Michael Munger on Franchising, Vertical Integration, and the Auto Industry 06/22/2009

The coexistence of franchising (independent residual claimants) and direct-ownership models with internal incentives (like Walmart, whose local managers and even associates have high autonomy and bonus incentives) shows that each organizational form is the answer to some particular transaction-cost problem, and economic 'just-so stories' that explain one form must also account for why the alternative thrives.

“the monkey with webbed feet who can swim there each of them is the answer to some cop located problem of transactions cost”

GM faced an unsolvable principal-agent problem with its dealers: poor or predatory local service sours customers not just on the dealer but on the GM brand itself, yet GM could not enforce good service because it was bound by franchisee contracts and state laws—so by the time it recognized the problem (creating Mr. Goodwrench advertising, etc.) it was too late.

“GM can't solve the principal-agent problem because they're bound with all these ropes about franchisee contracts with state governments so that they were stuck by the time they realized that it was a problem”

GM maintained multiple essentially identical car lines (Pontiac, Buick, Chevrolet, Cadillac) for price discrimination—the same underlying car with different sheet metal and trim sold at different price points—but became increasingly cynical, relying on brand loyalty as quality differences shrank, with the result that consumers defected to Honda rather than down-buying to Chevrolet.

“the reason they have the different lines is for price discrimination they're basically the same car but with different sheet metal”

When an external environment is not competitive, firms develop a bureaucratic, non-nimble corporate culture that leaves them structurally unable to adapt when competition finally arrives—they don't merely need to 'try harder,' they don't know how, because their entire hierarchy, design teams, and structure were built for a non-competitive world.

“when your external environment is not very competitive you get a corporate culture that's very bureaucratic and... not very nimble not very good at changing”

In any competitive market only the marginal buyer and marginal seller are indifferent at the market price; almost every buyer would have paid more and almost every seller would have accepted less, so money is 'left on the table'—but the gap is normally irrelevant because competition forces a single market price and buyers capture consumer surplus.

“almost every single buyer would have paid more and almost every single seller would have a test is less only the marginal buyer and the marginal sell or a tiny minority of the market participants are the ones who actually are indifferent”

GM cannot unilaterally terminate a franchise contract; by state law the franchisee is generally the only party who can end the contract unless the manufacturer can show cause (e.g., the dealer underperformed).

“the provision for most of them by state law is that the franchisee is the only one who has the option of ending the contract unless you can show cause”

In 46 of the main U.S. states it is illegal for automobile companies to vertically integrate by owning their retail dealerships directly; dealers must be locally owned.

“in 46 of the main states it's illegal for any of the automobile companies to own their retail outlets directly they have to be locally owned”

The Reagan-era voluntary import restraints on Japanese cars created a corrupt bargain that benefited both sides: American makers were shielded because there weren't enough imports to compete away their advantage, and Honda's profits increased dramatically because the restraints (backed by Japanese government allocation among its three makers, effectively a non-compete that would have violated the Sherman Act) meant Japanese sellers weren't forced to drive prices down.

“the voluntary restraint agreement benefitted American car makers because there weren't enough really to be able to compete away the advantage... and it benefited Honda it did dramatically increase their profits”

The U.S. auto industry of the 1940s-60s functioned as a cushy cartel: three large firms generating rents, with unions able to extract a share of those profits in the form of higher pay and especially long-term healthcare and pension benefits, while creativity was channeled into sheet-metal design rather than competition.

“they are somewhat of a cartel partly because there's only three of them but partly because the union is said bunches of rules and compensation procedures that limit their ability to compete with each other”

The 1970s oil price shock harmed U.S. automakers not just by reducing driving but by suddenly making small, high-mileage cars attractive—cars that American firms didn't make because cheap gasoline and abundant land had given Americans no incentive to demand them, while foreign makers (with high gas taxes) had been making them all along.

“it changes the attractiveness of certain kinds of cars and those kind of cars aren't made small cars and those cars cars with high mileage those cars aren't made much the United States”

State laws prevent manufacturers from closing a dealership without the dealer's permission unless they pay back the entire franchise fee, which forces GM to keep manufacturing unprofitable lines (like Pontiac) because stopping production would trigger massive franchise-fee repayments to dealers nationwide.

