The European Automotive Industry
Industry Features
In this chapter we will
describe the basic features of the industry, and discuss how they
affect the level of competition and conduct of market actors.
As mentioned in section 2.4 we will use a modified version of
Porters five forces to describe the basic features of the
industry. The model is modified in order to concentrate on the
factors that have special relevance for the automotive industry.
Thus we will not discuss all the factors that are normally
synonymous with Porters five forces, but rather select the
factors that have special relevance and incorporate them into
Porters framework.
Figure 3.1
It should be mentioned that
this model has little analytical value in itself, and is merely a
tool for structuring the presentation of the industry. Thus, in
some cases we shall need other theories to examine the individual
features. In these cases we will state the theories used, in the
relevant section. For an overview of theories used, see section
2.4 on methodology.
As it is shown in the model we will not discuss substitutes as
intended in Porters original model. The reason for this is that
the substitutes available for private motoring have little effect
on the nature and level of competition in the car industry.
However if large monopoly power were to emerge in the industry,
public transportation as a substitute may set limits on the
prices of a monopoly producer. However, substitutes are needed in
order to define the industry. Hence we have changed substitutes
to industry definition. Of course this will be the first issue to
be discussed below.
The features relating to barriers of entry will not only be
discussed from the perspective of keeping out potential entrants,
but also from the perspective of how these factors affect actors
that are already in the industry. Under buyers we shall mainly
focus on demand, both with respect to current quantity and with
respect to the factors that influence the size of demand. This
section will contain a large amount of empirical data regarding
the size of the industry. Further we will discuss market power
and vertical integration on the supply side as well as on the
demand side. For the section of rivalry we will measure and
examine the effects of concentration. Also we shall discuss
overcapacity in the industry, as well as exit barriers and fixed
costs.
Below industry definition, rivalry, buyers, suppliers and
barriers to entry are discussed in that order. This order is not
coincidental. There is an amount of interrelatedness between the
individual factors of the model, and the order has been chosen in
an attempt to describe the most basic structures first, and their
dependants later. However, in some cases it may be necessary to
refer to a later sections.
INDUSTRY DEFINITION
Below we shall briefly define the industry in question. In order
to do so, we need to discuss not only the industry itself, but
also the possible substitutes. An industry is merely a group of
companies that produce a product with similar distinctive
features. Thus we need to identify these features.
As mentioned in section 2.5 on limitation, this report focuses on
the passenger car industry in Europe. The benefits provided to
consumers of the industry products are easy transportation, and
thus possible substitutes are other forms of transportation. In
Western Europe the main substitute for cars is public
transportation and non-motorised transportation like bicycles.
Public transportation functions as a substitute for longer
distances, whereas non-motorised transportation is a substitute
on shorter distances.
The effect of the presence of substitutes depends on the
closeness of these substitutes . That is how much they resemble
the product in question. One of the main features for personal
motorised vehicles relative to public transportation is
convenience and flexibility. However these differences are
decreasing, as public transportation is experiencing considerable
growth as an effect of pollution pressures toward collective,
low-emission forms of transportation. This has induced policy
makers to set up more advanced schemes of public transportation,
which allows for increased flexibility through more departures.
Thus public transportation is an increasingly significant
substitute to private car ownership at lower prices. This induces
car manufacturers to produce cars that are more economic with
respect to variable costs like fuel.
From the discussion above we have limited our focus to personal
motorised transportation. However, even in this category there is
a large amount of different companies, like component producers,
car dealerships etc. This report will focus on companies that
assemble the finished vehicle. All of these companies are also in
the business of making engines, and designing vehicles. However
this definition excludes companies that only produce car
components, whereas assembling companies that are vertically
integrated into component production are included.
Rivalry
Below we shall discuss some factors that affect the rivalry, and
thus the fierceness of competition in the car industry.
Concentration
Economic theory suggests that the vigour of competition is
related positively to the number of firms in the relevant
industry when other conditions such as height of barriers are
equal. There are a number of reasons for this phenomenon.
One is that in highly concentrated industries, firms have a
larger degree of market power. This is most obvious in the case
of maximum concentration namely monopoly, but market power also
occurs where there is more than one actor in a concentrated
industry. It has been estimated that in an industry where the 4
largest firms control more than 40% of the market, oligopolistic
competition is likely to occur .
The effect of such market power is that firms face a less elastic
demand curve. Thus in order to sell one extra unit, the firm
needs to reduce the price on all units, placing marginal revenue
below the demand curve. As the firm produces at MC equals MR,
price is higher than average costs. Thus there are monopoly rents
for the firm. This is shown below in figure 3.2.
In a situation where industry concentration is at a minimum,
substitution between firms will lead to a situation, where the
individual firm faces highly elastic demand. This happens because
firms cannot sell at a price significantly above the price of its
competitors, and consequently competition will push prices
towards the level of average costs. Accordingly economic rents
are minimised.
