How Do Franchise Termination Restrictions Affect Consumers?

Transcription

1 How Do Franchise Termination Restrictions Affect Consumers? Eduardo Montoya and Alison Rauh I. Introduction In opening remarks in January at a Federal Trade Commission ( FTC ) workshop on issues in auto distribution, Chairwoman Edith Ramirez described an automobile marketplace on the precipice of dramatic change. 1 Ms. Ramirez pointed to the entry of new manufacturers like Tesla and Elio that are developing new types of vehicles and championing direct distribution methods currently prohibited in most states. She pointed to the growth of the sharing economy, and the rapid development of autonomous cars two factors that workshop participants suggested might sharply reduce the need for dealerships in the future. And, in perhaps a moment of foreshadowing, the Chairwoman reminded the audience that the FTC continues to ask whether consumers benefit from the current system of auto regulation and to evaluate whether change is needed. A lively debate on the merits of auto regulation followed the FTC Chairwoman s remarks. The debate mirrored a broader discussion on the wisdom of franchise laws and policy toward vertical restraints generally. Dealer termination restrictions figured prominently in the workshop discussions. Broadly, state termination restrictions allow manufacturers to close dealerships only for good cause, and establish the procedures necessary to demonstrate good cause. 2 By design, these regulations increase the time and cost required for a manufacturer to close dealerships. That is, the regulations protect dealership owners who have invested heavily in their businesses and are seen as important to local economies. An unintended consequence may be to lock the manufacturer into a distribution network with low profitability that cannot adapt to changes in demand. In this article, we consider the background and economic theory relevant to this debate. We conclude by pointing to some of the basic, empirical questions that remain unanswered at the core of this debate: Do franchise laws like termination restrictions help or hurt consumers? What would happen if we relaxed franchise laws in key industries such as the auto industry? II. Auto Franchise Termination Restrictions We begin with an overview of the history and economics of termination restrictions in the U.S. auto industry: Where did these termination restrictions come from, and what exactly do the laws say? What effects do they have on manufacturers and dealers? And why might they help or hurt consumers? A. Background Franchise laws in the auto industry began as a way to correct a perceived power imbalance between manufacturers and dealers. 3 A 1939 study of the auto industry by the FTC details inequitable contract provisions at the expense of dealers (e.g., at-will termination clauses with short notice periods). The FTC found that such 1 Edith Ramirez, 1/19/16, January 19, 2016 Workshop Transcript, FTC Workshop on Auto Distribution: Current Issues and Trends, pp As we discuss below, it is important to understand that these restrictions interact with other protections for dealerships, such as prohibitions against direct sales by manufacturers, as well as geographic encroachment protections that require a manufacturer to demonstrate need prior to establishing a new dealership in an existing dealership s Relevant Market Area. 3 Franchising was not the only distribution arrangement tried in the auto industry the early years of the industry saw many types of approaches. For a description of how the industry converged toward the franchise dealer model, see Francine Lafontaine and Fiona Scott Morton, Markets: State franchise laws, dealer terminations, and the auto crisis, The Journal of Economic Perspectives, Vol. 24, No. 3 (Summer 2010), pp March

2 provisions were used to force particular dealer behavior, such as buying and selling greater volumes than dealers wanted. 4 In a New Yorker article, James Surowiecki offers Ford s behavior during a recession in the early 1920s as an example of this behavior. 5 According to Mr. Surowiecki, Ford required dealers to buy vehicles for which there was no retail demand in order to keep its own sales volume high. 6 Mr. Surowiecki argues that Ford was able to require the dealers to make these purchases because if dealers did not comply, they risked termination or non-renewal. This would result in the dealer losing the ability to sell Ford cars in the future, as well as all their investments in their facilities and reputation. 7 Regulation soon followed. Auto franchise laws have since evolved to regulate many aspects of the manufacturer-dealer relationship. The content of the statutes reflect a concern for fairness between manufacturers and dealers, rather than a direct interest in consumer welfare. Typical provisions may include: 8 Licensing. Dealers must be licensed, and manufacturers may only retail cars through dealers. This prevents manufacturers from vertically integrating or using Internet distribution. Termination and non-renewal. Manufacturers may not terminate or decline to renew dealerships other than for good cause, where good cause may mean insolvency, license revocation, conviction of a felony, or fraud, but typically does not include efficiency or manufacturer profit. Post-termination obligations. If a dealer is terminated by the manufacturer, or sometimes even if the dealer chooses to terminate the relationship, manufacturers must buy back unsold vehicles, parts, accessories, special tools, and equipment. In some cases, compensation might include the entire fair market value of the franchise. Encroachment protections. Formal notice must be given to a manufacturer s existing dealers before adding or relocating a dealership. Dealers within a certain radius of the proposed location have the right to protest. Often, a manufacturer must demonstrate need to establish a new dealership in an existing dealer s Relevant Market Area. Quantity forcing. Manufacturers are prohibited from requiring dealers to purchase more vehicles than they otherwise would have purchased. Dealer-specific wholesale prices. Manufacturers must offer the same prices to all dealers in a state, or in a relevant market area. Thus, dealer-specific wholesale price discounts may be difficult to use to encourage particular behavior. Financial incentives. Some states require that financial incentives given to dealers in other states must also be given to dealers in that state, unless substantially different conditions can be shown. In some cases, if manufacturers provide financial incentives for facility improvements, even dealerships that do not improve their facilities must also be compensated. In order to better understand the motivations for and consequences of such regulations, we next 4 FTC, Report on Motor Vehicle Industry. United States Government Printing Office, Washington: James Surowiecki, Dealer s Choice, The New Yorker, 9/4/06 6 James Surowiecki, Dealer s Choice, The New Yorker, 9/4/06 7 James Surowiecki, Dealer s Choice, The New Yorker, 9/4/06 8 Provisions vary by state, and we do not imply that all states have all provisions. This listing draws heavily on No. 3 (Summer 2010), pp Lafontaine and Morton also provide an Online Appendix with a state-bystate summary of key provisions. March