“they cannot close the dealership without the dealers permission unless they pay basically pay back the entire franchise fee”

The original explanation for selling automobiles through franchises—that imperfect capital markets in the early 1900s and 1930s forced manufacturers to raise capital via franchise fees from locally-collateralized dealers—is a plausible but false story, because the practice continued even after auto companies were well capitalized.

“it turns out that although that's plug like a lot of things in economic trust as you know it's a plausible story it's just not true”

Haggling is a mechanism for price discrimination: the salesman's goal is to elicit the maximum price the buyer is willing to pay, which sellers can exploit when there is a gap between the buyer's maximum and the seller's minimum; this is why Priceline-style 'name your price' systems can actually disadvantage consumers who reveal their maximum.

“what the person is trying to do what the salesman is trying to do is elicit from you information about the maximum price that you will pay”

The political power in the manufacturer-dealer relationship is the reverse of the intuitive picture: rather than the large corporation dominating small dealers, local franchise dealer associations hold disproportionate political clout (especially via contributions to House members), and bankruptcy is the only way for manufacturers to escape these constraints.

“it's actually backward all of the political power lies with the fran cheats franchisees and bankruptcy is the only way to get them out of this”

Much of economics is ex-post storytelling, and there is nothing wrong with that because attempting to construct a coherent story about why an institution exists teaches a great deal about how the world works—even though many unknown facts could later render those stories untenable.

“a lot of economics is expose storytelling there's nothing wrong with that and a lot of times you learn a great deal about how the world works from being forced to figure out if you can come up with a story”

As dealers shifted from selling cars (flow) to servicing the large installed stock of existing cars, and as the auto business bundled three separable functions—sales, service, and financing—the only places profit was actually made were financing (GMAC) and service, while manufacturing and sales merely broke even, suggesting service and financing were the less competitive, tied-good segments.

“for years the most profitable part of TM was GMAC the GM except its corporation which was the financing arm they made money the automobile manufacturing part of it broke even and the the franchises made money on service”

The Saturn experiment was GM's attempt to create a foreign-style, no-haggle, friendly car company from scratch in the hope that Saturn's culture would influence GM's broader corporate culture; instead the GM culture metastasized into Saturn, demonstrating that GM knew what it needed to do but was too constrained to change its existing lines.

“the original hope was that the Saturn corporate culture would would solve and then influence the GM corporate culture... it went the other way”

Whether a market has a single 'no-haggle' price or negotiated prices depends on two possible explanations: either the transaction costs of negotiating individual prices are so high they swamp the profits from discrimination, or competition forces a single price everywhere except markets like houses and cars.

“the transactions cost of negotiating separate prices for each buyer are so big that it would swamp the profits you would get from being able to discriminate”

Detroit executives suffered a psychological insularity in which they assumed everyone lived as they did (large station wagons for country picnics), were mystified that anyone would want a small car, and marketed by asking 'how do you like our cars' rather than 'what kind of car would you like.'

“they actually had meetings where they were mystified why would anybody have a small car well it won't last we don't need to pay any attention”

The persistence of haggling is a puzzle with two competing hypotheses: Munger believes haggling persists because it benefits manufacturers (allowing higher average prices via discrimination), while Roberts speculates it may persist because it produces a lower average price by revealing the day-to-day P-star that firms couldn't accurately set in advance given inventory uncertainty.

“I think the reason that they still used haggling is that it benefits them they could make more profits”

A Hayekian local-knowledge explanation may justify the franchise model: independent franchisees with a residual claim on profits have stronger incentives and better local-market knowledge than salaried employees, so a manufacturer may earn more by 'giving away' profit to a franchisee than by vertically integrating—supported by Richard Smith's 1982 Journal of Law and Economics analysis of profit rates and residual claimancy.

“local knowledge that there's no way corporate can successfully understand what's going on at the local level... better to put those decisions in the hands of the people closest to it”