Indsæt figure 3.2 fra side 19
Indsæt billede fra s. 23
In all circumstances the
existence of overcapacity is a powerful catalyst for fierce
competition. In such an environment the marginal cost of
producing an extra unit is relatively low, and the break-even
level in terms of units sold is relatively high. Thus the firms
in the industry have a strong incentive to cut prices, in order
to stimulate demand, and consequently putting their excess
capacity to use.
Exit barriers and value of fixed costs
Another determinant of competition in the car industry is exit
barriers and the value of fixed costs. These are somewhat
interrelated since fixed costs relating to specialised assets is
an exit barrier.
The effect of high exit barriers is that firms tend to stay in
the industry, even if it is not profitable. This leads to
increased competition, as some market actors are willing to
operate at a loss in order to avoid the high costs of exit. Such
exit barriers can stem from a number of factors, like for example
contracts that are expensive to break or specialised assets as
mentioned above.
In the car industry there are a number of highly specialised
assets like production plants and the value of knowledge in the
form of R&D (R&D is quantified in chapter 7). Such assets
cannot be transferred to other industries without loosing value.
Thus if a firm chooses to leave the industry, it will loose the
value of its specialised assets. This is not the same as to say
that existing firms should always stay in the car industry. If
the firm is running at a loss, and there is no chance of turning
this situation, it will be better to incur the cost of loosing
its assets right away. However if the deficit is perceived to be
temporary, the value of assets will incite the company to stay in
the industry, in the expectation of future profits.
In the car industry, where there are a number of large producers
(see appendix A), industry specific assets are likely to be
traded among industry actors at a reasonable price. Thus there
doesn't seem to be much of a case for the high exit barriers
argument in the car industry.
High fixed costs are another catalyst for competition. High fixed
costs often lead to low variable costs and marginal costs. Thus
firms are induced to cut costs, in order to sell more, so as to
cover their high proportion of fixed costs. Fixed costs will be
further examined and quantified in chapter 7. Here we show, that
the amount of capital to labour is relatively high in the
industry, but at the same time labour costs, far exceed
depreciations. Thus although fixed costs are high there appear to
be no extreme threat for price wars. Both fixed costs and exit
barriers are related to the game theory example above, since sunk
costs are necessary to make a credible commitment to the
industry.
Industry growth
In a situation where the size of an industry is declining, there
is a struggle, to be an industry survivor. Hence low growth leads
to intense competition, whereas high growth diverts the attention
of companies towards capturing the shares of the new market, so
that competition is less head-on.
After almost fifty years of steady post-war growth, only
interrupted by the oil crises in 1973 and the early eighties, car
demand suddenly dropped by a massive 16.8% in 1993. Only 11.3
million cars were sold in 1993. This is nearly 2.1 million units
less than the previous year. In other words a loss of 2,5 billion
ECU, which is equivalent to the total output of all Western
European Volkswagen plants. The development is shown in figure
3.3 below.
Indsæt figur 3.3 fra side 25
With the benefit of hindsight, the 1993 trend
line break should not have been as unpredictable as it looked at
the time. In reality demand had started to loose its edge already
a few years earlier. However at that time the change in growth
was concealed by two extraordinary events that temporarily
boosted demand.
In 1991, after the reunification of Germany, West- European
registrations enjoyed an almost overnight windfall of an
additional 700,000 East-German registrations. Together with the
beneficial effects on West-German new car sales, triggered off by
a massive export of second hand cars to former East- Germany.
Secondly, during the years that preceded their EC membership and
during the first years of membership Southern European market
like Spain, Greece and Portugal experienced a strong increase in
passenger car sales. During the period 1984- 1989 the Spanish car
market tripled from 500.000 in 1994 to 1.5 million in 1989.
Demand eased down again to previous levels after the average age
of car parc had settled at a lower level, more in line with the
newly found wealth and increases in GDP per head.
As it is shown in section 3.3.2 demand is correlated to economic
prosperity. In the table below we have shown some economic
indicators for EU15.
Table 3.1
Source: Neil Mulliniuex: The new car
market in Europe & OECD Economic Outlook.
Figures after 1996 are projected.
GDP per head has been increasing by a considerable percentage. However, GDP per head figures can be misleading because these figures do not consider differences in the cost of living, so it does not show the real standard of living. We therefore use the real GDP growth to measure economic growth, which includes differences in the cost of living. In 1994, for example, real GDP growth was only 2,6%, but growth of GDP per head was 6,4%. Real growth of GDP continued to improve in 1994 and 1995 after a period of low growth between 1991 and 1993. The economy of the region was estimated to have grown by 2,6% - 2,7% in each year. Though the European economy had below average rate of world trade growth, it was a good performance from such mature economies.
Table 3.2 
Source: Molle, Willem: The Economics of
European Integration; page 439
PPP = Purchasing Power Parity
If we look at the European economy, the average
for the countries that now make up the EU15 was almost three per
cent a year over the last forty years. First there was a long
period of high and stable growth (four per cent a year) that
lasted up to the first oil crisis. This coincided with the first
extension of EU. Next there was a period of adjustments, with low
growth (1,5 percent a year). The end of this period coincided
with the second extension. Finally the period since 1985 is one
of new dynamism (growth rate of 2.5 per cent a year).
