The New Legal Framework for Car Distribution

I

  The New Legal Framework for Car Distribution  

Table of Contents

List of Figures ...........................................................................................................................III

  Abbreviations  III

  Symbols  IV

  Executive Summary  1

1  Introduction  2

2  The Car Industry Before 2002  3

2.1  Car Distribution  3

2.2  IO Analysis of the European Car Industry  4

2.3  Trends in the Car Industry  9

3  EU Competition Policy with Regard to the Car Distribution  12

3.1  General Motivation of Competition Policy  12

3.2  Vertical Restraints and Recommendations from Theory  12

3.3  The Evolution of the Regulatory Framework for Car Distribution  13

3.4  Motivation of the New Regulation  15

4  The Regulation 1400 2002  17

4.1  Process of the Analyses  17

4.2  Definition of the distribution systems  17

4.3  Analyses of Articles  18

4.3.1  Article 2 Scope  18

4.3.2  Article 3 General Conditions  19

4.3.3  Article 4 Hardcore Restrictions  21

4.3.4  Article 5 Specific Conditions  27

4.3.5  Article 6 Withdrawal of the Benefit of the Re gulation  30

4.4  Status of the Implementation  31

5  Market Outcome and Critique  33

5.1  Market Outcome  33

5.2  Critique  37

5.2.1  Price Convergence  38

5.2.2  Cost Increase  39

5.2.3  Loss of Intangible Consumer Welfare  40

5.2.4  Consumer Preferences towards Car Distribution  41

5.2.5  Inconsistencies in the New Regulation  41

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  The New Legal Framework for Car Distribution  

5.2.6  Exemption from the Regulation: de Minimis Rule  42

6  Conclusion  43

7  Appendix  44

7.1  Welfare Analysis of Price Harmonization with Taxes  44

7.2  Market Shares  46

7.3  Full Results of Price Analysis  47

7.4  Price Levels 2002  48

7.5  Price Levels 2004  52

  Bibliography  56

  We are grateful to having had the opportunity to conduct expert interviews with  

  Matthias Brück Dealer Network Development Dr Ing h c F Porsche AG  

  Konrad Schumm principal officer DG competition European Commission  

  who valuably contributed to the present paper  

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  The New Legal Framework for Car Distribution  

List of Figures

  Figure 2-1: Distribution in the Automotive Industry  3

  Figure 2-2: Value Chain in the Automotive Industry  4

  Figure 2-3: Market Volume  5

  Figure 2-4: Contracted New Vehicle Dealers  6

  Figure 2-5: Service Outlets in Western Europe  6

  Figure 4-1: Double Marginalization  23

  Figure 4-2: Horizontal Externalities  25

  Figure 5-1: Price conversion 2002-2004  39

  Abbreviations  

  ACEA European Automobile Manufacturers Association  

  AG Aktiengesellschaft (German Stock Corporation)  

  Art Article  

  B2B business to business  

  B2C business to consumer  

  BATEX barriers to entry and exit  

  bn billion  

  CAGR compounded average growth rate  

  DG Directorate General  

  e g exempli gratia (for  instance)

  EC European Commission  

  ECU European Currency Unit  

  EU European Union  

  EUR Euro  

  HHI Herfindahl-Hirschman-Index  

  i a inter alia  

  i e id est (that  is)

  Ibid Ibidem (at the same place)  

  mn million  

  MRP manufacturer s recommended price  

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The New Legal Framework for Car Distribution

N.V. Naamloze Vennootschap (Dutch Stock Corporation) OEM original equipment manufacturer R&D research and development RPM Resale price maintenance SCP structure conduct performance SEM single European market

Symbols

A, B, C arbitrary equilibrium points

D D’ DWL MC MR p S u u’ p

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The New Legal Framework for Car Distribution

Executive Summary

The present paper discusses the new legal framework for the automotive distribution, which has been set by regulation 1400/2002 of the European Commission, and clarifies the

underlying rationale of this so-called block exemption. 1 To this end, the relevant market has been analysed along the structure conduct performance paradigm. Additionally, the existing

trends, e. g. the changing consumer preferences, the changing technological standards, and an increasing number of independent service chains, were investigated to integrate the dynamics into the model. In this context the meaning and the impact of the regulation have been

detailed with respect to consumer welfare.

