for new motor vehicles is "replacement demand." Decisions about replacing vehicles are relatively complicated: people compare the transportation services they get from their present vehicle and the costs associated with running it, with the services they could get from another vehicle, given the costs of buying and selling vehicles and of running the new one. (1) Replacement decisions are fairly readily moved forward or backward in time: for example, a household may replace a vehicle earlier than expected due to favorable prices and incentives, or it may postpone a replacement until uncertainty about income or unemployment resolves. (2) Replacement decisions are also affected by developments in the used-vehicle market: when people replace vehicles, they may buy either new or used, and they very often sell a vehicle on the used-vehicle market when they acquire another. Thus, although only production and sales of new vehicles affect the industry's contribution to GDP, demand for new vehicles is influenced by prices, quantities, and qualities in the used-vehicle market.

On the supply side, the motor vehicle industry has a relatively concentrated market structure, with the "Big Three" auto companies--General Motors, Ford, and Daimler-Chrysler--having a market share of about 65 percent in 2002. (3) This relatively tight market structure means that in making decisions about pricing, financing incentives, and types and characteristics of vehicles, producers must consider how their current behavior will affect the behavior of their competitors. They must also consider how their current behavior may affect market conditions in the future. For example, a company that improves the durability of its vehicles may realize higher sales in the short-run, but lower sales in the long-run, especially if competitors follow suit. (4) Similarly, automakers must consider how a period of strong sales would affect future demand for new vehicles, because pulling down the average age of vehicles boosts the flow of transportation services from the vehicle stock, potentially reducing the impetus for vehicle replacement in the medium-term.

In this context, many interesting developments have taken place in the motor vehicle industry in recent years. First, although vehicle production and sales were sluggish in the early 1990s, they surged as the economic expansion of that decade got underway. Sales were surprisingly strong in the second half of the decade, remaining at or above 15 million units per year. Although they cooled a bit in the economic slowdown of 2001, their pace has remained quite solid (Figure 1c). Second, new vehicle prices rose steadily at rates of 2-to-3.5 percent per year through 1996, and flattened out thereafter (Figure 1d). (5) Third, vehicle types and qualities changed appreciably. Larger vehicles, like sport-utility vehicles (SUVs) and minivans, grew in popularity as declining gasoline prices made such vehicles more affordable. Also, improved engineering and design tended to increase the lifespan of vehicles, which tends to stretch out the replacement demand schedule. Fourth, the increased use among manufacturers of flexible production methods made it easier for producers to change levels and composition of vehicle output in response to changes in demand. Finally, there was a notable increase in the prevalence of auto leasing. Prior to the 1990s, leasing had been limited to the high-luxury market segment, but in the early 1990s, options to lease were expanded to a much broader range of vehicles. (6) Yet in the later 1990s, the use of leasing started to trail off, as automakers reportedly realized large losses on their leasing portfolios. (7) Instead they tended to offer incentives in the form of zero-percent financing with 3-to-5 year contracts.