If we need to account for the differences in the cost of living,
we can use Purchasing Power Parity (PPP) index. This index allows
for more direct comparison of living standards in different
countries. In the above table PPP is set equal to 100 for the
average purchasing power in EU member countries. According to
table 3.8, Luxembourg had the highest standard of living, PPP
165, in1995, while Greece had the lowest standard of living, PPP
63, in EU. It means that an average citizen of Luxembourg's
purchasing power was nearly three times higher than an average
citizen of Greece.
All in all projected growth in Europe is moderate. Certainly the
potential for growth is not as big, as it tends to be projected
in the annual reports of the manufacturers. Combined with
saturated markets it does not appear that demand for cars is
likely to increase significantly in Europe. This low growth
environment is likely to increase competition in the industry.
However there may be a possibility for high growth in the East
European countries, if some of these are accepted for an EU
membership. Acceptance may lead to rapid Economic growth in these
areas, and hence a temporary boost in car demand, like the one in
Southern Europe in the late 80's.
BUYERS
Below we shall discuss the elements in the buyer section. These
include vertical integration, market power and demand. Demand has
been subdivided into three sections. The first, structure of
demand, presents empirical data on the sales of automotive
vehicles in different countries. The second section discusses the
factors that drive demand, while the third section discusses the
effect of segmented markets.
Structure of Demand
The table below shows the unit sales of passenger cars in 17
European countries in the period from 1991 to 1996.
Figure 3.3
Source: Neil Mullinieux: The new car
market in Europe; page 5
According to the table, the European total
market grew by 6,3% in 1996 and the growing convergence of the
European economies resulted in all countries showing positive
growth over the previous year. However, it is clear that all the
markets are mature to a greater or lesser degree. Only the
Norwegian car market is growing strongly. In other words, it
seems to be recovering to original levels from a deep depression.
There is still some overall growth potential in the southern
markets of Portugal, Spain and Greece, but even here the sale of
passenger cars is influenced far more by the immediate health of
the economy than by longer-term growth in GDP.
The five largest countries, namely Germany, France, Italy, UK and
Spain, dominate the European demand for automotive vehicles,
which is demonstrated in figure 3.4 below. Together these
countries accounted for 80,4% of car sales in 1996.
Indsæt figure 3.4 fra side 30
Despite a fall in sales from 4,158,674 units in
1991 to 3,496,320 units in 1996, Germany remained in a dominant
position in the market, accounting for 27.4% of all sales. The
German car market was already the largest in Europe before
unification and it has now risen to a new level. It is the key
market for any manufacturer, not just because of its size, but
because it consists of larger and more expensive vehicles than
most other countries .
France, Italy and the UK are markets of almost the same size,
with annual demand of nearly 2 million vehicles in each market,
each having approximately 15% of the European total market share.
While the UK, Spanish and French car markets recovered in 1994,
the demand for new cars declined further in Germany and Italy.
Recovery in French and Spanish market was boosted by
government-sponsored incentives for car replacement. Over the
last two years several governments have adopted the French idea
of offering incentives to stimulate the sales of passenger cars.
Usually this has taken the form of direct reduction in the price
of a new car, if cars of certain age were being replaced. The
stated rationale for this type of incentive was usually
environmental .
In Western Europe car ownership is about 20% below the level in
the USA, although the key markets of Germany, Italy and France
are much nearer to the American average . There are some other
factors, which will prevent car ownership in Europe ever reaching
the level in the USA. Europe has a smaller land area and a larger
population compared to USA. The average population density is
higher and this inhibits car ownership, particularly as more
people live in cities. By their very nature cities discourage the
use of cars by making it difficult to park, while they have
enough public transport services. Further more, most European
cities are much older than cities in the USA. Therefore it is not
easy for European cities to fulfil the special requirements of
wide and straight roads and plenty of parking space.
The European passenger car market, however, is large in
production and in turn over. It contributes nearly 1/3 of the
global car market. Worldwide sales of new cars increased from
33,1 million units in 1993 to about 35,0 million in 1994. At the
same time in the EU market, sales recovered to 11,2 million units
in 1994 from 10,7 million units in 1993. In 1996 sales of new car
in the European market increased to 12,8 million from 12,0
million in 1995. Even though this 6,3% of growth in the market
was extraordinary, the manufacturers did not seem to be well and
many of them experienced considerable problems in terms of low
margins and high marketing expenses . This is an indication of
tough competition.
Demand Factors
In the following pages we will aim to identify the factors drive
demand, and examine them. Where empirical data on a suggested
factor is available, we shall also seek to demonstrate the
relationship to demand.
Table 3.4
Source: Neil Mullinieux: The New Car
Market in Europe; Page 230
In order to do so, it is necessary
to begin with a few definitions relating to the size of demand.
