In an earlier post, I promised to write more about the economics of “Cash for Clunkers.” So here goes…
First, let’s think about how the program works. From the consumer’s perspective, you get either a $3,500 or $4,500 rebate on the purchase of a new vehicle if you are trading in a “clunker” for a more fuel efficient vehicle. The details of qualifying trade-ins can be seen here. From the car dealer’s perspective, it takes the clunker and hands it over to some sort of government entity to be destroyed. (Technically I think the cars get recycled and don’t just end up in a landfill somewhere, since that would be comically counter to the proposed environmental aspect of the program.)
As a result, the government rebate acts as a subsidy on the purchase of a new car. However, from the (smart) consumer’s perspective, the effective rebate is not the entire $3500 or $4500. This is because the consumer is forgoing whatever trade in value he would have gotten otherwise. If we consider that there are lots of dealerships that offer a $2000 or so minimum for a trade, the net rebate amount is actually a maximum of $1500 or $2500. If the consumer has a halfway decent car, this amount is going to be even lower since the net rebate is the difference between the government cash and the value of the trade. (I would hope that people aren’t turning in vehicles that are worth more than $4500!)
I hope that you now see that the cash for the clunker is a net subsidy of somewhere between $0 and $2500. Economics 101 teaches us that the benefits of a subsidy are generally shared between consumers and producers. Consumers benefit because they pay less out of pocket than they would have without the subsidy. Producers benefit because they receive a higher price than they would without the subsidy. This can be seen in the following diagram:
Some relevant points:
- Demand for cars increases (i.e. people want more cars) as cars get cheaper. Hopefully this is intuitive to you.
- Producers want to supply more cars if they can get a higher price for them. They will generally figure out how to produce more cars by running assembly lines closer to capacity, having employees work overtime, etc. (The higher price makes this profitable where it wouldn’t be otherwise.)
- The subsidy is effective in encouraging sales of more cars…how effective depends on how reponsive producers and consumers are to price. The increase in quantity of cars sold is greatest when consumers and producers are very price sensitive.
- The price that producers get for the cars goes up, but not by the full amount of the subsidy.
- The price that consumers pay out of pocket (net of the rebate) for the cars goes down, but not by the full amount of the subsidy.
- The two price changes above add up to the amount of the subsidy.
- You can’t see this directly in the graph, but if consumers are more price sensitive than producers, consumers will see less of the benefit from the subsidy than the producers. (The opposite is also true.)
- Again, you’ll have to take my word for this, but this outcome doesn’t change depending on whether the subsidy is given directly to the consumer or to the producer.
Glad we got that out of the way. Now that we understand a bit of economics, I want to introduce you to an article from edmunds.com about how consumers are getting ripped off because they are paying higher sticker prices for the cars because of Cash for Clunkers. Now, this is partly true and partly not true:
- Those consumers who are getting the Cash for Clunkers rebate are not paying a higher price once the rebate is taken into account, they just aren’t capturing the full value of the rebate.
- Those consumers who don’t have a clunker to trade in are getting crowded out of the market to a degree. This is because the car dealers aren’t going to cut a better deal for a non-clunker customer when there are plenty of less cash-constrained clunkers customers lining up out the door. In this way, customers without qualifying trade-ins are also subject to the higher prices.
Technically, the relevant text of the article is the following:
AutoObserver.com. “In some cases, they are choosing less expensive trim levels and option packages than had been typical in recent months, but paying more for them.”
“In truth, this program launched at the worst possible time of the year,” opined Edmunds.com CEO Jeremy Anwyl. “The annual summer sell-down typically creates a rush of activity for the industry, and this year that rush came right after automakers cut production in response to the floundering economy. It’s a simple case of supply and demand, bolstered by a reduced level of negotiation on the part of excited clunker traders. Add to this the automakers’ unseasonable reduction in incentives and the message is clear: if you buy a car this summer, you should expect to pay higher prices.”
In fairness, the “getting ripped off’ implication here is subtle…but then you have subsequent articles with fun headlines like Don’t Let Cash For Clunkers Short You. I would argue that this really should read “Don’t Let the Laws of Economics Short You”, but that doesn’t have the same ring to it.
