Pub. 55 2014-2015 Issue 1

29 2014 FALL ANALYSIS I. Proper Economic Analysis Demonstrates That Prohibitions On Vertical Integration In Motor Vehicle Distribution Do Not Harm Consumers Your writings argue that the elimination of current restrictions on vertical integration in the auto retailing industry would benefit consumers by allowing for greater efficiency and cost savings in automobile retailing. But your writings fail both to take into ac- count historical precedent and to recognize the highly competitive nature of today’s automotive market. As a consequence, the benefits you claimwill follow from the legislative changes you promote will not, in fact, be realized; what’s more, those changes would more likely harm consumers in unintended and unforeseen ways. For nearly 40 years, the automotive industry has been in a continuous cycle of dismantling, selling, or shuttering non-core assets and has steadily disintegrated production, logistics, and even engineering and design functions. Your writings fail both to appreciate these industry dynamics and to recognize the very tangible differences between theoretical constructs and market realities. In the sections that follow, we explain in detail why your arguments are flawed. A. Theory vs. Reality Although there is a large set of research that illustrates the theoretical benefits of vertical integration resulting in various gains in efficiency, when this analysis is applied to the automo- bile retail industry there are no clear comparable examples that provide any evidence of benefits to consumers. 5 Even if we look at the far broader framework of general retailer and manufacturer relationships, the results of empirical studies do not permit any clear conclusions to be drawn. Overall, it is important to note that the various models of vertical integration represent theoretical depictions of inter-firm relationships that typically contrast outcomes under spot market trades with those under complete vertical integration. The real- ity is that firms have a myriad of options regarding contractual solutions to issues of transaction costs or incentive problems. Bresnahan & Levin (2012). 6 These solutions include joint ven- tures, board seats, shared ownership, and franchising. Indeed, the terms of most franchising arrangements include vertical restraints that are effectively contract clauses imposed by one party in a vertical chain on another, such as those mandating the provision of warranty repair services. These vertical restraints can result in outcomes very similar to what would occur within a vertically integrated setting. Lafontaine & Slade (2013). 7 In your writings, you offer no specific citation for, nor provide any conclusive research demonstrating that there are, consumer benefits to vertical integration in automotive retailing. You do reference two surveys (the two cited in the previous paragraph), but neither of these provides support for your position that vertical integration would be beneficial to auto consumers. It is significant to note that Bresnahan &Levin are themselves generally critical of empirical studies of vertical integration, which runs somewhat contrary to a number of your arguments. For example, Bresnahan & Levin cite numerous statistical and methodological challenges that arise from testing. There are three criticisms that Bresnahan & Levin point out that are particularly relevant in this context: • First, Bresnahan & Levin observe that studies at the firm level tend to assume that the nature of goods and services being contracted on, the contracting environment, and the surrounding market context are the same. This makes it dif- ficult to determine whether the effects can be unambiguously attributed to the integration decision or whether, alternatively, firm specific factors (i.e. financing) or general market factors (i.e. market concentration) are more important. • Second, they note that theories of vertical integration can only be tested if there are empirical measures of abstract concepts like risk, monitoring costs, and effort. These factors cannot be readily measured and, in fact, are more often completely unobservable. In many cases, it is not clear whether the proxies capture the intended theoretical driver and whether these factors are independent of the factors driving organizational decisions. • Third, Bresnahan &Levin explain that testing for the effects of vertical integration is complicated by the possibility of a wide range of contractual solutions to a given problem. Most studies simply avoid any distinctions and rely on some sort of binary integrated versus non-integrated classification. Bresnahan & Levin essentially conclude that it is unclear whether the difference in outcomes between integration and non-integration is important in any economic sense. In the end, they can identify only a handful of industries where there is clear benefit from vertical integration. These industries are (1) bauxite production and alumina smelting, (2) coal mining and coal fired power plants, and (3) the airline and truck transportation indus- tries (where real time scheduling coordination is paramount in responding to changing circumstances within minutes or hours). While we accept that there may be benefits to vertical integration in these instances, there are simply no examples that apply to the general retail sector, let alone to automotive retailing in particular. You cite the retail gasoline market as an example of one in which vertical integration benefits consumers. We disagree with 5 Your letter to the New Jersey legislature states, at page 5, that “[w]hen manufacturers respond to competitive pressure by choosing to vertically integrate, consumers usually benefit through lower prices and/or higher quality.” But your analysis never moves beyond the theoretical to the actual market in which our members operate. 6 Timothy F. Bresnahan and Jonathan D. Levin, Vertical Integration and Market Structure, No. w17889, National Bureau of Economic Research, 2012. 7 Francine Lafontaine and M. Slade, Franchising and Exclusive Distribution: Adaptation and Antitrust, Oxford Handbook of International Antitrust, 2013.