The vehicle parc is the number of vehicles in use within a
market. Approximately 75 percent of the world's vehicle parc are
within developed markets, and it is set to exceed one billion
vehicles in 2015, of which just 59 percent will be in developed
markets. Vehicle parc change slowly, as parc dynamics revolve
around a current average vehicle life of 6-7 years and overall
parc renewal every 13 to 14 years. The rate of growth in vehicle
parc is the key determinant of the future structure of the
world's auto industry. This growth and associated volume are
determined by sales and scrappage in individual countries,
depending on level of development in each country. North America
and Western Europe have been dominant players as measured by
their combined share of the world GDP. Vehicle density is the
number of vehicles in use per person in a country. In 1995 the
average vehicle density in the world was 117 vehicles per 1000 of
the world population. In the developed world, density was 547 per
1000 people, while in the developing world it was estimated as 34
per 1000. Thus vehicle parc equals density times population.
Table 3.4 above shows data on these terms for sixteen European
countries.
Thus the primary factors that drive the demand are population
size, vehicle density and average vehicle life. We expect vehicle
life to depend on GDP pr. capita and the price of cars in the
country in question, since wealthier populations tend to drive
larger cars. However we lack the empirical data to test this.
Vehicle density is determined by a number of factors. Undoubtedly
one of these is the price of vehicles. This price is often
distorted by a number of taxes on vehicles and on the use of
vehicles. Due to the variety of government imposed expenses on
vehicle use, it is not easy to get a clear picture of the tax
pressure in different countries.
Further there is reason to believe, that vehicle density is
related to GDP pr. capita, and to population density. These
relationships are examined in the two figures below. The figures
are made of data from table 3.4 and appendix B, by plotting GDP
pr capita and population density, against vehicle density.
Cars are regarded as a luxury good, and thus it is likely that
the vehicle density is highly affected by the wealth of a
country's population. This relationship is demonstrated in the
figure below. Here there seems to be a strong positive
relationship, between wealth and vehicle density.
Indsæt Figure 3.5 fra s. 34
Another hypothesis is that the level of car ownership is related to the population density of a country. The reason for this is, that in areas with high population density there is less need for long distance transportation, and public transportation is often more advanced in these areas. However as it appears from the figure below there seems to be no empirical evidence of this hypothesis. Quite surprisingly there seems to be a positive relationship between population- and vehicle density.
Indsæt Figure 3.6 fra s. 34
However, as it can be seen there is a very
large variation in the data. This implies that the tendency
towards a positive relationship between population- and vehicle
density is unlikely to be statistically significant. Thus we
cannot conclude that there is any relationship between the two in
Europe.
For both of the graphs there is the problem, that the data is
influenced by other factors, than the one measured (e.g. taxes).
This is especially a problem in this case, where we only have 16
observations, which is not enough to ensure that factors are not
biased towards a specific result.
Apart from the factors mentioned above, the demand for cars, like
all other products, is affected by substitutes and complementary
goods. As mentioned in section 3.1 the primary substitute for
passenger cars is public transportation. Consequently if public
transportation becomes more competitive through better service or
lower prices, demand for cars will be lowered.
Likewise if the prices of complementary goods are lowered, demand
for cars will increase. Among the most important complementary
goods are fuel and road taxes (In some countries). A less obvious
complementary good is finance. Cars are a major expenditure in
the budgets of most people, and thus they often need some sort of
external finance in order to purchase cars. Hence the interest
rate will affect the demand for cars. This relationship has
caused the largest car manufacturers to integrate into financing,
thus allowing more control of this factor. This is discussed in
section 3.3.4.
The effect of segmented markets
Below we shall discuss the causes, evidence and effects of
segmentation.
Under an agreement which came into force on January 1, 1993 the
European Union (EU) and the European Free Trade Association
(EFTA) have effectively merged to create the European Economic
Area (EEA), which extends many of the provisions of the post-
1992 single market to EFTA member states . This has been labelled
the world's largest integrated market.
However, the market is still highly segmented into national
markets. This segmentation is caused by a number of factors.
While economic integration may have created a market of 380
million consumers, those consumers have very different levels of
purchasing power. The disparities are demonstrated in table 3.2.
One of the central aims of the EU and the wider EEA is to reduce
disparities between regions through structural aid. The main
targets for structural aid are Ireland, Portugal, Spain and
Greece. On top of these economic inequalities there are
significant differences in climate topography, roads
infrastructure, population density and culture, which combine to
market diversity.
No matter what the reason, the fact is that the European market
at present is very segmented, even though there is a trend
towards increased integration of the European market.
Table 3.5 
Source: European Commission; Car prices
within the European Union on 1 November 1995.
Notification: B=Belgium; D=Denmark;
E=Spain; F=France; IRL=Ireland; I=Italy; L=Luxembourg
NL=Nethrlands; A=Austria; P=Portugal; S=Sweden; UK=United
Kingdom.
