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
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
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.
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.
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.
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.