Friday, March 6, 2009

Enzo doesn't need Supply and Demand

Having learned about economics and business models from the courses I've taken over the past 3 years, combined with a passion for the auto industry and cars in general, I've been thinking about an interesting and relatively unique business model.  Of course, if you are familiar with the company you can tell from the title of this post that I am talking about none other than the one and only Ferrari.


Any first year business student will tell you that the rules of supply and demand state that in order to reach equilibrium, or maximum efficiency, supply must be equal to demand.  Apparently the executives at Ferrari skipped that lecture.  Instead of following this proven model, they have gone off the proverbial beaten path, and used a model that directly contradicts logic...at least at first glance.


There are literally lineups of customers waiting to pay the exorbitant fee to get into a new Ferrari every year.  In order to reach equilibrium, Ferrari should clearly increase their annual production to meet this excess in demand.  If a third year university student like myself is qualified to explain this obvious flaw in their business model, why have they not done anything about it?


The answer is that this shortage of supply is not a flaw, but a rather ingenious technique used to control the market for their product.


To explain this I'll start by asking a question.


How come we get excited when we see a pristine 348 blasting past us on the street with the throttle wide open and that 3.4L V8 emitting a symphony that puts Beethoven to shame?


Is it because of the beautiful body lines?  Of course.


Is it because of the aforementioned symphony? No doubt.


More importantly; however, it is because we do not often see a beautiful prancing horse galloping down the street, but rather a rust bucket Civic with a crappy four-banger and a tin can for a muffler (see: POS).


The fact that Ferraris are relatively rare gives them an aura of exclusivity, and here-in lies key to the Ferrari business model.  By limiting production to a level that falls short of demand they are able to control two important factors; price and rarity.  These two factors work as compliments to each other, giving Ferrari unprecedented control over the market.


Without getting too far into the details behind economic theory, it basically works like this.  The first thing you learn in economics is the rule of scarcity; which states, people have unlimited wants, but limited resources to satisfy those wants.  Thus, we cannot satisfy all of our desires and must make decisions as to which ones we wish to, or are able to attain, and which we do not wish to, or cannot attain.  Building on this rule, we have the supply and demand graph, which can be manipulated to show how the price of a good, and the quantity sold of said good, will be affected by changes in supply or demand.  Using this graph, we can tell that by reducing the supply of resources (in this case Ferrari vehicles) and leaving demand (in this case the number of people who want to buy a Ferrari) as is, the price of the good, or resource (Ferrari vehicle) will go up.


Applying what we have just learned (congratulations, you have just passed first year microeconomics) to the business model that Ferrari uses, we can start to shed light on why it works.  Essentially, by producing fewer cars than they are able to sell, they have more control over the price of their product, rather than letting the natural forces of the market (fluctuations in demand due to factors that the company cannot control, such as the current recession) decide the price for them, as is the case for most products.  This is important because when you know what the selling price will be, and you know how many cars you will sell, ie. all of them (there is a lineup waiting to buy these cars, remember?  Each one is spoken for before it is made!) you therefore know exactly how much revenue you will have at the end of the year.  


All Ferrari has to do is figure out how much it costs them to make one car, multiply that by the total number they plan to make that year, add the overhead costs and bingo...they know their costs and their revenue.  Revenue - Costs = Profit.  So essentially, Ferrari is able to determine how much profit they will make at any specific price they choose.  For most companies, even a small increase in price will have a negative effect on how many units they sell, but since there is a lineup of people waiting to buy Ferraris, an increase in price (within reason) will have absolutely no effect on how many cars they will sell.  Thus, Ferrari can maximize their revenues by setting the price at the maximum cost people are willing to pay, without increasing it so much that too many customers take their names off the waiting list.  The other factor that comes into play is the fact that the fewer cars they make, they more they are able to charge for each one.  Thus, the trick is to find the best combination of production volume and price to maximize proft.


As I said earlier, by limiting supply, not only to does Ferrari control price, but also rarity.  By operating on a limited production run each year, they ensure that the market doesn't become flooded with Ferrari's (remember how we get excited when we see that 348 because they aren't very common).  This rarity is essential to protecting the status and exclusivity of the brand, which is essentially what makes a Ferrari so desirable, and thereby allows them to have such incredible control over setting the selling price.  Ferrari is not only adept at controlling the market for their new cars, but used ones also.  By running a limited production volume year after year, they ensure that the used market doesn't become too big, thus retaining the exclusivity that gives new and old Ferraris alike their high status level.


This plan virtually guarantees that the company will have stability over the long term, as long as they don't sell out for a short term gain.  Of course, if they ever wanted to, Ferrari could produce enough cars each year to meet demand.  They would make much more money if they did this; however, over time the cars would lose their aura of exclusivity, and all of a sudden Ferrari just wouldn't be in that top teir anymore, but rather competing with the likes of Porshce, which sells a much higher volume of cars.  By losing that exclusivity, Ferrari would lose a significant amount of control they have over the market and they would no longer be able to charge such obscene prices for their product.  Simply put, they would make more money in the short term but it would cost them in the long run.


So now we have seen how Ferrari controls both price and exclusivity by limiting their production.  They don't sell out in the short term, but rather play for the long term gain...always thinking about the future.  At Ferrari, the planning for the future of the business is matched only by the planning of future technologies to put in their cars, many of which are developed by their Formula 1 team.  This type of forward thinking will help Ferrari make it through this recession with a lot less trouble than most automakers are experiencing.


What's that you say...the economy is going to be even worse this year?  Not to worry, if demand goes down, just produce fewer cars.  They will be saving on variable costs (materials and labour), while keeping demand and exclusivity, their bread and butter so to speak, as high as always.  Plus, people who buy Ferraris, especially new ones, have, for the most part, enough money that the state of the economy wouldn't affect their decision to buy a Ferrari.


Never wavering from their plan, that horse can keep standing on its hind legs for the foreseeable future.  If only the same could be said for GM...

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