Evidence of this segmentation can be found in the prices of
cars across Europe. The table above shows prices of seven
different car models across Europe. Prices are calculated free of
tax as an index relative to the cheapest country. The figures are
from November 1, 1995. The brands selected for the table has been
chosen, in order to ensure maximum diversity across manufacturers
and segments. Thus we have chosen seven models from seven
manufacturers across six segments.
The table clearly shows that there are large differences in
prices across Europe. Further it shows that there are no clear
patterns with respect to cheap and expensive countries. In an
integrated market price differences should not exist, as higher
prices in one country would encourage the population to buy their
cars in other countries, thus levelling prices throughout Europe.
Since this is not happening, it must be because there are
barriers, and hence markets must be segmented.
The major effect of the segmented markets is that it allows firms
to price discriminate. In section 3.2.1 we discussed how a firm
facing a downwardsloping demand curve, will need to lower the
price on all units in order to sell an additional unit. In a
segmented market the firm can select a price in each market
independent from other markets. Thus if a manufacturer wishes to
sell an additional unit, he can do so by lowering the price of
all units in just that market.
A manufacturer that is able to price discriminate perfectly sets
a price on each car sold equal to the maximum the individual
customer is willing to pay (first degree price discrimination),
whereas a non-discriminating manufacturer will set the price at
the level the marginal customer is willing to pay. This can be
illustrated through the demand curve. The downwardsloping demand
curve indicates, that the first customers are willing to pay more
than the customers further to the right on the demand curve.
Consequently in a situation where there is only one price, some
customers are paying less, than what they would be willing to pay
if they had to. However a perfectly discriminating manufacturer
can extract this surplus for himself and thus earn higher
profits. This is demonstrated in the figure below.
Indsæt Figure 3.7 fra side 38
Segmented markets allow price discrimination on the basis of
national markets, and as it is shown in the figure this can be
used to get higher profits. However as it is also shown, the
benefit from discrimination depends on the slope of the demand
curve or rather the elasticity of demand. In infinitely elastic
markets consumers are willing to pay approximately the same
amount for different products, and thus there is no basis for
discrimination.
Since the slope of the demand curve faced by the individual
manufacturer depends on the level of industry competition as
argued in section 2.1, it depends on all the other issues
addressed in this chapter. For example a manufacturer in a highly
concentrated industry can more easily benefit from price
discrimination than a manufacturer in a more differentiated
industry, where competition sets limits for the prices the
manufacturer can charge. In the section summary we argue, that
competition in the industry is high, leading to rather elastic
demand. This decreases the gains from price discrimination.
Obviously no manufacturers in the car industry are able to
discriminate perfectly, that is on the background of the
individual consumer's willingness to pay. The car manufacturers
are merely able to discriminate on the basis of national markets,
and thus the size of the dark shaded area in figure 3.7 becomes
much smaller. The exact size depends on the shape of the demand
curve in the individual markets. Thus due to price discrimination
the manufacturers can set optimum prices in each market, which
yields higher profits than optimising from an aggregate point of
view. Consequently prices will be set higher in countries where
competition is weak and consumers are wealthy with elastic
demand.
The effect of segmented markets on competition can be discussed.
It is obvious, that segmented markets limit the extent of price
wars. If a price war occurs in one national market, this price
war does not automatically transfer to all other markets. Thus
the cost of price wars are lower in segmented market.
It can be argued that the lower cost of price wars increases the
likelihood of such wars occurring, thus increasing competition.
On the other hand segmented markets may also deter smaller
competitors from challenging larger firms. For example if a small
manufacturer enters the Dutch market, at a low price, the larger
competitors can relatively cheaply cut prices in that market in
order to outcompete the new entrant in a segmented Europe.
However in an integrated market, the large firm would have to cut
prices in all markets, thus making the move more expensive. Thus
competition from smaller competitors are limited in segmented
markets.
Market Power and Vertical Integration on the Demand
Side
The buyers of the automotive industry are a highly dispersed
group. Most of the cars produced end up in private ownership,
even though a few are sold to rental or leasing companies. Also
many companies provide cars for employees that need the vehicle
in their daily work.
Most cars are sold through dealerships, which are in most cases
not owned by a manufacturer, even though they often have strong
relations to specific manufacturers . The investments made by
these dealerships are quite small, since they are not required to
do any R&D or investment in any specialised assets. Hence if
dealers are dissatisfied with the manufacturer, or the other way
around, they can quite easily swap to another. Thus there exist
little buyer power in the relationship between the manufacturers
and dealerships.
Due to this low market power, transactions are often done at
arms-length, and there is little need for vertical integration
into dealerships .
However in some ways the manufacturers have invested into
distribution. Thus all of the seven largest manufacturers
described in chapter 5 have established financing companies .
These companies provide finance for the individual buyers, as
well as the dealerships, which need to finance their stock of
vehicles.
