The United States Automobile Industry - Term Paper Example

United States Automobile Industry Introduction The US automobile segment is a huge industry producing durable consumer goods and using a nationally oriented advertising strategy to market its product. The auto industry is one of the most influential segments in the US economy, providing a substantial fraction of the national employment and having a major impact on GDP. Considering all the intermediate products used in auto construction and distribution (rubber, machine tools, trucking, etc.), the total impact of the automobile industry goes far beyond the direct impact. Automobiles are durable experience goods that sell for a fairly high price. Consequently, as the purchase of a car constitutes a large investment for the average household, the demand for cars is fairly price and income elastic and strongly affected by macroeconomic conditions, including income trends, employment, and interest rates (Adams and Brock, 1995: 68). Because we look at competitive performance within the industry, however, we do not consider the industry's overall performance and its impact on the national economy. The US automobile industry is highly concentrated, with domestic production dominated by a tight triopoly. The top three firms, General Motors, Ford, and Chrysler (the 'Big Three'), account for 98% of domestic production. This high concentration started mainly in the 1930s. In the first three decades after the automobile was invented in the 1890s, more than 80 firms existed in the industry, with a number of companies entering and leaving the market every year. The number of companies that managed to stay efficient and profitable, and that survived the Depression in the 1930s, shrank to eight firms in the 1940s (White, 1982: 143). Since then, the Big Three have merged with or bought the remaining domestic firms. Historical Analysis In the 1970s, however, US auto makers first began to face significant foreign competition. German and especially Japanese car markers, which were already established in their home markets, entered the US market with small, efficient cars that provided stiff competition for domestic producers. Today, imports account for about a quarter of the existing US market share (as opposed to 0.4% market share immediately after World-War II). This trend is reflected in Figure 1, which shows the market shares of the Big Three over our sample period. This considerable gain in market share for the foreign companies resulted mainly from the oil crisis of 1979, after which US consumers began to value fuel efficiency over size and style. The importance of barriers to entry in this industry is widely debated. In general, a long-run barrier is any cost or factor that permits market incumbents to earn supernormal returns while deterring entry. Examples include absolute (capital) costs, economies of scale, product differentiation, sunk exit costs, strategic behavior, special resources or licenses, and other legal restrictions. Because both incumbents and new entrants appears to enjoy the same benefits of economies of scale, these do not appear to constitute a major entry barrier in the US auto industry. White (1971: 38-53) estimates the minimum efficient scale of production in automobiles to be about 400,000 vehicles per year, which amounts to only an 8-10% market share. Absolute capital requirements, however, may be more important. New entrants in the automobile market must build a variety of plants, such as engine and final assembly plants, that require significant sunk costs, and establish a distribution and a dealership network to sell 400,000 units. According to the Department of Transportation this can easily cost over a billion dollars (Adams and Brock, 1990: 110). This large investment for the new entrant, along with the uncertainty of future success, provides a relatively high barrier to entry. Auto Industry and US Economics The automobile industry has long been viewed as a key sector for business economists in preparing their assessments of macroeconomic activity. Central bankers are also concerned about developments in the industry for similar reasons. However, from the perspective of central bankers in the developed world, the auto sector provides insights beyond macroeconomic analysis. As a key barometer of adjustments in the manufacturing sector, the industry provides substantial insights eesential to formulating monetary policy. The insights offered are particularly important in periods of substantial adjustments in the economy. The Auto Industry And The Business Cycle One factor that directly contributes to the industry's disproportionate impact on economic activity is its cyclical nature. Detailed information on the automotive industry illustrates its disproportionate impact on regional and national economic activity. For example, the U.S. automotive sector directly contributes approximately 4 percent of total output as measured by gross domestic product (GDP). However, on a quarterly basis the sector can account for more than 40 percent of the change in GDP. The frequent changes in the industry affect many downstream industries and can influence national manufacturing, sometimes to an overwhelming extent. For example, in the U.S. during the 1993 summer slowdown, almost the entire weakness could be attributed to the sector. In the case of the third quarter of that year, production and sales for the industry slumped, and the impact on the manufacturing sector and the overall economy was rather startling. The declines in shipments and industrial production of the motor vehicles and parts component of manufacturing were several times larger than the overall declines in manufacturing. Shipments of autos and parts were down 15.5 percent in July from the March peak -- over five