The European Automotive Industry
FUTURE OF THE INDUSTRY
In this chapter we shall discuss how some of the factors
discussed earlier in the report are likely to change, and how
that will affect the car industry.
ECONOMIES OF SCALE
Over the past decade there has been a trend towards increased
concentration in the car industry. This has been demonstrated
through a number of mergers in the industry, the latest being
Chrysler and Mercedes-Benz. So far there is no indication that
merger acti-vity will cease in the near future. It can be argued
that for each of these mergers, there is a distinct reason, and
thus that this is not a general trend. For example, the above
Chrysler-Mercedes merger is related to market access, while it
can be argued, that the Rolls Royce BMW deal is related to
prestige and thus marketing.
In spite of this we think that the merger activity is a general
trend towards a new equili-brium with fewer firms in the
industry. The cause of this is discussed through the theore-tical
argument below.
The theory is based on the argument, that in a competitive
industry price must equal ave-rage costs, as positive economic
profits would lead to entry, whereas negative economic profits
would lead to exit. The average cost function can be described by
the equation below:
Where: n = number of firms; F = Fixed costs; S= Size of
industry;
c = Variable costs.
The argument is that AC includes variable costs and a share of
the fixed costs. Fixed costs must be incurred by all the firms in
the industry, and thus the more firms in an industry, the higher
the average costs.
The price function in the industry can be described by:
Where b is a
constant; n = number of firms; c = variable costs.
Hence price equals variable costs + a margin that decreases with
the number of firms.
Thus price decreases with an increased number of firms, while
average costs increases. In equilibrium price equals average
costs. This is demonstrated in the figure below.
Indsæt figure 8.1
fra side 94
Source: Krugman and Obstfeld; page
130
As it appears in the figure a decrease in the number of firms
can happen either through upward move by the AC curve or a
downward move by the P curve. Referring to the two equations
above, this can happen in case of increased fixed costs, or
decreased variable costs.
An immediate impulse is that the merger activity in the car
industry happens as an effect of decreased variable costs, due to
better production technology. It is likely that produc-tion
technology has decreased variable costs in the industry, but that
does not explain the ongoing concentration, since c appears on
both sides of the equation P=AC. Thus the im-proved production
technology simply lowers the cost and price of products, but
doesn't change the equilibrium number of firms in the industry.
Hence the only explanation for the merger activity is increased
fixed costs.
As we have discussed earlier in chapter 3 such fixed costs are
likely to relate especially to R&D. Thus it appears, that the
increasing R&D costs, and the need for constant introduc-tion
of new models are causing a concentration in the industry. This
allows firms to use their R&D across several models.
Another issue relating to economies of scale is minimum
efficiency scale. It has been argued that new production
technology is leading to lower MES . Theoretically this should
allow for a deconcentration in the industry, as smaller players
can operate at an efficient level. However as mentioned above the
trend goes in the other direction, with increased concentration.
The reason for this contradiction is, as already discussed in
section 3.5.1, that an MES of 200.000 units is so small, that it
only affects smaller market actors. In other words the economies
of scale in production are much smaller than eco-nomies of scale
in R&D. Hence MES is not very important among the large
players in the automotive industry.
CONCENTRATION AND R&D
As discussed above the industry is likely to experience
concentration as an effect of in-creasing R&D costs. The
question is whether this will decrease the level of competition
in the industry.
With an HHI of 1012, the concentration is not very high at
present. Thus even if concen-tration increases a little, this is
not likely to decrease competition. One reason for this is the
large overcapacity in the industry, which will force market
actors towards 7intense competition.
Another reason for a likely concentration increase, is the
ongoing globalisation. This makes it necessary for manufacturers
to be present in all major world markets, in order to stay
competitive. Smaller firms do not have the resources to compete
in all major mar-kets, which leads to further pressure for
alliances or mergers.
VERTICAL INTEGRATION
Car production is increasingly specialised. Hence manufacturers
need increasingly speci-fic components. This makes substitution
on the supply side more difficult, which increa-ses the market
power tension, thus making vertical integration more likely, as
described in section 3.4.1. A prerequisite for the rise of such
market power is that the specialised components require
specialised assets.
However, it can also be argued, that new management thinking is
leading in the other direction. The success of Japanese
manufacturers, with their system of very close tran-sactions in a
non-integrated environment, has spurred European and American
producers to seek opportunities in the same direction. Thus this
new thinking poses a threat to the conventional idea of
integration versus arms-length transactions.
Another reason for less vertical integration is differences in
MES. As mentioned above in section 8.1, MES is decreasing in the
car industry. This automatically leads to higher dif-ferences in
MES for the manufacturing and car component industry. For example
if MES for manufacturing drops to 175.000 units pr. year, while
MES for a specific component is 400.000 units, integration is
less likely to happen.