The financing part is very important in the decision whether to
buy a car, and in most instances the cost of financing is part of
the total cost of the car. Thus owning financing companies, allow
the manufacturers more control over the cost of the cars. Also
car manufacturers are usually, as mentioned in the introduction
very large companies with deep pockets, and thus they are able to
provide this finance.
Another important feature of the integration of financing
companies is that it is an alternative to vertical integration
into dealerships. Since the owners of these dealerships usually
do not have the funds to invest in a stock of cars and parts some
sort of financing is needed. The financing companies of the large
manufacturers provide this finance. Without these vertical
integration into dealerships might be necessary.
Further some of the companies have invested in car rental
companies. An example is Ford that bought Hertz in 1987 . This
action can hardly be explained from a market power approach, but
rather that Ford wished to ensure a secure demand for their
vehicles, while entering a profitable business.
SUPPLIERS
It is not the intent of this report to conduct a thorough
analysis of the car components industry. Instead we will merely
point out the special relationship between component
manufacturers and assembly companies.
For this we shall use the theory of transaction costs, as a
determinant of vertical integration. We shall also point out the
relationship between market power and vertical integration.
Further we shall briefly discuss the barriers to forward
integration by component manufacturers, and the importance of
good supplier relations to competitiveness.
Market Power and Vertical Integration
Market power exists when one side of a relationship is more
dependent on the other, than the other way around. E.g. A is more
dependent on B, than B is on A.
Market power often occurs as a consequence of transaction costs.
In the car industry transaction costs occur due to asset
specificity. Often component suppliers are required to invest in
very specific assets, in order to produce the components for a
specific manufacturer . This specificity of assets lead to the
possibility of opportunistic behaviour by the manufacturers, as
they face the opportunity of demanding lower prices after the
specific investment has been made.
The reaction of component producers is to secure themselves
against this risk. This can be done through charging a premium or
demanding a long-term contract. In both cases there are
transaction costs, as the long-term contract doesn't allow for
flexibility in either price or product, as the industry changes
over time.
Thus the required investment in specific assets lead to market
power, since manufacturers may act opportunistically. This leads
to transaction costs, as component producers seek to protect
themselves from opportunistic behaviour. One way to eliminate the
chance of such behaviour is vertical integration since it removes
the incentive for opportunistic behaviour.
Consequently vertical integration in the car industry is much
more likely on the supply side than on the demand side.
Manufacturers are especially likely to integrate vertically into
components that are specific for the single manufacturer, and
require large investment in assets. In chapter 7 we have tried to
quantify the level of vertical integration for 4 manufacturers.
An alternative to vertical integration, is close co-operation
with component manufacturers, which is an integral part of the
Japanese Just in time system. We will not discuss this phenomenon
any further.
Barriers to Forward Integration
In the case where the component manufacturers have the
opportunity to integrate forward into assembly of cars this would
increase competition. However, all of the component producers
face the same barriers as everyone else. These include economies
of scale, R&D and branding.
Further if component producers attempt forward integration, they
will do so at the risk of loosing existing revenue, as assembly
manufacturers are unlikely to help a potential competitor.
The Importance of Supplier Relations
Supplier relations are very important to car manufacturers, as
they are needed in the car aftermarket.
As a consequence of vertical integration, car manufacturers make
some of their own components. The production of these components
is under the control of the manufacturer. However production of
components sourced from other firms may pose a problem in the
aftermarket. The aftermarket is the market for components and
service after the initial sale of the automobile. Problems may
arise if these suppliers choose to discontinue production of
parts that are used in vehicles no longer in production. Since
these vehicles are still in use, there is still a small demand
for such parts, in the case of repairs. Often this demand is too
small to sustain production of these parts, however they are
essential to the manufacturer, because the price and availability
of aftermarket sales and services of older models affect the sale
of new models . Thus car manufacturers are dependent on their
relationship to component suppliers, with respect to the
availability of parts for repair. This is a further reason for
vertical integration.
BARRIERS TO ENTRY
Barriers to entry are highly important to the profitability and
competition of an industry, since low barriers to entry will
encourage new entrants in the industry, until economic profits no
longer exist. Thus competition is lowered through high barriers
to entry. Below we shall discuss the barriers that are relevant
to the car industry.
Economies of Scale
Economies of scale are often cited as a factor leading to entry
barriers. In industries where economies of scale are significant,
firms need a large volume of production in order to stay in the
industry. If a company does not have such volume, it will face
higher average costs, than other firms, and will eventually
perish under the forces of competition from larger market actors.
Economies of scale occur when companies face a downwardsloping
average cost curve. However as it is indicated in figure 3.8
below, average cost usually only drops for a while, before it
flattens and eventually starts to rise.
Figure 3.8 
Economies of scale work as an entry barrier, because firms who
wish to enter the industry, must have enough volume to produce at
the flat part of the slope. The minimum required volume is called
the minimum efficiency scale (MES).
One type of economies of scale arises as a consequence of fixed
costs. Often if production is large enough, it is profitable to
invest in a more efficient production plant, which lowers the
marginal costs, but increases the fixed costs.