The analyses have shown that the new regulation complies with the guiding principles of

competition policy and thus fosters competition in the industry. This stands in contrast to its predecessors, which were influenced by lobbying of the car industry and had thus laid the foundation for a heavily regulated business. As shown in this paper, a leap towards increased

consumer welfare has been made by weakening the market power of the industry. Among others, the separation of sales and services, the permission of multi-brand outlets and the ban

of price discrimination c an be named as examples for reforms brought forward in the regulation. Furthermore, the so-called location clause will be abolished as of October 2005, which means that dealerships are allowed to open new outlets anywhere in the common

market without the consent of the manufacturer. However, in the course of disallowing vertical restraints, of which some had previously helped to secure efficiencies in the value

chain, a relative welfare loss has also developed. For instance, the increased free-riding issues could inspire a development to the detriment of the consumer and the convergence of prices at a high level could be disadvantageous to consumers in low income member states.

Although the regulation has already come a far way, the critique that is voiced at the end of this paper, shows that there is significant room for improvement, once the regulation expires

in 2010. Key points are the price convergence towards the level of the high price countries, some inconsistencies in the regulation and a possible loss of intangible consumer welfare. In the end whether the additional welfare surplus outweighs the new welfare loss has to be

decided on a per country basis.

1 Compare European Commission (2002a).

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The New Legal Framework for Car Distribution

1 Introduction

The goal of this paper is the economical evaluation of the new legal framework for car distribution in Europe, which has been set by regulation 1400/2002 of the European

Commission in 2002. 2 For that purpose the underlying rationale of this so-called block exemption regulation shall be investigated. Finally, the meaning and the impact of the

regulation shall further be evaluated with regard to its impact on consumer welfare. The present analysis begins with a general introduction to car distribution before 2002 further

detailed by an analysis of the industry along the structure-conduct-performance paradigm. 3 Here the industry is defined as the integrated value chain from supplier over manufacturer to distributor. After this static analysis of the market structure, the conduct of the players and the

profitability of the industry, the part concludes by an investigation of the trends in the industry to add a dynamic perspective. In this background, the new regulation is put in context with the European competition policy. Thus the EC's general motivation, especially concerning

vertical restraints, is discussed, closing with a short overview on the regulatory history of car distribution. The analysis presumes with a presentation and discussion of the most relevant

articles of the new regulation 1400/2002 with special regard to its economical implications. Where appropriate economic theory is used to facilitate the understanding. After looking at the status of the implementation, the likely market outcome of the new regulation is described

and hypotheses for further developments are deducted. The paper concludes by voicing critique – giving empirical evidence where appropriate – and shading light on various issues

that bear conflict potential for the future.

2 Compare European Commission (2002a).

3 Compare Bain (1959), quoted after Carlton, Perloff (1999), p. 238 et seqq..

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The New Legal Framework for Car Distribution

2 The Car Industry Before 2002

2.1 Car Distribution

In the car industry, distribution can be understood as all the activities that take place after the

manufactured car leaves the factory. 4 Thus it includes sales and service. As it interacts with the customer, it has a great importance regarding customer satisfaction and the creation of

brand image. Distribution is not necessarily carried out by the manufacturer, but in fact, often independent dealers handle distribution. In general, three distribution channels can be identified, as depicted in Figure 2-1.

Distribution in the Automotive Industry 5

Figure 2-1:

In the first case, the manufacturer directly distributes its products to the customer, for example via wholly-owned dealerships. In the second case, the manufacturer uses marketing agents, which act on behalf of the manufacturer and thus carry no economic risk. In the prevalent

case, the manufacturer uses independent authorised dealers to distribute his cars.