3 turn to economic theory as it relates to termination restrictions B. Basic economics of franchise relationships and termination restrictions As the early history of the auto industry demonstrates, franchise relationships have inherent tensions. Each party, franchisor and franchisee, depends on the other to provide high levels of quality, creativity, and efficiency in the production of goods and the provision of retail services. But because the two companies are independent, they face different incentives and risks. A situation in which the manufacturer can use the threat of termination to coerce particular actions by a dealer is an example of the holdup problem. 9 The key idea is that one party (the dealer) must make an upfront investment (establishing a high quality dealership) in order to transact with another party (by reselling and servicing the manufacturer s vehicles). The investment is to some degree relationshipspecific, in the sense that a dealer s brand reputation, inventory, repair equipment, and employee training are specific to reselling and servicing a particular manufacturer s vehicles. These assets would have lower (or zero) value in any other usage. Under these conditions, the manufacturer could use the threat of termination to dictate how many vehicles the dealer has to purchase from the manufacturer, to set retail prices, to enforce quality standards, or in general to expropriate all of the returns to any relationship-specific investments made by dealers. 10 Both manufacturers and dealers need to find a solution to the hold-up problem. Manufacturers need dealers to make relationship-specific investments in their business, but they know that under the risk of hold-up, dealers have limited incentive to do so. In extreme cases, if the manufacturer cannot credibly commit to behave fairly, distribution through dealerships would be impossible because no rational dealer would enter the market at all. In theory, solutions to the hold-up problem might arise through regulation, through privately negotiated contracts enforced by the courts, or simply through a manufacturer s need to maintain a reputation for fairness in order to compete with other manufacturers for dealerships. But hold-up is not the only incentive problem that manufacturers and dealers face. While hold-up in this setting results from opportunistic behavior by manufacturers, double marginalization and free riding problems arise from opportunistic behavior on the part of dealers. These two problems are closely related to the density of a manufacturer s distribution network, and to restrictions on dealer terminations. From the manufacturer s perspective, the ability to freely close (and open) dealerships is a way to optimize the density of their distribution network. This is important because both isolated dealerships and dense clusters of dealerships can reduce the manufacturer s profits and reduce consumer welfare. An isolated dealership will have some degree of 9 This is an important problem in economics. The incentive problems it represents are seen as central to understanding why firms exist and in determining what work is done within the firm versus outside the firm. See, e.g., Bengt Holmström and John Roberts, 1998, The boundaries of the firm revisited, Journal of Economic Perspectives, Vol. 12, No. 4, pp One of the earliest discussions focused on the relationship between auto manufacturers and their parts suppliers. Benjamin Klein, Robert Crawford, and Armen Archian (1978), Vertical integration, appropriable rents, and the competitive contracting process, Journal of Law and Economics, Vol. 21, pp Of course, manufacturers have also made enormous upfront investments in order to produce vehicles. If dealers could coordinate, they could potentially hold up the manufacturer by refusing to distribute any product unless the contracting terms were to their benefit. But without coordination, an individual dealer typically would not have this degree of bargaining power. March