Scherer and Ross suggest that minimum efficiency scale for a car
production plant is 200.000 units . Obviously this is a very
rough estimate, since it doesn't take into account that different
car models are likely to require different production plants.
However, minimum efficiency scale is very difficult to estimate
accurately, but 200.000 units are not very much taking into
account, that Ford alone produced 7 million cars in 1997
worldwide . Further evidence against product economies of scale
as an entry barrier can be found in the fact that most
manufacturers operate more than one plant. Thus it appears that
economies of scale is only an entry barrier for the smallest and
often specialised companies. Hence economies of scale might be an
argument for producing a wide range of vehicles in different
segments, since many of the factory operations are the same, no
matter which model is being made.
For larger companies there are no product economies of scale,
since these manufacturers far exceed the minimum efficiency scale
of 200.000 units. However there is still theoretical evidence
that there are economies of scale for large manufacturers, which
will be discussed in chapter 8. These economies of scale are
likely to relate to fixed and sunk costs, which do not relate to
quantity of output. Here we think especially of R&D, but also
of marketing.
R&D will be discussed separately below, and quantified in
chapter 7.
Research and Development
On average the five manufacturers Ford, GM and Volkswagen spent
5,8% of sales (weighted avg.) on R&D (See Section 7.4 for
details). This is way above the average industry, which spends
approximately 0,8% of sales on R&D . For comparison the
average in ethical drugs is 10,2% and in semiconductors 6,1%.
Although an industry average for the car industry has not been
available, it appears that the car industry is very intense on
R&D. The reason for this can be found in the special
industrial structure. Throughout this chapter we have discussed
factors that limit and facilitate competition. In the section
summary below it becomes clear that the car industry is basically
highly competitive, but at the same time there are factors that
contribute to a bit of market power for the individual firm.
This is a structure that is ideal for facilitating R&D
spending. In a situation of perfect competition where the
individual firm faces a perfectly elastic demand, there is no
incentive for companies to spend money on R&D, since all
firms will earn the same profits. However in such a situation a
revolutionary innovation, might help to change the market
structure. On the other hand in a situation, where the individual
firms have large market power, and face little competition, there
is little incentive for innovation and R&D . This thesis is
based on a Schumpeterian argument, where disruption and threat is
a catalyst of innovation. Such disruptions are small in
established monopolies.
Another interesting aspect of the average percentage of R&D
for the companies above is that it is above the industry average.
Since these companies are among the largest in the industry, it
seems that R&D is necessary for growth and success in the
industry. This gives R&D a role as an entry barrier, since
most small companies cannot afford the large expenditures
connected with R&D. At the same time R&D costs are sunk.
Thus there are significant economies of scale connected to
R&D, which further facilitates its role as a barrier to
entry.
Brand Identity
Brand identity is closely related to marketing expenditure. For
Ford and General Motors this equals approximately 2,4% of sales
revenue. In 1977 the average industry spend 0,66% of revenue on
advertising , but this figure has probably risen as a consequence
of the increased public attention towards mass media. Thus the
car industry appears to have marketing expenditures close to the
average industry.
However Brand identity may still work as a powerful deterrent to
new entrants. The purchase of a car is a major expense for most
potential customers. Therefore it is important for the customer
to be certain, that he is buying a quality product, and that he
can acquire spare parts and service should a problem arise.
Consequently it is important for manufacturers to have a strong
public profile of stability and quality. Well-established
companies can provide this more easily than newcomers.
Due to the combination of high price and a wide variety of
manufacturers and product lines, potential buyers are likely to
involve themselves in the purchase. Hence it becomes important
for the manufacturers to provide information about their products
to their customers. This further increases the importance of
marketing.
Product differences
R&D and marketing both contribute to product differences in
the car industry. R&D because it allows the manufacturers to
develop new and different models, marketing because it gives
consumers different perceptions of the manufacturers in the
industry.
Thus the internal substitutability in the automotive industry
becomes imperfect. This means that consumers are not indifferent
to which car they purchase. Further it means that the car market
becomes less transparent, and thus it is difficult for the
consumers to evaluate how to get most value for their money.
In a situation of imperfect substitutability each manufacturer
faces a slightly downwardsloping demand curve, or rather the
manufacturers have some power over prices. As mentioned in
section 3.2.1 a downwardsloping demand curve indicates some
market power and thus some monopoly rents. Consequently product
development and marketing lead to product differences, which
again lead to market power. This market power decreases the level
of competition somewhat, and keeps the industry away from a
situation of almost perfect competition.
Government Policy
Several important aspects of automotive design are subject to
government regulatory standards. While regulatory standards are
primarily aimed at achieving two common social objectives,
vehicle safety and environmental protection, they differ greatly
from one market to another. Nations and regions independently
have developed their own automotive regulatory standards with
accompanying certification and testing procedures over time. As
the automobile marketplace has become increasingly global,
differing regulatory standards have become a major barrier to
trade. Thus these regulatory differences are highly important in
segmenting the European market (See section 3.3.3).
