The New Legal Framework for Car Distribution

Table of Contents

List of Figures

Abbreviations

Symbols

Executive Summary

1 Introduction

2 The Car Industry Before 2002
2.1 Car Distribution
2.2 IO Analysis of the European Car Industry
2.3 Trends in the Car Industry

3 EU Competition Policy with Regard to the Car Distribution
3.1 General Motivation of Competition Policy
3.2 Vertical Restraints and Recommendations from Theory
3.3 The Evolution of the Regulatory Framework for Car Distribution
3.4 Motivation of the New Regulation

4 The Regulation 1400/2002
4.1 Process of the Analyses
4.2 Definition of the distribution systems
4.3 Analyses of Articles
4.3.1 Article 2 – Scope
4.3.2 Article 3 – General Conditions
4.3.3 Article 4 – Hardcore Restrictions
4.3.4 Article 5 – Specific Conditions
4.3.5 Article 6 – Withdrawal of the Benefit of the Regulation
4.4 Status of the Implementation

5 Market Outcome and Critique
5.1 Market Outcome
5.2 Critique
5.2.1 Price Convergence
5.2.2 Cost Increase
5.2.3 Loss of Intangible Consumer Welfare
5.2.4 Consumer Preferences towards Car Distribution
5.2.5 Inconsistencies in the New Regulation
5.2.6 Exemption from the Regulation: de Minimis Rule

6 Conclusion

7 Appendix
7.1 Welfare Analysis of Price Harmonization with Taxes
7.2 Market Shares
7.3 Full Results of Price Analysis
7.4 Price Levels 2002
7.5 Price Levels 2004

Bibliography

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

List of Figures

Figure 2-1: Distribution in the Automotive Industry

Figure 2-2: Value Chain in the Automotive Industry

Figure 2-3: Market Volume

Figure 2-4: Contracted New Vehicle Dealers

Figure 2-5: Service Outlets in Western Europe

Figure 4-1: Double Marginalization

Figure 4-2: Horizontal Externalities

Figure 5-1: Price conversion 2002-2004

Abbreviations

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Symbols

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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 can 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 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 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.

Figure 2 - 1 : Distribution in the Automotive Industry^[5]

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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.

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.

Figure 2 - 2 : Value Chain in the Automotive Industry^[6]

illustration not visible in this excerpt

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]

Figure 2 - 3 : Market Volume^[8]

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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]

Figure 2 - 4 : Contracted New Vehicle Dealers^[15]

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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 new vehicle sales market, regardless of the low concentration ratio. In after-sales, the overall number of outlets was 335,000 (Figure 2-5).

Figure 2 - 5 : Service Outlets in Western Europe^[16]

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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 channels was mostly dominated by the traditional approach of local, independent dealers, 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, very 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 level 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]

2.3 Trends in the Car Industry

Having conducted a SCP analysis of the relevant parts of the value chain the trends within the industry will now be analysed. It is important to notice that these trends came into force already at the end of the 90s, therefore it can be said that they were not induced by the new regulation in 2002. Within the consumer market it can be distinguished between six trends forcing structural changes in the industry.

First, today’s consumer preferences are changing. They are best described by the three characteristics “flexibility”, “mobility” and “individuality”.^[26] Therefore, he nowadays needs a service that is more tailored to his specific needs – however the car industry is one of the last sectors to respond to these needs, especially with regards to the variety of distribution channels and services around the product.^[27] Moreover, brand loyalty has declined as products are becoming more homogeneous regarding their physical characteristics.^[28] The continuing proliferation of the internet leads to decreasing search costs and finally to a higher information level of the consumer – inter- and intra-brand comparability regarding product characteristics and prices increases. Therefore, it can be concluded that the consumer gets more price sensitive, but at the same time his service requirements increase.

Second, new types of customers are entering the market. Large corporations are increasingly relying on external service providers – so-called fleet management companies, e. g. LeasePlan Corporation N.V..^[29] These companies follow the "one-shop" concept providing the full range of services, such as the purchase, financing, insurance, maintenance. Besides leasing companies car rental is also getting more important. The proportion of “fleet customers” out of total new vehicle sales ranges from 35% in the UK to more than 70% in Italy with a growing share.^[30] Obviously the purchase power of these corporations is significantly higher compared to traditional customers. Moreover they generally circumvent the dealer and purchase directly at the manufacturer.

Third, another important factor is the lengthening of service intervals and at the time increasing technological standards of today’s vehicles. In 1990 the standard interval for a service was 15,000 km compared to the recommended intervals of 30,000 km and 50,000 km for gas and diesel vehicles today.^[31] This leads to less frequent sales of the high margin maintenance services.