(Warning for the future: I don’t think I am done talking about clunkers yet- it’s really a nice playground for economic snark. Whee. On a sidenote, does it bother anyone else that the government can be paying out $4500 for a combined benefit to consumers and producers of at most $2500? Technically, the value to the consumer and producer is even lower than what is stated above if the consumer wouldn’t have purchased the vehicle without the subsidy. Either the government must be getting some decent cash for the recycled car parts or there must be one hell of an environmental benefit to having a smaller SUV as opposed to a larger one. =P)
18 responses so far ↓
1 D Delay // Aug 16, 2009 at 9:12 am
Many dealers are advertising ‘an additional discount’ of $4,500 on the CforC, for a shadow discount that appears to be $9,000. I would assume the dealers are raising prices by $4,500 first, before slapping on the matching discount.
2 Christopher Scott // Aug 16, 2009 at 9:40 am
Couple of points - The pricing of externalities is important. If you have a large and heavy car, they do more damage to the roads, so having a lighter car or SUV helps cut down on road construction and maintenance costs. Less construction means less delays on the roads too. Also, large cars make the road less safe for other drivers. Smaller SUV’s could cut down on accident fatalities or injuries. And this program has been highly effective at raising the average mpg of the car fleet, I would have to research it a bit, but I remember an NY times blog or article (either freakanomics or economix) saying that the average car turned in was 12 mpg and the average new car was 18 mpg, which cuts down on gasoline usage and carbon emissions. So this program can only make sense if you add in externalities that are pretty hard to price anyway…
3 Tony // Aug 16, 2009 at 11:15 am
“does it bother anyone else that the government can be paying out $4500 for a combined benefit to consumers and producers of at most $2500?”
Yes! And, I don’t know the details, but the clunkers are destroyed in the recycling process. Do you know who pays for the demolition and recycling? Is it a net gain to “recycle” a car, compared with just parking it in Montana?
Is the demolition an additional governmental cost? Is this an implicit responsibility for the dealerships? Accounting for that cost seems relevant.
4 Dan L // Aug 16, 2009 at 11:52 am
WOW. If you really believe that dealerships give you a “$2000 minimum for a trade,” then I have a bridge to sell you.
5 Larry // Aug 16, 2009 at 12:14 pm
So it bothers me that we are destroying capitol (cars that work) to replace it with more expensive capitol on credit when we just crashed out of a bubble caused by very similar behavior… don’t we learn?
What about the dead weight loss to society of destroyed capitol? Essentially, this is a perfect example in the real world of the broken window fallacy in action.
6 Daniel C. // Aug 16, 2009 at 1:30 pm
Another factor making it look like a good scam is that customers getting the subsidy will pay price closer to sticker, instead of negotiating. I was looking at this, and I decided to make some repairs in my 10 year old minivan, instead of buying a new one. (I care about externalities, but the first principle is (My) Cash (flow) is King, right?)
As I researched the issue, a dealer showed me a car that they had just replaced the tire rings, so the sticker price (already over my limit) would be increased by $2000. That would have costed me (he insisted many times) just $20 for each $1000 I borrow, so $40 a month for the foreseeable future… Thanks, but…
As a devil advocate (kinda), though, this subsidy is not bad from a macroecon perspective. The injection of $1B (possibly $2B+ once authorized) will have the effect of probably saving jobs, increasing output, the famous and forgotten multiplier effect, and maybe saving a few viable companies that did not receive direct help from the government. Those cars will need more expensive insurance, more care (in the form of cleaners, or car washes), will be more of a pleasure to drive, so people will use them more, defeating the purpose of consuming less gasoline (but at a higher mpg rate), eating out those days, etc… simple way to reactivate the economy. (but people will actually have less disposable income because of the added car payments… How does this work?)
At the same time, once current inventory is exhausted (and we are almost there as dealers know and tell), car companies may decide to produce only cars with bigger margins, instead of consumer’s economy driven ones… Who knows? Consumers are evil and always demand only what is good for them… Companies are always looking for the greater good of consumers (those that are also called shareholders, cause they consume their stock!)
Anyway… let’s hope that this subsidy makes true the “ceteris paribus, but they never are” saying, and helps getting us out of the mess we created for ourselves.
7 Jacob // Aug 16, 2009 at 2:25 pm
Jodi, I think that your, and many other’s, assumption that ‘cash for clunkers’ is beneficial to the environment is wrong. I can not support this without numbers, which I’m too lazy to research, but think of all the materials and energy that goes into producing a new vehicle and getting it to market. The increase realized in gas mileage and/or decrease in oil consumption, must be viewed in tandem with the resources used to make and distribute the car. I think the mileage requirements were more to gain political support for a program that benefits politicians and car dealers more than the environment or tax payers.
