Economics Q&A: What economic factors affect the demand for new cars?

The motor industry is one of the sectors whose fortunes seems to permeate nearly every part of the economy. Most of us know someone who works in the motor trade and changes in demand and production have sizeable effects not just on the industry itself but on many supply-chain businesses and economic activity in areas where car production is concentrated.

In 2010 just over two million new cars were registered in the UK - a rise of 1.8% on the 2009 figure. The biggest single course of rising demand came from the fleet market which rose by over 10% in 2010, but demand for and spending on privately bought cars slipped following the end of the Car Scrappage Incentive Scheme. Crucially for the year ahead, the new car market is forecast to decline by 5% in 2011 to 1.93 million units - according to the Society of Motor Manufacturers and Traders “difficult market conditions continue.”

So what are the main factors that affect the market demand for new cars?

1/ Strength of business demand for new vehicles.
These are cars bought as fleet vehicles for example by taxi firms, fleet cars required by car hire businesses and new vehicles used by utility companies and the police force. Demand for fleet cars picked up in the second half of 2010 but 2011 may see a decline in demand in part because of public sector spending cuts.

2/ Real incomes of car buyers relative to car prices
New cars are normal goods with a high income elasticity of demand. When real incomes are rising (i.e. pay is increasing faster than inflation) we expect to see an expansion of demand for new vehicles as they become more affordable. In 2011 this factor is likely to cause a fall in demand because millions of people have experienced either a pay freeze or a pay cut and this, together with higher taxes including VAT is causing real disposable income to fall.

3/ The cost and availability of motor finance (credit)
Some new car buyers pay in cash but many rely on securing a finance agreement and pay in instalments. It remains tough to get a new loan to pay for a car and the average rate of interest on unsecured credit has been rising even though official monetary policy interest rates are at historic lows. The high real rate of interest on car loans will put off new buyers.

4/ The cost of running a vehicle
The costs of running a vehicle continue to rise well above the average rate of consumer price inflation. Petrol prices are at a record high and car insurance premiums are increasing at a rapid rate. High petrol prices do not always bring about a fall in demand for vehicles since a new car is often more fuel efficient than an older offering the buyer the chance to save money.

5/ Consumer confidence
Buying a new car is a major purchase and, with macroeconomic conditions remaining uncertain, there is a lack of consumer confidence that this is a good time to make a major purchase. People are having a tough time with a recession and many will opt to postpone their purchase of a new car until the situation improves. In 2011 the fear of job losses (in the public and private sector) will dominate many people’s thoughts.

6/ The end of the government’s Scrappage Incentive Scheme and the rise in VAT
The car scrappage incentive scheme came to an end in May 2010 - it had offered at £2000 subsidy for owners of 9 year old cars who traded them in for a new one. In January 2011 VAT has increased from 17.5% to 20% - an increase which has added almost £320 to a £15,000 car.

Overall
There are strong grounds for thinking that 2011 will be a difficult year for the UK motor industry. New car sales are likely to decline by 5% or more and this will have a direct effect on production in UK factories. It will also affect the demand for imported new vehicles although changes in the sterling exchange rate will affect the balance between demand for domestic and overseas produced cars.