4 local monopoly power, giving the dealer an incentive to restrict quantities and charge higher prices. This reduces the manufacturer s profits and harms consumers; economists call this concern double marginalization. A distribution network that has too many dealers can create what economists call a free rider problem among dealers. The idea is that after a dealership invests in the attractive showrooms, consumer education and other sales efforts needed to convey vehicle quality and match a potential buyer with their preferred model, the informed buyer will naturally seek out the lowest price among any of the same manufacturer s dealerships nearby. Same brand dealerships thus get a free ride on costly sales efforts by their neighbors. 11 As a result, all dealerships may under-invest in pre-sale services, reducing the manufacturer s profits, failing to improve the public perception of the brand, and delivering fewer cars to consumers. 12 Auto franchise laws respond to the hold-up concerns of dealers, but tend to prohibit market solutions to the double marginalization and free rider problems. For example, direct sales by the manufacturer would eliminate double marginalization (and hold up), but franchise laws prohibit these direct sales. 13 The threat of termination could be used to encourage dealers to sell more product at lower prices, eliminating the double marginalization problem, but franchise laws make termination difficult. 11 Selling many durable goods requires a large showroom to display products, so that consumers can select the best model to satisfy their particular needs. Showrooms, of course, cost money as does the inventory on display. If only one distributor has a well-stocked showroom, all customers go to that showroom to decide which product to buy, but they can buy from other distributors with less fancy showrooms and smaller inventories. These distributors can charge a lower price than the first distributor because their costs are lower. Thus no dealer has an incentive to maintain a wellstocked showroom. Dennis W. Carlton and Jeffrey M. Perloff, Modern Industrial Organization, 2nd edition, 1994, pp This highlights conceptually the under-investment that may result from free riding. In principle, manufacturers Dealer terminations could also manage the free rider problem by eliminating dealerships (at the risk of increasing double marginalization concerns), but only if they can be defended by the manufacturer as being for good cause. C. The problem of changing demand conditions and inflexible dealer networks The economic tensions described above are especially problematic if demand is changing over time. As noted, there are trade-offs between having a small versus large number of dealerships in a given area. If local demand changes rapidly, then it is unlikely that the number of dealers will remain optimal from either the manufacturers or the dealers perspectives. Some markets will have too many dealerships while others have too few. Dealer termination restrictions make it difficult for manufacturers to adjust their dealership networks either to close or to add dealerships. The dealer networks of the major U.S. automakers were put into place under market and regulatory conditions that have changed significantly. Import competition has increased and market shares have fallen, reducing the number of dealerships needed. 14 Moreover, demand has shifted from metro areas to exurbs, implying dealerships are no longer in ideal may be able to impose quality conditions in their dealer agreements directly, which would provide good cause for termination, or they may use financial incentives to reward certain behaviors. But state provisions may make these options difficult to employ in practice. 13 Direct sales may be problematic for other reasons, e.g., if they are more costly or imply a loss of local knowledge, retail skill, or sales effort. But in principle, vertical integration eliminates double marginalization. 14 Shares of the Detroit 3 Ford, GM, and Chrysler fell from over 80 percent in the 1970s to 48 percent in Francine Lafontaine and Fiona Scott Morton, Markets: State franchise laws, dealer terminations, and the auto crisis, The Journal of Economic Perspectives, Vol. 24, No. 3 (Summer 2010), pp , at p March

5 locations. 15 And technological change may have increased the optimal size of an auto dealer, leading to dealerships that are too small. 16 All of these factors would make the existing dealership network too large in many areas, making it vulnerable to free riding, underinvestment in promotional efforts, and lower returns to the manufacturer compared to an optimal network. In the end, consumer welfare could improve if a manufacturer had a smaller dealer network that provided consumers with better presale service, more vehicles and at better prices than a larger network. Lower prices are more likely if manufacturers can use the threat of termination to encourage dealers to keep sales volume high. This is one of the major problems with auto franchise laws identified by economists Lafontaine and Morton. 17 To illustrate the concern that U.S. auto manufacturers might have too many dealerships, Lafontaine and Morton provide data showing that foreign dealerships sell several times more vehicles per dealership than Ford, GM, and Chrysler. 18 They argue U.S. manufacturers may be at a competitive disadvantage compared to foreign manufacturers because US dealer networks were put into place under earlier demand conditions and US manufacturers can no longer easily modify the network. For related reasons, termination restrictions make it more difficult to add dealerships in places where demand is high. The manufacturer knows that placing a particular dealer in a particular location will be difficult to reverse. If the manufacturer is uncertain about future demand, or about whether a different dealer might be more successful in that location, the manufacturer might have to wait until it has better information about what the most profitable choice would be. This will tend to reduce the opening of new dealerships. III. Potential Evidence from the Financial Crisis Do auto franchise laws like termination restrictions help consumers? Or have they gone too far in the direction of preventing hold-up, while preventing market solutions to the freeriding problem and optimal dealer networks? Unfortunately, empirical evidence is scarce. Lafontaine and Morton suggest that dealer protections have harmed both manufacturers and consumers, leading to higher retail costs and retail car prices, inflexible dealer networks, and limited innovation in car distribution. 19 The analysis above suggests that if US manufacturers were allowed to re-optimize their distribution network and close and/or relocate certain dealers, then manufacturers total sales could potentially increase, as would service quality at dealerships. In particular, the analysis suggests that by closing and/or relocating dealerships, the US manufacturers would reduce free-riding by dealers, increasing dealer profits (and potentially increasing prices), but also encouraging dealer investment. This could be to consumers benefit even if retail prices rise at the same time. During the financial crisis, very similar concerns led the Treasury Auto Team to allow certain major U.S. auto manufacturers to close 15 No. 3 (Summer 2010), pp , at p No. 3 (Summer 2010), pp , at p No. 3 (Summer 2010), pp Table 2, Francine Lafontaine and Fiona Scott Morton, Markets: State franchise laws, dealer terminations, and the auto crisis, The Journal of Economic Perspectives, Vol. 24, No. 3 (Summer 2010), pp No. 3 (Summer 2010), pp , at p March

