APs and Car Prices: It’s Supply and Demand lah!

Last week, Bernama and other sources reported Dato’ Mukhriz Mahathir’s bewilderment at Pakatan Rakyat’s proposal to auction Approved Permits (APs) to import cars. Essentially, Mukhriz said that auctioning APs (instead of giving them out at a fixed price) would increase car prices. Mukhriz is of course the Deputy International Trade and Industry Minister. In a letter to Malaysiakini, Pakatan Rakyat’s Rafizi Ramli promptly responded to these concerns, describing in generous detail why the good Deputy Minister had been mistaken.

Of course, only one of them can be right. I drew some graphs to help illustrate who was right (spoiler alert – it’s Rafizi), and where the other person (read: Mukhriz) may have got it wrong. The mistake comes down to an oversight of one of the most basic concepts in economics: that prices are determined by both supply and demand.

To illustrate how this basic concept comes into play in this case, I drew some simple graphs. So if you’re like me and you like pictures, maybe this explanation will be helpful.

Let’s start with the status quo, illustrated in Figure 1.

Variables:

P_GL = Global price of cars imported to Malaysia, including taxes, duties, and shipping cost (for simplicity, we pick a single price for imported cars and assume the Malaysian market has no effect on the global price)
D_MY = Aggregate demand curve for imported cars in Malaysia
E      = Market equilibrium, in absence of AP limits
Q_AP = Number of APs issued
P_MY = Profit maximizing price for imported cars in the Malaysian market if Q_AP APs are issued
P_AP = P_GL + Price of APs

The purpose of issuing APs is to limit the number of imported vehicles in the Malaysian market to give an advantage to local automotive makers. Without the AP system, Malaysians would buy more imported cars (Q_E imported cars at the global price P_GL) and fewer local cars. Instead, the government issues only Q_AP APs to import cars, and issues them to selected importers.

By reducing the supply of imported cars to Q_AP, price (you guessed it!) increases. Malaysians are now willing to pay P_MY for imported cars, instead of P_GL. This is where I’m guessing Mukhriz forgot about the demand curve. Perhaps he assumed that Malaysians pay P_AP, not P_MY.

So, where does the extra money (P_MY – P_GL) go to? Some of the money (P_AP – P_GL) goes to the government when it sells the APs to the importers. The remainder (P_MY – P_AP) turns into profit for either the importers, or the dealers who buy the cars from the importers.

Auctioning APs

So what happens if the government auctions the APs instead of giving them to select importers? Will car prices increase? Let’s take a look at Figure 2.

If APs are auctioned publicly, dealers no longer need to depend on importers – they can buy APs directly from the government. The dealers will start bidding at the original AP price (P_AP – P_GL). They will bid higher and higher, continuously increasing the AP price (P’_AP – P_GL) until P’_AP is so close to P_MY that paying any more for APs would make selling cars unprofitable.

The price of APs has increased, but the price of the cars P_MY remains unchanged.

All else constant, the price of the cars will only increase, as Mukhriz reportedly asserted, if to begin with, importers and dealers were not selling the cars at the profit-maximizing P_MY.

Dealers don’t lose

So where does the money go to now? Under the auction system, a much larger share (P’_AP – P_GL in Figure 2) will go to the government, while dealers will make P_MY – P’_AP.

But dealers do not lose out. The only party that loses is the middle-person – importers – who are made redundant (of course, some companies are both importers and dealers). Under the original AP system, the dealers were engaging in the same bidding process, only they were beholden to the importers instead of the government.

Reduced duties reduce car prices

Pakatan Rakyat also plans to reduce car prices by reducing duties. This will of course work, but how this will reduce prices of imported cars is less straightforward compared to how this will reduce prices of locally made cars.

Reducing duties alone (P_GL to P’_GL in Figure 3) will not directly reduce prices of imported cars. As long as Q_AP remains the same, P_MY will remain unchanged.

But by reducing duties on all cars, the demand for all cars will increase and more cars will be purchased. Q_AP is set at 10% of total market volume. So, when more cars are bought and the market volume increases, Q_AP will increase proportionally, to Q’_AP. With this increase in supply of imported cars, P_MY decreases to P’_MY.

The government currently issues APs at RM10,000 per AP to around 100 select companies.  As Rafizi explained at a forum on car prices, the government could gain more than RM3 billion every year by auctioning the APs.

So there you have it. By overlooking the basic concept of supply and demand, our Deputy Minister has dismissed a multi-billion ringgit opportunity.