Truth on the Market

In Continental T.V. v. GTE Sylvania (1977), Justice Powell observed that antitrust law should go easy on manufacturer restraints on dealer resale because manufacturers could always decide to integrate forward into distribution and bypass dealers altogether.  As anyone who has followed electric car manufacturer Tesla’s recent travails will know, Justice Powell’s observation is not true of the auto industry.  Dealer franchise laws in most states require car manufacturers to sell through independent dealers.  Tesla apparently would like to bypass the traditional dealership model and sell directly to customers, which is landing the company in legal hot waters in many states, including traditionally “free market” states like Texas, Virginia, and North Carolina.

Tesla is the offspring of the South African-American entrepreneur Elon Musk, who also brought us Pay-Pal and SpaceX.  The company’s luxury electric cars have caused a sensation in the auto industry, including a review by Consumer Reports calling Tesla’s Model S the best car it ever tested.  Extraordinarily for a startup, in the first quarter of 2013, Tesla Model S sales exceeded the top line offerings of the established German luxury brands, Mercedes, BMW, and Audi.  Indeed, more Teslas were sold than BMW 7 series and Audi A8s combined.

One would imagine that Tesla’s biggest problem would be economic and technological—creating the infrastructure for battery-pack swap and charging facilities necessary to persuade customers that powering their Teslas will be as seamless as pumping gas at a filling station.  (Telsa’s recently announced 90-second battery pack swap will go a long way in that direction).  Alas, Tesla’s major stumbling block seems to be more legal than technological.  Tesla wants to open its own showrooms and sell directly to customers.  The powerful car dealers’ lobby has been invoking decades-old dealer franchising laws to block Tesla’s progress, insisting that Tesla must sell through independent, franchised dealers like other car companies do.  Tesla has been lobbying for legislative reforms at the state level, thus far with mixed success.

The basic economics of the problem are straightforward.  As Ronald Coase taught us, whether a car manufacturer keeps the distribution function in house or buys distribution services on the market is a question of the agency and transactions costs of those respective forms of distribution.  There are many reasons why manufacturers might prefer to distribute through independent dealers.  This shifts the investment in distribution to someone other than the manufacturer, allowing the manufacturer to focus on its core competence in research and development and manufacturing.  It shifts managerial decisions to managers with local market knowledge.  It may create economies of scale or scope as dealers sell several different brands under a single roof.

But there are also good reasons why a manufacturer might prefer to sell directly to consumers.  The manufacturer may be concerned that the dealers will focus more on short-term sales maximization rather than long-term investment in building the brand.  (This could be particularly concerning to a company like Tesla that is introducing a disruptive new technology that still needs to be proven in the market).  The manufacturer may worry that independent dealers will be insufficiently loyal and push other brands.  It may fret that local dealers will be unsophisticated about new technologies and that training and monitoring will be easier if retail distribution stays in house.

There is no a priori reason to favor one model or the other, and I have no idea whether Tesla is better off distributing through traditional dealer networks.  But I find it hard to fathom any good reason why the law should prohibit a car manufacturer from picking whatever distribution model it thinks best.  As a newcomer to these state dealer laws, I’ve been trying to keep an open mind that they might be supported by some legitimate policy concern and not pure protectionism.  Unfortunately, whenever a dealer-aligned speaker opens his mouth to defend these laws, the case that it’s just protectionism gets stronger.

One argument I’ve seen attributed to the auto dealers—and I sincerely hope that there’s some mistake and this is not actually an argument they’re making—is that creating “competition” in retail distribution of Tesla cars is necessary to prevent Tesla from price gouging customers. The idea that a vertically integrated manufacturer has a “monopoly” over the brand’s retail distribution that needs to be broken up by outsourcing the retail function to independent dealers is farcical.  If Tesla has market power, it will extract the full monopoly profit regardless of whether it sells to dealers or end users.  (It will be fully embedded in either the wholesale or resale price).  Since retail distribution is just a cost of doing business, Tesla will increase its monopoly profits by minimizing the cost of retail distribution since then it will sell more cars.  If anything, as economists have long recognized, outsourcing the retail distribution function to locally dominant automobile dealers could lead to double marginalization and increased prices.