times the decline in total manufacturing shipments. Even though the auto industry accounts for slightly less than 10 percent of total shipments, the industry's decline accounted (on a share-weighted basis) for half of the total decline in manufacturing shipments and for about 85 percent of the decline in durable goods manufacturing. In industrial production, the decline in the autos and parts component from April to July (-0.8 percent) was nearly three times greater than the decline in total manufacturing. In addition, the slump in auto production impacted supplier industries, such as rubber, glass and steel that generated additional weakness in the durable goods sector of manufacturing. Not surprisingly, the slump in the industry was directly translated into more than just poor manufacturing statistics. The third-quarter drag in the auto sector had a substantial impact on GDP for the quarter, which came in below widespread expectations. The auto drag on GDP for the quarter was almost a full percentage point, and adjusting the reported GDP for this factor facilitates a better understanding of the weak reported number. Fortunately, this drag was temporary due in large measure to short-term developments that subsequently corrected themselves. As the U.S. economy picked up momentum in subsequent quarters, the auto industry also provided a large share of the boost. Motor vehicle activity increased well above overall production gains, especially in the fourth quarter. This pickup translated into a large contribution to GDP during the fourth quarter of 1993 and the first quarter of 1994. The auto contribution for the fourth quarter was in excess of 2 percentage points, while the first quarter was above 1.6 percentage points (or almost half of the GDP increase of 3.4 percent). Projecting out into the future, the industry is expected to provide a boost to German recovery due to an increase in sales and production. Although still modest, production is increasing year over year and will have a positive and sizable impact on economic activity. Perhaps the best news in terms of the German recovery is the fact that the better-than-expected growth of GDP in the first quarter of 1994 did not yet benefit from the increased activity of the automotive industry. AUTOS AND STRUCTURAL CHANGES The automotive industry's impact is more than cyclical. The industry is a global industry that has been at the heart of the manufacturing changes in much of the developed world throughout most of this century. In today's environment of wholesale realignment of markets, production processes and organizational structures, policymakers must understand the degree and direction of change. Fortunately, industries like the automotive industry provide significant insights into current and future directions for the entire economy. The changes occurring in today's marketplace involve substantial shifts that alter the economic landscape. The changes relate to the emergence of a global economy characterized by a move toward the service sector, ongoing and constant restructuring in the manufacturing core, globalization of previously (partially or wholly) insulated domestic markets, and increased technological development and enhanced factor mobility. This realignment has substantial repercussions for all segments of the economy. For policymakers grasping the impact of the adjustments is vital, if policy is going to complement economic development. The changes entail an alteration in business processes, adjustments in employment, constraints on government, and an overall environment constrained by competitive pressures. As a result, the rules by which policy is formulated are radically altered. In assessing this transformation, it is instructive to review the automobile industry once more. The automotive industry has incurred dynamic change internally during the past few decades. From a period of insulation and stability, the industry has been transformed by the 1990s. In the U.S., Big Three market share fell, red ink accumulated, and domestic companies began a retrenchment that continues today. In this context, external factors -- oil shocks and foreign competition -- appear to have eroded the market share of domestic producers and are blamed for many of the problems of the industry. Yet, more fundamentally, technological and operational changes have done as much to erode the dominance of the domestic industry as external factors. Of course, these technological changes are linked directly to increased market penetration by imports and the emergence of transplants. Processes associated with lean production, quality initiatives, supplier integration and other techniques were at the core of the challenge facing U.S. industry. The transformation of the industry has been startling and the repercussions on the economy substantial. For instance, due to the downsizing of domestic facilities and operational adjustments, employment levels at the Big Three have declined by almost half since the late 1970s (Figure 1). The transformation has brought forward significant pain and suffering for workers in this market and for the economy. Falling income, lower wages, slow rates of economic growth and other concerns are directly associated with these changes. At the same time many necessary and beneficial adjustments occurred. In fact, due to these adjustments, the U.S. industry is much better suited to compete in the marketplace of today and tomorrow. The gains of restructuring include significant increases in productivity. In 1980 the Big Three found themselves at a substantial disadvantage in terms of costs due in large measure to a productivity gap between domestic and foreign production. By 1992 this gap had been all but eliminated as the domestic industry improved unit productivity in excess