State Franchise Regulation

This is the fourth carryover from student blogs, with guest blogger Asher Stevens-Lubin. In his defense he wrote this post at the very start of the term, before we'd covered franchising issues (and had David in as a speaker). Both Ruggles and Smitka append comments. Roberts-Lubin's citations are detailed at the bottom.

The cost of the auto distribution system in the United States has been estimated as averaging up to 30 percent of vehicle price, with 15 percent on the end of the manufacturer (in the form of advertising, loans, and rebates) and the other 15 percent solidly on the side of the retailer, or dealer. This 15 percent of the total price of a given vehicle is due to the cost to dealers of financing inventory, paying for insurance, advertising, and paying commissions. [Source: Marti et al.]

Early in the history of the US auto industry, most manufacturers sold their vehicles directly to the consumer. However with the advent of Ford’s assembly line and the mass-production of automobiles, distribution was more efficient through retailers since manufacturers mainly had just one or two factories located near resources like steel mills (making the assessment of demand and provision of customer services easier for retailers).

In these early days, this franchise system was conducted through voluntary contracts between manufacturers and dealers. However since then, virtually every state has codified the automobile franchise system, making it illegal for manufacturers to sell automobiles directly to the consumer; largely because states earn around 20 percent of their sales taxes from automobile retail, but also because car dealerships account for, on average, 7-8 percent of employment. [Source: Lafontaine & Morton]

Ruggles writes: This is the first misnomer. The reason for state franchise law is to protect Dealers from their Suppliers. A Dealer makes a SIGNIFICANT investment to represent an OEM's products. That Dealer is then in in a position of subjugation to that supplier without significant protection other than the traditional franchise agreement. The supplier could over supply or under supply on a whim. The supplier could provide premium stock to a competitor while withholding premium stock from the original Dealer. The supplier could make unreasonable demands on the original Dealer and use the control of inventory supply, compensation for warranty repairs, etc. to coerce Dealer. Without Dealer protection the supplier could open a factory owned store near the franchise Dealer, and under sell that dealer to drive them out of business. This is the primary reason for Franchise laws.

This model was beneficial to both manufacturers and retailers until the advent of the Information Age in the late nineteen-eighties. With the arrival of global instantaneous information sharing and online automobile sale, disintermediation occurred—that is, the role of the retailer became superfluous (or at least very much different). Cutting back on its number of dealerships has been a key means for GM to reattain profitability. [Source: Bodish]

Ruggles writes: The model is STILL beneficial to both OEMs and Retailers.

Disintermediation has NOT occurred, at least not yet. Cutting back on the number of its Dealerships was NOT a key means for GM to regain profitability. GM's customers are its Dealers. Consumer end users are the customer of their Dealers. Getting rid of customers doesn't help an auto OEM become profitable. GM realized their mistake and reinstated many of the terminated Dealers with some urging from Congress. The story behind how Team Auto came to the conclusion that reducing Dealerships helped OEM profitability is a long one. Looking through this blog one will find numerous columns on the subject. But if one wants to read the most scathing criticism of that mistaken thinking, read the SIGTARP report on the auto bailout (such as HERE).

Yesterday, Automotive News reported that Tesla Motors CEO Elon Musk (the same billionaire entrepreneur who plans to build a colony on Mars and die there himself, “just not on impact”) will “consider federal options” in his battle to overturn automobile franchise laws.

Ruggles writes: Actually, Elon Musk is NOT seeking to overturn automobile franchise law. He is looking for the means for Tesla to own its own Dealerships. This is not a problem in most states as long as there are no Tesla franchised Dealers. Musk plans to have NO privately owned franchised Dealers in any state, or so he thinks, UNTIL he realizes that expansion is limited by his own personal finances and having franchised Dealers might benefit him and his company. Personally, I have no problem with Tesla owning its own stores, and don't think anyone else should either, as long as Tesla isn't competing against any franchised Telsa dealers. But he did run afoul of the Texas auto franchise law, and that is where the legal action is taking place. Read Maryann Keller's statement about the matter in this blog.

He tweeted a link to a petition calling for the same on the White House’s website (as of this writing it had just over 5000 signatures). Musk runs Tesla Motors on a “mall-based” retail network, which dealers in Texas and elsewhere have alleged violates many states’ laws.

David Hyatt, a spokesman for the National Automobile Dealers Association, responded to this petition’s claim that franchise laws “stifle the auto industry, keep prices of new vehicles up and reduce consumer choice,” stating that “the franchise system is good for consumers, good for communities and good for the economy. Manufacturers that sell their vehicles directly to consumers – and don't let anyone else sell that vehicle – eliminate competitive pricing.”^[4]

Ruggles writes: Yes, the state franchise laws stifle the auto industry to the point they have only sold as many as 17 million new vehicles in a year. So we can sell what, 20 million without Dealers? Who will deal with the tradeins and do the warranty work? If you want to see new vehicle prices rise, get rid of the franchise Dealers and leave it to the OEMs. Is anyone familiar with the Ford Collection experiment which failed miserably?

Yet allowing manufacturers to sell cars directly to the consumer could very well reduce inventory costs, and whether it does should be left to be seen. In other words, if retailing actually increases competition and lowers prices, then dealerships will survive the deregulation of the automobile franchising system.

Ruggles writes: It won't be seen any time soon. There is NO EVIDENCE that manufacturers selling directly to consumers will save inventory costs. NONE.

Now this is an arbitrary sum up. Why should the purpose be to lower prices? The mission is to let the competitive market determine prices. We're not going to see any deregulation of the automobile franchise system. Dealers have made BILLIONS of dollars of investment in their businesses based on the franchise system. The numbers are so high there is no way for OEMs to finance their own dealer network, and they know it.

the prof (Smitka) writes [originally April 23rd, 2013]: Whether dealers are “necessary” is something we’ll talk about; it’s good that you picked up the Tesla, which is attempting to circumvent state franchise law with Texas as a test case. Auto distribution was a key, probably the key, institution in the development of franchising; fast food is strictly post-WWII but as we’ll read, autos date to the 1920s. The case is much more complex than just physical distribution and inventory costs; on a regional basis swapping among dealers addresses the latter, because you can (potentially) sell cars held by others, but selling out of inventory is more profitable. However, a dealership also provides for the purchase of used cars (and then their sale), arranges finance, and handles service. “The Factory” has found that an impossible business to run as part of a large organization, and not just in the US but also in Japan, Germany, the UK and emerging markets such as China, Brazil and India. That ought to suggest that the issues are rather more complex.

So we might instead ask: what might make Tesla different? Or is this a transitional pattern (which, by the way, ties up a lot of capital)?

Bodish, Gerald R. (2009). "Economic Effects of State Bans on Direct Manufacturer Sales to Car Buyers." Department of Justice Economic Analysis Group Competition Advocacy Paper #09-1 CA.

Lafontaine, Francine and Morton, Fiona Scott (2010). “State Franchise Laws, Dealer Terminations, and the Auto Crisis.” Journal of Economic Perspectives 24:3 (Summer), 233–250.

Martí, Eric, Garth Saloner, and A. Michael Spence (2000). "Disintermediation in the U.S. Auto Industry." Graduate School of Business, Stanford University, Case Number: EC-10.