A second argument is that having local dealers is necessary to ensure that customers are adequately served.  For example, Bob Glaser of the North Carolina Automobile Dealer’s Association has asserted that the restrictions are a form of “consumer protection,” since “a dealer who has invested a significant amount of capital in a community is more committed to taking care of that area’s customers.”  The obvious rejoinder is that Tesla has as much or more of an interest as the dealers in seeing that customers get the level of service they’re willing to pay for.   If Tesla gets a bad reputation for quality, it will fail.  I suppose that one might worry if  Tesla were a fly-by-night operation selling customers an expensive durable good at a high price and then fleeing with its profits and leaving customers without support.  But that’s obviously unlikely of a company that’s pouring billions of dollars into the creation of a new product and a recharging and battery swapping infrastructure.  Car manufacturers make considerably larger fixed capital investments than do dealers and I’m sure that the dealer failure and exit rate is considerably higher than that of manufacturers.

A related argument is that dealers play an important role in complying with local laws regarding titling and safety inspection.  But this argument doesn’t work either.  First, observe that at present most states only prohibit manufacturers from opening their own dealerships—they don’t prohibit online sales from outside the state.  (North Carolina recently passed a statute banning online sales as well).  There’s no reason why a manufacturer-owned dealership should be less capable of complying with local laws than an independent dealer.  Second, why should Internet sales involve evasion of state titling and safety inspection laws?  Internet sales can just as easily be subject to the same titling and inspection requirements as dealer-initiated sales.

Another argument I’ve heard is that prohibiting manufacturers from integrating forward into distribution is necessary to prevent them from competing unfairly with their own franchised dealers by undercutting them on price.  The logic of this argument is a little fuzzy. What would a manufacturer set up franchised dealers only to undercut them ruinously?  I suppose it might be some variant of the usual free-rider arguments—the manufacturer would set up independent dealers, free-ride on their local brand promotion, and then cut them out once the brand was established.  (Why the dealers can’t contractually bargain for protections from this isn’t clear).  But all of this is a lark for present purposes.  It clearly doesn’t apply to Tesla, which wants to avoid franchising altogether.  At most, if one were worried about “undercutting,” the rule should be a prohibition on manufacturer retail operations for manufacturers that also franchise, not for those that bypass franchising altogether.

Some people have quite fairly complained that Tesla shouldn’t be given special exemptions when other car companies are bound by the dealer restrictions.  For sure, but that cuts in favor of amending or repealing these laws altogether, not enforcing them against Tesla.  If anything, if it’s true that Tesla would obtain a competitive advantage by bypassing traditional dealer networks, consumers should want this advantage available to all car companies.  To put it other way, this argument is basically an admission that the dealer laws are raising car prices.

The last argument I’ve heard—and it’s a real doozy—is that independent dealers are civic bastions of local communities and therefore deserve to be specially protected.  Never mind the fact that many auto dealerships are owned and operated by large regional chains rather than local Boy Scouts troopmasters.  Why on God’s green earth should we single out automobiles for economic protectionism in order to subsidize local civic participation?  Why stop with automobiles?  Why not household appliances, twinkies, and lingerie?   And who is to say that Tesla will be any less civic minded than franchised auto dealers?  Further, if the model of direct distribution is so superior to franchised distribution that eliminating legal restrictions would put the dealers out of business, there must be something systematically inefficient about franchised distribution.  In that case, both consumers and local communities would be better served if state legislatures just levied a tax on auto sales and distributed them pro rata to local civic organizations.

Since the arguments for dealer laws are so weak, I’m left with the firm impression that this is just special interest rent-seeking of the worst kind.  It’s a real shame that Tesla—seemingly one of the most innovative, successful, and environmentally correct American industrial firms of the last decade—is going to have to spend tens of millions of dollars and may eventually have to cut shady political deals for the right to sell its own products.  I’m ordinarily a fan of federalism and states’ rights, but if the current debacle continues, it may be necessary for Congress to step in with preemptive federal legislation.