All in all it is not possible theoretically to argue how vertical
integration is likely to change in the future. However it does
appear that there is a trend towards lower value added within the
car industry. For example in the analysis conducted by Karel
Williams of this phenomenon for the period of 1980 to 1991 there
are indications of much higher levels of vertical integration for
PSA and BMW than our analysis indicates. However the methodology
of these analyses are quite different, making comparisons
difficult. Volks-wagen is the only company that provides data on
material costs for an extended period of time. These data show
that material cost as a percentage of costs of sales increased
from 64% in 1988 to 67,5% in 1997 indicating a slight decrease in
vertical integration .
SEGMENTED MARKETS AND INDUSTRIAL POLICY
As we have discussed in section 3.3.4, the national markets in
Europe are heavily seg-mented. This segmentation has occurred,
due to a number of differences. A very impor-tant one among
these, are differences in regulatory environments.
However with the trend towards continued European Integration,
some of these differen-ces are likely to converge over time.
Hence markets will become less segmented, and thus manufacturers
will loose the opportunity of price discrimination. This will
definitely lead to lower profits in the industry. The effect on
competition is more difficult to estimate. As we have argued in
section 3.3.4 the effect of price discrimination on competition,
is not clear, and thus we will have to wait and see.
For the world as a whole the tendency is in the exact opposite
direction. With the rapid development of new markets in
developing countries, there is a high risk that the number of new
regulatory requirements world wide will escalate quickly,
creating new technical barriers to trade. As mentioned several
times throughout this report, we focus on the European industry
only. However this global trend towards different regulations,
will also affect the actors that concentrate on the European
market. The reason is that the costs of testing and adapting car
models for different regulatory environments, is a sunk cost, and
thus much of the savings in the European Market, will be absorbed
by regulations in other markets. Thus testing and adaptation
costs cannot be expected to fall in the near future.
All in all it can be said, that government regulation has two
opposite effects on profit-ability. On one hand it allows price
discrimination, while on the other it increases costs of testing.
Another issue with respect to government interference, is the
increased focus on en-vironmental transportation. More and more
regulations and incentives for this purpose are being introduced.
This will cause manufacturers to focus more on smaller vehicles.
This is not really an industry structure issue, but rather a
marketing issue. However, it might have severe effects for
companies at the high end of the market. These companies will be
forced to move into lower segments, thus increasing competition
in these segments.
The last issue under government policy is that in the future, EU
regulations will make any kind of government subsidies difficult
to implement. This of course removes a barrier to competition.
OVERCAPACITY
As discussed in section 3.2.2 there is presently overcapacity in
the industry. Since most of the actors are contemplating new
investments, there seems to be no reason for this situa-tion to
change. Further as argued in section 3.2.4, there is no reason to
believe, that a growth in demand will cancel the effects of
overcapacity. This overcapacity is a very strong argument for
continued heavy competition in the industry, which will lead to
fur-ther restructuring.
ARENAS OF COMPETITION
With respect to the arenas of competition, we do not expect
significant changes, over the next years.
It has been argued that uniform regulation in the EU and
pressures for smaller cars, will lead to a commoditisation of the
car market . This would lead to more elastic demand, and thus a
higher level of competition. In such an environment, there would
be no possi-bility of escaping the price pressures through
differentiation, putting even more emphasis on the cost
efficiency.
However there are also arguments in the opposite direction. As we
argued in section 8.2, there is a tendency towards lower MES in
the industry. This will make diversity among models more viable,
as it will no longer be necessary to produce similar cars in
order to use the same production plants. Eventually this would
lead to increased differentiation in the industry.
In the timing and know-how arena, efficient R&D will uphold
its importance, in an incre-asingly competitive environment,
where companies are required to improve constantly in order to
survive. This is in line with D'Avenis theory suggesting that in
all industries competition increase over time.
As we have already mentioned in section 4.5, deep pockets are of
great importance in a restructuring industry. As a consequence of
the overcapacity, this restructuring is likely to continue. Thus
deep pockets will remain an important advantage.
SECTION SUMMARY
In this chapter we have argued that a restructuring is currently
in process and that this is likely to continue. Thus we expect
continued mergers in the industry. Further we have argued
theoretically, that the reason for this is increased fixed costs,
most likely con-nected to increasing R&D expenditures.
Mergers will lead to an increased concentration as measured by
the HHI. However, it is unlikely that this increased
concentration will lead to increased market power and de-creased
competition, since the HHI is still relatively low, due to the
large number of equal sized competitors. Further, the
overcapacity is likely to continue in its role as a powerful
catalyst of competition.
It can be argued that vertical integration on the supply side is
likely to increase as a con-sequence of increased need for
specialised components and assets in the component indu-stry.
However, the trend is in the other direction, which is likely to
be a consequence of new management thinking and MES
differentials.
The segmentation of European markets is decreasing, because of
the increased integrati-on. This is especially important with
respect to harmonisation of technical standards. The effect of
the integration, is that manufacturers will loose the opportunity
to price discri-minate, but will be able to cut costs on testing
and adapting models for different markets. Further the increased
focus on environmental issues, will push the manufacturers
towards smaller cars. This will lead to increased competition in
the C and D segments.
Finally we have argued, that competitiveness is likely to be
based on the same factors in the future, namely low cost
production and efficient R&D. Also financial resources are
important, while the industry is restructuring.