The American Economic Review, Vol. 101, No. 3, May 2011
11 Pages Posted: 8 Oct 2012
Date Written: May 1, 2011
Durable goods producers can face a pernicious feedback loop between their financial health and the demand for their products. Financial distress can reduce demand for a firm’s products if it causes consumers to worry about the firm’s ability to supply flows of goods and services — such as warranties, spare parts, and maintenance — that are typically bundled with the primary durable good. This drop in demand harms the firm’s profitability, exacerbating its financial distress, which in turn further heightens the demand impact. In principle, this cycle can spiral until the firm falls into bankruptcy. The feedback mechanism might even sustain “bank- run-like” self-fulfilling expectations (e.g., Douglas W. Diamond and Philip H. Dybvig, 1983): if consumers suddenly believe a firm is distressed, even incorrectly, the resulting demand effect could push the firm into distress and even bankruptcy.
Concerns about such effects in auto manufacturing played a prominent role in policy discussions during the recent recession. Some feared that the already struggling General Motors and Chrysler would be further harmed due to consumers’ worries about warranty viability. In March 2009, the U.S. Treasury announced the creation of the Warranty Commitment Program, which guaranteed warranties of new GM or Chrysler cars should either firm go bankrupt. This program was justified by its defenders as a device that could break the vicious circle between consumer expectations of firms’ financial health and demand for their products, serving a function akin to bank deposit insurance. If the feedback mechanism was weak, however, such policies would be at best a wasteful distraction and at worst an unnecessary and possibly large transfer from taxpayers to automakers and their consumers. Measuring this feedback loop’s strength is important for evaluating how it affects equilibrium outcomes in this and other durable goods markets as well as in evaluating interventions like the Warranty Commitment Program.
In this paper, we measure the impact of this feedback mechanism on outcomes in the auto market. One of the key inputs into this analysis comes from our related work (Ali Hortaçsu, Gregor Matvos, Chad Syverson, and Sriram Venkataraman, 2010) where we measure the direct effect of automakers’ financial distress on consumer demand. We found that shifting an automaker’s probability of default from zero to a near certain bankruptcy reduced the market prices of that producer’s cars by roughly five percent (e.g., $1400 on a $28,000 car). Here, we measure the equilibrium impact of this, taking into account its feedback effect on an automaker’s financial health and its influence on that firm’s pricing and debt service choices. We do so by building a simple model where an automaker builds and sells cars to earn profits for its equity holders and service its debt payments. Consumers’ demand depends on their expectations about whether the firm will continue operating (i.e., not default on its debt) and therefore be able to provide full flows of bundled goods and services that arrive after the initial purchase.
We find that multiple equilibria in prices (and therefore sales and operating profits) and bankruptcy probabilities can arise in the model, confirming the possibility of self-fulfilling expectations. We then combine our estimate of how much an automaker’s financial distress affects demand for its cars with measures of the model’s other parameters gleaned from data on actual automakers’ operations and solve the model to see if multiple equilibria are likely in the current auto market. Finally, we do a counterfactual exercise to gauge how market outcomes would change if consumer demand were unaffected by an automaker’s financial health.
Suggested Citation: Suggested Citation
Hortacsu, Ali and Matvos, Gregor and Shin, Chaehee and Syverson, Chad and Venkataraman, Sriram, Is an Automaker's Road to Bankruptcy Paved with Customers' Beliefs? (May 1, 2011). The American Economic Review, Vol. 101, No. 3, May 2011; UNC Kenan-Flagler Research Paper No. 2013-24. Available at SSRN: https://ssrn.com/abstract=2158358