Fourth, the changed preferences of the consumer lead to shorter product life cycles and to higher product variety putting pressure on the cost side of the manufacturer. On the sales side the manufacturer is faced with an increasing inter-brand competition due to the increasing technological conformity of products. Therefore, car manufacturers are increasingly distinguishing themselves by higher marketing efforts trying to differentiate their product and to enhance the consumer's purchase experience.^[32] Besides these efforts to increase the sales car manufacturers try to cut costs switching to internet applications. With respect to the B2C market, the forecasts of sales from the manufacturer directly to the customer via the internet have not materialised.^[33] Regarding the B2B, i. e. especially the manufacturer – dealer relationship, cost reducing effects from using the internet are estimated to be very high.

Fifth, as a condition for the aforementioned savings to materialise higher investments in EDP by the dealers are required which further drains their financial capabilities. Other factors putting pressure on their already low margins are the dense network of car dealers that increases both inter- and intra-brand competition, higher investments in the workshop due to increasing technology standards but at the same time larger service intervals, fleet managers often co-operating with independent repairers and larger investments to provide the purchase experience for the consumer combined. These factors decrease margins and will trigger a wave of consolidation among the dealers leading to the emergence of large dealerships with several outlets achieving the necessary economies of scale to stay in business. The dealer LUEG AG is only one example.^[34] The trend towards larger territorial responsibility for one dealer with several outlets allows to mitigate intra-brand competition as well as to achieve higher purchasing power and market power. Moreover it allows the dealer to step into co-operations with banks and insurance companies to offer additional services.

Sixth, with regards to repair services independent repair chains, so-called “fast-fitters” such as Pit-Stop, have grown by more than 20% since 2000 reaching a market share of almost 10%, increasingly eating in the pie of the official dealers and independent repairers.^[35] These chains have competitive advantages due to higher purchase power vis-à-vis spare parts suppliers, their ability to invest in technical diagnosis tools and their advantage of building up a brand and thereby mitigating the asymmetric information problem between consumers and non-official repairers.

This part has shown that even before the new regulation became effective in 2002 several factors forced the car industry to become more customer oriented. As a consequence the distribution changed throughout the end of the 90s from a production oriented system, the so-called “stock-push system”, towards a market oriented “pull system”. Thereby the market system itself has put the consumer to a certain extent in a position which forced the industry to adjust to his changing preferences. However, the regulatory barriers for path breaking innovations in the distribution channels leading to higher consumer welfare remain and the following section will elaborate on the European Commission's motivation to further liberalize the car distribution sector.

3 EU Competition Policy with Regard to the Car Distribution

3.1 General Motivation of Competition Policy

A motivation for competition policy would not arise in perfectly competitive markets with complete information and a large number of buyers and sellers. But this idealized economy rarely exists as complete information is hardly achievable and many markets are characterized with constellations, e. g. small number of players on the seller side, that affect the price mechanism to the detriment of other agents in the market. In order to rebalance the departures from the perfectly competitive model authorities can either intervene by affecting prices, e. g. via taxes, or by controlling the behaviour directly.

Besides this, the generic goal of restoring that balance the EU is founded on the four “Freedoms”, i. e. Freedom of Goods, Persons, Services and Capital which lay the basis for one single European market and which function as the guiding principles for the European authorities, amongst them DG Competition.^[36] The Treaty’s Section VI “Common rules on competition, taxation and approximation of laws” with its Article 81 prohibiting all agreements that adversely affect competition sets the framework for the European competition policy. The main challenge of competition policy, which lies in determining the effects of a sheer uncountable number of agreements, becomes evident when looking at paragraph 3 of Article 81 that allows for deviations if these lead to efficiency gains and “consumers get a fair share of the resulting benefit”. This focus on consumer welfare is institutionalized by Article 153(1): “In order to promote the interests of consumers and to ensure a high level of consumer protection the Community shall contribute to protecting the health, safety and economic interests of consumers”. In this respect special consideration is given to vertical restraints, a specific form of affecting trade between competing undertakings.

3.2 Vertical Restraints and Recommendations from Theory

Before the regulation itself is analysed, the evolution of the economic interest in vertical restraints should be understood. In the standard textbook case of economic theory – perfect competition – standard sale contracts allow the buyer to freely decide on the further use of the good purchased. Vertical restraints can be defined as any economic exchange that differs from this contract..^[37] From this point of view, perfect competition in vertical relationships is in general welfare maximizing as it is in horizontal relationships. Classic economic theory therefore viewed vertical restrains as a measure of the upstream firm (manufacturer) to reduce the independence of downstream firms (distributors), which in turn harmed consumers. For example, resale price maintenance was seen as little different from horizontal price-fixing.^[38] In this thinking, vertical restraints were imposed by upstream firms to maximize their profits. The Chicago school, developed in the 1960s and 1970s, offered a new view on vertical restraints, stressing possible positive efficiency gains in the vertical relationship and a positive effect on total economic surplus. In particular, the Chicago school addressed efficiency gains coming from the elimination of external effects, hold-up problems and elimination of double marginalization.^[39] Due to the Chicago analyses, "there [was] growing acceptance of the view that vertical agreements can rarely have anti-competitive consequences".^[40] More recently, economic discussion again centred on possible anti-competitive and welfare-reducing effects of vertical restraints. As Comanor's exemplary work shows, not all vertical restraints can be viewed as neutral or pro-competitive.^[41] Particularly, vertical restraints can act as entry barriers. So with the benefits postulated by the Chicago school being shaded in doubt, academia now calls for a case by case approach to evaluate vertical agreements.^[42]

While economic theory answers the question of welfare effects of vertical restraints ambiguously, the topic is of great interest for the regulation authorities.