6 large numbers of dealerships under bankruptcy protection. 20 In the near term, the Auto Team expected total sales to decline with the smaller network. 21 But the increased investments at the dealerships were expected to drive a rebound in aggregate sales by year three. 22 By year five, sales were expected to be 25 percent larger under the smaller network than under the larger network. 23 Thus, evidence of increased total sales and dealer investment following these bankruptcy terminations would be consistent with the analysis above in suggesting that auto franchise laws have gone too far in the direction of preventing hold-up, while preventing market solutions to the free-riding problem under changing demand conditions. To our knowledge, no empirical study has yet assessed whether dealer terminations during the financial crisis eventually increased manufacturer sales and dealer investment. However, work by Ozturk, Venkataraman, and Chintagunta does assess the short-run price effects. 24 On average, they find that prices increased following dealership exits. This is consistent with the idea that eliminating termination restrictions should increase dealer profits, thus reducing free-riding and creating greater motivation to invest. 25 But without information on total manufacturer sales or direct evidence of increased investment, the net effect on consumer welfare remains an open question for future research. 26 IV. Conclusion Termination restrictions, and franchise laws generally, remain a contentious area in policy towards vertical relationships. The rapid changes in the auto industry motivate us to continue asking whether current regulation delivers the maximum benefits to consumers. In this article, we showed that economic theory provides a rich basis for understanding the costs and benefits of dealer termination restrictions. Empirical evidence, on the other hand, is scarce. While bankruptcy reorganizations during the financial crisis offer some potential lessons, key questions about the quantity and quality effects 20 Dealership Networks, 7/19/ Dealership Networks, 7/19/10, p. 9. An auto team memo noted that the remaining dealerships would initially capture 75 percent of the terminated dealerships in the first year. 22 Dealership Networks, 7/19/10, pp As the report explains, the reasoning was that smaller dealership networks would reduce competition among dealerships and increase sales volume for the remaining dealerships. It was believed this would then allow the dealerships to invest more in their facilities, thus improving the brand equity of GM and Chrysler. 23 Dealership Networks, 7/19/10, p In particular, they study the trade-off in price effects of dealership exits resulting from, on the one hand, reduced within-brand competition ( competition effects ), which will tend to increase prices; and on the other hand, those resulting from a reduction in local demand due to having fewer dealerships clustered nearby (i.e., lost agglomeration effects ), which will tend to reduce prices. 25 Importantly, there are several ways in which the effects of dealer terminations under bankruptcy differ from those that would occur under a permanent change in franchise laws. For example, bankruptcy reorganization is a onetime event, whereas a change in franchise law would be permanent. Both manufacturers and dealers may behave differently under a one-time event. Additionally, under a change in franchise law, all manufacturers would be able to change their behavior. This would introduce strategic concerns that would complicate the analysis. 26 The courts have long recognized that increased investment which would result from limiting the number of distributors may ultimately increase inter-brand competition, even when it reduces within-brand competition. Continental T.V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36 (1977). March

7 of allowing dealer terminations remain for future work. The views expressed in this article are solely those of the authors, who are responsible for the content, and do not necessarily reflect the views of Cornerstone Research. Alison Rauh Cornerstone Research Eduardo Montoya Cornerstone Research March Copyright 2017 American Bar Association. All rights reserved. The contents of this publication may not be reproduced, in whole or in part, without written permission of the ABA. All requests for reprints should be sent to