4 Compare Creutzig (1993), p. 53.

5 Source: self-provided with reference to Becker (1998), p. 528.

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The New Legal Framework for Car Distribution

2.2 IO Analysis of the European Car Industry

For the understanding of the legal and economic implications of the new regulation 1400/2002, the European car industry should be analysed as of 2002 in a concise manner. Therefore, this section presents the status quo before the new regulation in the industry according to the Structure-Conduct-Performance (SCP) framework. The scope of the SCP analysis is limited to the levels of the value chain which are relevant for the understanding of the EC regulation. Therefore, the analysis focuses on suppliers, manufacturers and dealers as presented in Figure 2-2.

Value Chain in the Automotive Industry 6

Figure 2-2:

The main market segments “new vehicle sales” and “after-sales”, i.e. repair and sales of spare parts, are examined separately. Since the new regulation does not affect the sale of pre-owned cars directly, that market segment is not subject to the analysis. The European market for light motor vehicles – trucks etc. are excluded – is sizeable as depicted in Figure 2. With 12 million people employed, the car industry is of overall economic importance. 7

6 Source: self-provided.

7 Compare ACEA (2004), p. 32.

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The New Legal Framework for Car Distribution

Market Volume 8

Figure 2-3:

The market for new vehicles is mature as there is a large “installed base” of 189 mn cars in

Western Europe and new purchases are mainly replacement driven. 9 It can be observed that the average age of cars on European streets is increasing. As cars get replaced later, the demand for spare parts and repair increases. Therefore, growth is sluggish in the new vehicle market, but positive in the after-sales market (Figure 2-3).

In 2002, the concentration in the European car industry varied strongly between the different levels of the value chain. On the supplier level, there were more than 8,000 supplier active in

the automotive industry. 10 While this figure itself indicates low market concentration, the heterogeneity of the market for car supplies has to be taken into account. In the different

segments, it can be supposed that the level of concentration was partially higher. 11 In car manufacturing, the concentration ratio C4 was 53% in 1999 while the Herfindahl-Hirschman-

Index (HHI) was 1,078 (Appendix 7.2). 12 From a competition policy point of view, this

indicates a moderately concentrated market with an oligopoly structure. 13 In new vehicle sales, the picture is quite different. In 2000, there were 54,000 contracted dealers with

106,000 outlets in Western Europe (Figure 2-4), with a large share of very small dealers. 14

8 Source: Andersen (2001), p. 250.

9 Compare Andersen (2001), p. 238.

10 Compare Accenture (2002), p. 2.

11 Compare Andersen (2001), p. 251.

12 Compare European Commission (2000), p. 29.

13 Compare Department of Justice (2004).

14 Compare Andersen (2001), p. 240.

6 The New Legal Framework for Car Distribution

Contracted New Vehicle Dealers 15

Figure 2-4:

At first glance, the market does not appear to be concentrated. However, spatial barriers must not be neglected. It might have been difficult for consumers to find other car dealers than their local one and incur sizeable search costs. Thus, perfect competition cannot be assumed in the ne w vehicle sales market, regardless of the low concentration ratio. In after-sales, the overall number of outlets was 335,000 (Figure 2-5).

Service Outlets in Western Europe 16

Figure 2-5:

15 Source: Andersen (2001), p. 240.

16 Source: Andersen (2001), p. 320.

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The New Legal Framework for Car Distribution

Again, the concentration level was very low, while spatial barriers and transaction costs

limited the competitive effect of such a fragmented market structure . Interestingly, different types of business models existed in the after-sales market: Service outlets of authorised sales

dealers and independent repair outlets.