Compliance with multiple regulatory frameworks reduces vehicle
affordability as it imposes substantial cost penalties and design
manufacturing constraints. It is fundamentally inconsistent with
free trade in a global automobile market. It also extends the
time needed to develop new products, preventing manufacturers
from responding quickly to the changing needs of consumers'
world-wide. As it will be argued in the next chapter, exactly the
quick response is an important source of competitiveness.
Additional costs incurred to design and develop different
versions of a particular model simply to meet different
regulatory and certification requirements may add more than 10
percent to the design and development cost of the product. Higher
costs mean higher prices for consumers and reduced choice of
products
There are two mechanisms by which government intervention is
contributing to the emerging shape of the automotive industry:
environmental regulation and co-founded R&D programs.
With regard to environmental issues, certain town and city
centers have been closed to traffic, and incentive schemes have
been set up. Among these are cars fitted with catalytic
converters, scrappage incentives, and electric vehicles .
With regard to R&D it is essential that public authorities
support the research and development efforts of the industry. EU
has a key role in stimulating joint research and technological
level between companies within the industry as well as on a wider
multisectoral basis. It is to Europe that credit must be given
for the major advances of recent years (injection, ABS, power
assisted steering automatic gearbox, converter, etc.).
Europe's technological capability in the automotive sector is
great. But in the field of research and development going beyond
basic research, European co-operation in global terms is lagging
behind the United States and Japan .
State aids remain a controversial area of the EUs competition
policy. The actual orientation of governments is for the reform
of state aid control and for more transparency in the
Commission's decision-making process for the approval of state
aids granted by Community governments to public and privately
owned enterprises.
State aid weakens the competitiveness of the European industry.
First it can lead to distortions within the market, which lead to
inappropriate levels of outputs and perhaps inefficiency.
Secondly, it can distort the nature of the oligopoly game,
leading to unfair advantages or if governments engage in matching
each other in the aid given to their own national firms socially
wasteful expenditure .
The reason for using state aid in the car industry, is that it
employs a lot of people, contributes a lot to a country's Gross
Domestic Product and car makers want to sell cars and will invest
behind barriers to do so.
All in all government policy has large effects on competition.
The different standards in the different countries help to
segment the market, making price discrimination easier, while
state aid works as an entry barrier to keep out new potential
entrants
SECTION SUMMARY
In this section we have used Porters framework to evaluate
different features of the industry, with respect to their effect
on the level of competition. Further we have established some
relationships between these features and the conduct of market
actors.
Substitutes were used to define the industry as the companies
that assemble motorised vehicles for personal use. We further
argued that the closest substitute is public transportation, but
that this poses no real threat to the industry at present.
Further we have shown that the European car industry is
characterised by a moderate concentration, which allows the
manufacturers little market power. There is a large amount of
overcapacity in the industry, which induces heavy competition. In
spite of this manufacturers are still investing in production
plants, which we suggest is a consequence of game theory and
strategic thinking. Although the sunk costs are relatively high
in the industry, this doesn't lead to high exit barriers, because
production assets are industry rather than firm specific. Thus
the companies are able to sell their assets at a reasonable
price. The markets for cars in Western Europe are saturated, and
thus industry growth is rather small, which leads to tough
competition for the existing customers. The fixed costs of the
industry are, however, an incentive to cut costs.
Germany dominates the demand in the car industry, followed by
France, Italy, UK and Spain. The main factor driving demand is
economic prosperity. The buyers of cars are highly dispersed, and
thus have little power. The segmentation of the European market
has allowed the use of price discrimination, which increases
profits.
Due to specialised assets there are a larger potential for
vertical integration on the supply side of the industry. Car
manufacturers are somewhat dependent on their suppliers for
components for vehicles that are no longer in production.
The main barrier to entry is the high costs of R&D, followed
by the importance of a good reputation. Economies of scale in
production do exist, but with a minimum efficiency scale of
approximately 200.000 units, it only affects smaller
corporations.
R&D and brand identity both contribute to product
differences, which allows the manufacturers a little market
power.
Of the factors mentioned above, the following facilitate a high
level of competition:
# Overcapacity
# Low industry growth
# Supplier dependency
# High fixed costs
The following factors limit the level of competition:
# No close substitutes
# Moderate Concentration
# Insignificant exit barriers
# Dispersed buyers
# Entry barriers due to R&D costs
# Product differences.
In spite of these factors the car industry is highly competitive.
The reason for this is that the factors that limit competition
only provide marginal market power. For example the concentration
and product differences that are large enough to provide
manufacturers with a little discretion over prices, and a
slightly declining demand curve, but too small to provide any
real monopoly power.
The factors that facilitate competition on the other hand are
very powerful. Especially the overcapacity has led to a very
competitive environment, as all manufacturers try to increase
their sales through lower prices in order to use their capacity.
Thus all in all we will characterise the European Automotive
industry as highly competitive.