8 Jacob // Aug 16, 2009 at 2:30 pm
oh, and I meant to add that the parts are not recycled. I read an article (I’m not sure where) and also heard from a friend who is a buyer for Schnitzer Steel, that the car’s engines have all fluids drained from them, and then are locked up by injecting a certain substance (I don’t know what). These are then sold for scrap. This also takes plenty of cheap, used cars off the market that would otherwise be available for sale to low-income individuals, thereby increasing the cost of a used vehicle to those who can least afford them.
9 Trey // Aug 17, 2009 at 12:49 am
The first thing that comes to mind when reading about the Cash For Clunkers is exactly what Larry posted above. In a country as extremely leveraged as America, encouraging consumers to obtain more debt to purchase cars that will depreciate by 20%+ in the first week seems a bit counterintuitive. I don’t have time to do the research, but it seems that these purchases could result in a decrease in many consumers’ disposable recurring cash flow due to new loan payments and insurance premiums. This leads me to believe that this is nothing more than an extremely short-term stimulus and a shot in the arm of the auto industry, unless consumers can save more per month from improved gas mileage than they shell out for their new loan payments.
10 Marshall // Aug 17, 2009 at 2:00 am
I don’t understand this last statement:
“On a sidenote, does it bother anyone else that the government can be paying out $4500 for a combined benefit to consumers and producers of at most $2500?”.
If this savings is as you state it, then the government is “buying” a car for $2000 that no one else will buy. This is likely seen as a service whose benefit extends to other areas (environmental, short-term economic stability, etc), even if all they ultimately do is scrap it.
Obviously the deal is going to make no sense in an idealized 2 variable model. It’s not supposed to benefit the country or the government in a 5 year auto market.
Dealer trade-in offers are absolute bullshit anyway, and are just an excuse to lure customers in and raise the overall sticker price on slow-selling cars. I think this market is too deceptive to reach a nice, clean statistical equilibrium described by perfect linear curves. I doubt any two people are paying the same price for a particular model, and that the mean price one week bears much resemblance to the week before. +/-$1000 has got to be at the noise level.
11 Kevin // Aug 17, 2009 at 1:53 pm
really? I have to be the one to point this out?
I know you know this, but…
Demand for cars increases (i.e. people want more cars) as cars get cheaper.
intro econ was incredibly boring if only because the teachers kept repeating, over and over, demand (or supply) does not change in response to price. I guess we all need reminders now and then…i know you meant quantity demanded, but still.
12 Trey // Aug 17, 2009 at 2:09 pm
Kevin,
I noticed it too, but figured it was an oversight. I’m no economist, but an actual shift in the demand curve might occur if one were to approach the “rebates” as increases in income. If that were the case, I believe the graph might include an outward shift in the demand curve to the higher price - but that approach could be a stretch and would not provide the graphical representation of the subsidy as shown above.
13 Ben // Aug 17, 2009 at 5:12 pm
Here’s the hell of a Global Warming benefit:
* Moving from a Hummer H2 to a Prius reduces carbon production by about 10 tons per year (12k miles @ 41.6 MPG versus 12 MPG, 8.877 kg CO2/gal)
* Each ton of CO2 is worth about $5.20 (cost of carbon offsets via Wikipedia)
* => $52/year saved
It’s unlikely the clunker would be driven for more than another 10 years if it really is a clunker, so net Global Warming impact is probably well under $500.
14 Julien Couvreur // Sep 5, 2009 at 12:47 pm
“Economics 101 teaches us that the benefits of a subsidy are generally shared between consumers and producers.”
Actually, Economics 101 teaches that subsidies benefit some consumers and producers, and harm some consumers and producers.
As Henry Hazlitt puts it, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups”.
In particular, the subsidy costs all taxpayers, who did not volunteer their money (for which they had better uses) thus lowering their satisfaction.
It also costs all other producers, except those receiving the subsidy. For example, second-hand car dealers and repair shops, and retailers and producers of any other consumer good. The subsidy is increasing incentive toward new cars, so the consumer is marginally more inclined to spend in that industry, as opposed to anything else.
Also worth mentioning is that “cash for clunkers” sets rules on destroying the reclaimed engines. Destroying goods is not value creating. Otherwise we would just dig holes and fill them (wasting labor) and wage wars (wasting lives, goods, lands, and armament). Oh, wait, we’re doing both!
15 CAR GUY in LOS Angeles CA - Expedite Trucking Forums // Oct 5, 2009 at 11:44 pm
[...] Daily Kos: Car Dealers Abusing Cash For Clunkers? 5 downsides to ‘cash for clunkers’ - MSN Money Economic Models Triumph Again, Cash For Clunkers Edition (Part 1)
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