In the next paragraphs, the relevant articles of the regulation 1400/2002, which constitutes a special adoption of the general vertical restraints block exemption 2790/1999 to the car industry, and its economic implications will be analysed, keeping in mind this academic and regulatory debate.

3.3 The Evolution of the Regulatory Framework for Car Distribution

This part shows how the car distribution regulation has evolved from one creating Europe’s most protected sector to the one setting the framework for open competition. In the early 1980s the EU Commission headed by Jacques Delors launched the Single European Market (SEM) project which was based on the concept of the four freedoms of goods. But throughout industrialized nations the common practice in the car distribution sector had been to grant distributors geographical monopolies on the sale of cars and in return they accepted to sell only one brand commonly referred to as exclusive dealing.

In the course of the SEM discussions car manufacturers, their distributors and supporters in the member states had the EC to adopt Regulation 123/85 (“123/85”).^[43] The parties argued that the car distribution sector was different from other goods sector and therefore required special treatment such as the right of manufacturers to impose exclusivity on distributors, to grant territorial monopolies to car distributors and to terminate contracts with the distributors without right of appeal. Moreover independent service companies did not have the right to service cars under warranty and only OEM parts were used in servicing. 123/85, which granted wide exemption to the rules set forth in Article 81 of the EC Treaty, was put in place with the clause that it would be reviewed after 10 years of practice.

In light of a possible renegotiation of 123/85 the European Automobile Manufacturers Association (ACEA), the main lobby group of the car manufacturers, positioned from the very beginning to renew the exemption indefinitely. As of 1985 it brought forward arguments that the car distribution sector had to be treated differently to consumer goods due to its specific characteristics. The manufacturers emphasized that a car is a product bundle that includes pre- and after-sales service and is therefore not a typical “off the shelf” product. Moreover, they based their argumentation on safety for consumer that needs to be secured and thus the safety features of cars had to be guaranteed by regular and qualitative maintenance, which allegedly could best be provided through selective^[44] and exclusive distribution. Furthermore they stated that meeting safety standards required high investments such as training of staff, diagnostic tools and safety equipment that could only be provided if a certain return on investment was guaranteed.^[45]

[...]

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^[1] Compare European Commission (2002a).

^[2] Compare European Commission (2002a).

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

^[4] Compare Creutzig (1993), p. 53.

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

^[6] Source: self-provided.

^[7] Compare ACEA (2004), p. 32.

^[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.

^[15] Source: Andersen (2001), p. 240.

^[16] Source: Andersen (2001), p. 320.

^[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.

^[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.

^[26] Compare Oehm, Erhard (2000), p. 76.

^[27] Compare Landmann, Ralf (1999), p. 75.

^[28] Compare Heß (1998), p. 3.

^[29] Compare LeasePlan (2004).

^[30] Autopolis (2000), p. 10.

^[31] Compare Meunzel, Dringenberg (2000), p. 4.

^[32] Compare Volkswagen (2004).

^[33] Compare Reinking (2001): Instead of the 500 cars forecasted to sell over the internet, Opel only sold 61.

^[34] The corporation accounts for 41 dealer outlets in the Ruhrgebiet and Saxony employing 1,900 staff and an annual turnover of €700 mn.

^[35] See Andersen (2001), p. 254.

^[36] European Commission (2002b).

^[37] Compare Church, Ware (2000), p. 688.

^[38] Compare Lipczynski, Wilson (2001), p. 295 et seq..

^[39] Compare Neven, Papandropoulos, Seabright (1998), p. 17 et seqq..

^[40] Compare Comanor, Frech III (1985), p. 539.

^[41] Compare Comanor, Frech III (1985), p. 539 et seqq..

^[42] Neven, Papadropoulos, Seabright (1998), p. 35 et seqq..

^[43] Compare European Commission (1984).

^[44] Selective distribution allows the manufacturer to set quality criteria that dealerships have to meet.

^[45] See ACEA (1993): “The cost for advanced repair equipment is high and financial returns are unattractive. […] The only way the manufacturers can guarantee the continued existence of a competent network is based on the Block Exemption […]. If manufacturers were no longer permitted to operate on this basis, dealers would only concentrate on the profitable elements of the business and nobody would take responsibility for the financially unattractive service related to emissions and service for which sophisticated high tech equipment is indispensable".