Question

1. The process for buying a car in the U.S. seems to usually exhibit the following characteristics (it may differ from these, but I’m not an expert in the auto industry so just take these as given for the sake of argument):
   1. A car dealership purchases cars from a manufacturer at a specific wholesale price, set by the manufacturer.
   2. The car dealership puts a sticker in the car window which includes the MSRP, or manufacturer suggested retail price.
   3. The car dealership negotiates the actual selling (retail) price with individual customers, such that the same car may sell for different retail prices for different customers.

For the three prices mentioned above (wholesale price, MSRP, and retail/selling price) describe how much market power an individual car dealership would have in setting each price. In terms of just the retail/selling price, how might an individual car dealership’s potential market power be affected by the presence of other car dealerships in town? (E.g., a small town that has one dealership vs. a larger city where several car dealerships usually cluster in a certain area).

Given that car dealerships always ensure that the retail/selling price exceeds the wholesale price, such that customers pay more for the car than the dealership itself does, why do customers continue using car dealerships instead of purchasing the car directly from the manufacturer at its factory?

Answer 1

Wholesale Price: The dealership has no power in setting this price. This is pre-determined by the manufacturer.

MSRP: This is the retail price suggested by the manufacturer. So the dealership again has very little to say in this. However, the dealer can bargain with the manufacturer to increase this price because it is based on this that he can bargain with the customers. The power to set this price is higher than the power to set the wholesale price.

Retail/Selling Price: This is completely in the hands of the dealer. He bargains with the customer and decides on the final price.

If there are too many car dealerships, customers have multiple options to choose from. One way to entice the customer is to lower prices. However, lowering prices too much means the dealer will go for a lower profit. So he will have to coordinate in such a way so as to have the same price as is given by other dealers. Thus his dealership will be a price taker and hence have no control on the retail selling price setting.

There are multiple reasons to buy from a dealer than a factory

1) The factories are not present everywhere. One factory may serve multiple different locations. It becomes difficult for the customer to travel those large distances to get a single car

2) The dealerships buy in bulk and hence the cost of transportation gets divided among many cars. However, a customer buying a single car may have to pay a lot for transportation which will push up the effective price of the car.

3) There are options to bargain or get additional accessories at a dealership which is not possible at a wholeseller.

So customers always buys from dealerships as even though the base price may be higher, the cost of hassles, transportation, etc adds up when buying from a dealership not to mention the fact that a dealership may not want to sell individual units.