In 2002, the industry exhibited barriers to entry and exit (BATEX) on the different levels of the value chain. For new entrants in the car manufacturing business, the barriers to entry are

sizeable. Regulatory requirements, such as safety and environmental regulations, make it difficult for new players to enter the market. Furthermore, economies of scale and learning

economies are enormous, regarding the intensive capital requirements and the learning curve that car manufacturers face. Additionally, the incumbents use strategic investments to raise

BATEX for potential entrants. They incur sunk cost in form of advertising and R&D

expenditure. 17 This cost can only be recaptured in the market and thus signals potential rivals the incumbent’s willingness to fight a price war in case of entry. Finally, the vertical

relationships between car manufacturer and suppliers might act as a barrier to entry. At the dealership level, the main barrier to entry was territorial exclusivity car manufacturers granted

their authorised dealers. This, in effect, gave each car dealer a local monopoly, which was further strengthened by the bundling of sales and service. Additionally, the required specific knowledge and necessary electronic devices for car repair constitute barriers to entry for this

market segment.

Products in the car industry are differentiated. In Europe, 40 brands and more than 250

models are offered to consumers that are brand loyal – often for their lifetime. 18 After-sales products and services are also perceived to be differentiated since, e. g. the resale value of a pre-owned car is significantly higher for cars with full service history.

The conduct in the industry in 2002 was mainly determined by a generally low concentration on the supplier level, a moderate concentration on the manufacturer level and a fragmented

structure on the dealer/after-sales level. Car suppliers aimed to offset the increasing pressure from car manufacturers by distributing directly to the customer and building up a

differentiated product. For example, they set up own outlets for spare parts distribution. 19 On the manufacturer level, strategic interaction took place. While the choice of distribution cha nnels was mostly dominated by the traditional approach of local, independent dealers,

17 Compare Andersen (2001), p. 238: For example, 6% of car manufacturer's sales are spent on average on

advertising.

18 Compare European Commission (2000), p. 29.

19 Compare Andersen (2001), p. 257.

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The New Legal Framework for Car Distribution

particularly upscale car manufacturers had integrated downstream and opened wholly-owned

sales outlets. Promotional strategies varied across the industry and included indirect price rebates, free product upgrades. Competitive conduct was mainly observed on price and

product. Rebate wars, especially to reduce excessive stock, and new product launches were important competitive weapons in the industry. On the dealer level, v ery little strategic interaction took place.

In 2002, profitability in the European car industry was low. On the supplier level, firms

earned on average a single-digit profit margin. 20 Pressure on supplier profitability came

especially from manufacturers with the market power to require annual price decreases. 21 On the manufacturer level, profitability was negative. 22 On the dealership- level, significant differences between the profitability of the sale of new vehicles and after-sales products and

services were observable. The contribution margins of new vehicle sales was a mediocre 3%,

while the contribution margin on sales of spare parts was 18% and 13% on repairs. 23 Dealers, therefore, used sales of spare parts and repairs to cross-subsidise new vehicle sales. These cross-subsidies are also labelled the sales-service link. Overall, the dealer earned a net margin

of 1% on his sales. 24 Regarding structure, conduct and performance on the different levels of the value chain, the level of the competition can be assessed. In new vehicles sales, regardless of the concentrated

and oligopolistic structure, competition between manufacturers, i. e. inter-brand, competition was high. This also helps to explain the low profitability of new vehicle sales on the

dealership le vel despite their local market power. Competition between dealers of the same brand, i. e. intra-brand competition, was low, what can be explained by the high entry barriers for their respective local monopolies. The high profitability and the fragmented structure in

after-sales had attracted new entrants and increased competition in this segment. However, it

has to be noted that authorised after-sales outlets still captured the main share of the market. 25

20 Compare Andersen (2001), p. 82. The supplier margin earned a margin of 5%.

21 Compare Andersen (2001), p. 257.

22 Compare Bert, Neuen (2004), p. 34. For large European car manufacturers, ROE was -2% in 2001/2002. 23 Compare Andersen (2001), p. 250.

24 Compare Andersen (2001), p. 238.

25 See Andersen (2001), p. 7: 33% of the overall after-sales outlets are authorised dealers. They capture 53% of the volume of the market.