Thursday, December 4, 2008

Death Spiral as Dictated by Microeconomics 101

If anybody has any doubts about the auto industry is in deep trouble, what planet are you from?

Holistically, we all know that the auto makers have been in trouble for a long, long time. I went to the school named after Alfred P. Sloan, a long-time chairman and president of General Motors, and I should have learned something about what went wrong.

I'm just going to scratch the surface and let you all dig deeper into what thousands of things went wrong.

So, what went wrong with the whole industry? PRICE COMPETITION. To throw some b-school lingos here, firms compete by leveraging a variety of weapons like marketing, supply and demand, sales strategy, cost advantage, innovation, etc. If anyone has sat through Lecture 3-4 of your microeconomics class, you've probably learned that price competition is the evil of all competitive strategy. This is because price competition drives the profit down to zero until one company is left with a huge market share with no money left in the pocket.

Back to the auto industry turmoil....

There are empirical evidence that the auto industry used to be profitable until some brilliant strategists came up with innovative pricing strategy called "Everyone gets an employee discount". The death spiral goes like this. First, GM has this promotion nationwide to steal would-be other companies' customers. In this segment, the customers are pretty price-sensitive and would select the lowest price available. Then, another brilliant pricing strategists at Ford and Chrysler have no option other than matching GM's pricing. The prices across the models keep going down the curve until nobody makes money by selling cars. Yes. This is what happened.

Fastforward to today, CNN's headline talks about car dealers getting creative. Man, these people just don't learn anything from experience. The death spiral is soon to turn into death bobsled ride. I wonder if the Congress realizes this.
So what else could be done here? Everything, except price competition. Coke and Pepsi are profitable because they compete in promotion/marketing/brand. Dell made money because of the low cost structure. Google made money (among many other reasons) because of its willingness to take risks to innovate. Apple made money because..umm.... well... Steve Jobs. Kleiner Perkins and Sequoia Capital have the market power because of the network externalities to be able to take a first look at quality deals. I mean anything but price competition is okay.

(By the way, I'm listening to the auto hearing right now and just heard that the auto makers want to make more efficient and longer-lasting cars. Wrong. Make efficient, yet short-lasting cars. There ain't no recurring revenue until the customer comes back to drop big bucks for another cool car.)

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