of 40 percent. Additionally, the domestic industry supplemented these productivity increases by improving the quality and customer service associated with selling vehicles. The quality difference between Japanese nameplates and the domestic industry has narrowed substantially over the past few decades. Current buyer surveys also indicate that the difference has been narrowed even further and the Big Three now have numerous models listed very favorably on buyer survey lists. Finally, the domestic industry has come a long way in product development, both in terms of the shrinking of development time (and therefore cost) and in terms of the finished product. The recent surge in domestic market share reflects not only an appreciation in the yen but the improved products in the showrooms of the Big Three. From the Chrysler L-H sedans to the top-selling Taurus to the award-winning Saturn, the domestic industry has become successful at putting a product on the road people actually want to buy. These developments in the auto sector are similar to the trends transforming other large segments of the U.S. economy. Evaluating Conditions in The U.S. The first challenge in this new and rapidly changing environment stems from the structural impediments to growth that have distorted the most recent economic cycle. By any measure, this cycle was peculiar. It cannot be characterized as a deep or a severe slump. Instead, as indicated by the growth pattern of GDP, it was an extended period of subpar economic growth going back to the late 1980s. Additionally, even after the recovery got under way, the boost was modest and extremely volatile, especially with respect to developments in labor markets. The second challenge for policymakers today stems directly from the level of change and adjustment occurring in the world. We are living in turbulent times, and making sense of current and future directions is difficult. Fortunately, insights can be drawn from past experience. And for policymakers one of the best laboratories available is with industries like autos. One concern for the Fed arose from the surprisingly strong auto sales increases beginning in the fourth quarter of 1993. Sales for the first quarter increased on an adjusted daily sales basis by 18 percent over relatively flat 1993 levels. On a seasonally adjusted annualized basis, sales for total light vehicles were approximately 15.5 million units, the highest rate so far during the recovery. Although good news for the manufacturers, the strength of sales in the first quarter of 1994 added to the concern of the manufacturers' ability to meet demand in the auto segment. Domestic manufacturers planned some inventory accumulation during the first quarter in preparation for the more robust spring sales period and model changeovers. However, inventories were flat over the quarter and at extremely low levels heading into the second quarter. Adding to the concern of policymakers was the difficulty in boosting inventories in response to strong sales because of capacity limitations. In all fairness it should be noted that capacity levels are increasingly in a state of flux. The ability to add a shift, eliminate supply and production bottlenecks, and use non-U.S. production sites are all factors partially offsetting traditional views of capacity. However, even taking these considerations into account, the operating rates for the plants producing light trucks were close to maximum levels. Conclusion Given the sales strength and capacity limits, the primary policy question is the potential for price increases. In fact, the price increases for some models in 1993 vs. 1994, light trucks in particular, have been generally in excess of 4 percent. On a company level, although there has not been a tight correlation between operating rates and relative price increases for specific models, the strong sales environments for light trucks has allowed for some price increases. And the stronger price increases in the light truck segment raise added concern over the direction of vehicle prices in 1994 and beyond as the light truck market continues to expand at an aggressive pace. However, price data for the 1994 model year have yet to show aggressive price increases for domestic manufacturers. In total, including model year increases and midyear price increase, the weighted index (weighted by sales shares) projects that the Big Three have increased combined prices by 2 percent. While light truck adjustments still dominate the price increases to date with a weighted price rise of 2 percent, that is far less than the 4 percent pace of prior years. Price increases for domestic passenger cars have been less than 1 percent thus far this year. What accounts for the weak price increases in spite of the sales surge? The structural shifts in the market-place must be assessed as a key component. In response to the surge, domestic manufacturers continue to focus on relieving capacity constraints through investment and adjustments to manufacturing processes. Additionally, competitive pressures have certainly not dissipated, even in spite of the rise of the value of the yen. In fact, competitive constraints are substantial, keeping narrow the price gap between domestic and foreign nameplates. The competitive constraints between manufacturers also should not be discounted. In virtually every segment of the market, the Big Three are fiercely competing -- including the hot selling segments. Consequently, although initially one could conclude that the potential for price increases in the industry was significant, changes in the structure of the marketplace made price increases less than historical experience would suggest. This development was an important input to monetary policy decisions. 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