Small is beautiful?

A supply shock might lead to a shift in demand rather than a marginal adjustment in purchasing decisions.

An analysis by Power Information Network found that consumer interest in full-size SUVs has dropped substantially over the past year. Full-sized SUV sales fell 21% in February after a 31% drop in January, when compared with the same months a year ago (Milwaukee Journal Sentinel 3/16/2005).

To move the excess inventory, carmakers are offering bigger than ever incentives to potential buyers. Edmunds.com says large SUVs carry the highest average incentives: $3,740 per vehicle by April, up 14% from the month before, vs just $1,800 for compact cars. Not so long ago, small cars needed big rebates while big SUVs sold fast at full price (Business Week 5/31/2004).

High oil prices explained this sudden shift in vehicle-size consumer preference. In August, 2005, the price of crude oil per barrel has shot past $60. Many economists believe prices will stay high for years due to rising demand from China and India and unrest in the oil-producing countries. A recent poll by Kelly Blue Book found that one in six car buyers has changed purchase plans because of higher fuel costs.

On the surface, this looks like a textbook case of how the prices of and demand for complementary goods should behave. Namely, when the price of a good rises, the demand for complementary goods would fall leading to lower prices.

But the story is more complicated than that. When a 2005 Chevy Suburban 2500 was marked down from $39,940 to $31,674, the saving amounted to $8,266 (Atlanta Journal-Constitution). If we use the saving to give a $1 per gallon subsidy to gas price to keep it at $2.00 per gallon, the saving is large enough to subsidize almost 100,000 miles of driving at 12 mpg. Driving an average of 15,000 miles per year, that means close to seven years of driving at the same old price of $2 per gallon. In other words, the shift to more fuel-efficient vehicles was not entirely a decision based on marginal costs and marginal benefits. It is a shift in preference based on a change of visions. Car buyers may think it is no long hip to drive gas-guzzling huge vehicles regardless of driving costs.