A joint initiative of Ludwig-Maximilians Universitys Center for Economic Studies and the Ifo Institute for Economic Research

Area Conference on

Applied Microeconomics

5 6 March 2010 CESifo Conference Centre, Munich

Competition and Innovation in the US Automobile Market Vivek Ghosal

CESifo GmbH Poschingerstr. 5 81679 Munich Germany

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Competition and Innovation in the US Automobile Market

Vivek Ghosal* March 2010

VERY PRELIMINARY AND INCOMPLETE! Prepared for presentation at CESifo Applied Micro workshop
Abstract This paper studies competition and innovation in the US automobile market. The data used in this paper are over the period (approximately) 1969-present. The firms included in my sample are: General Motors, Ford, Chrysler, BMW, Daimler, Volkswagen, Toyota, Nissan, Honda, and some other smaller firms. My dataset includes information on market shares, patents, number of models, composition of the automobile fleet such as smaller versus larger cars and engines, engine characteristics including horsepower, capacity and fuel-efficiency, quality of cars reflecting cost of ownership and repair records, among several other key variables. While much research has been done on this industry, no paper has examined this industry over such a longperiod of time and with a such rich dataset to fully understand the dynamics of competition and innovation. Specifically, in this paper, I present the results on examining the responsiveness of firms market shares to income and fuel price shocks, and relate them to some underlying characteristics of the firms. My preliminary results show wide variation in the relevant income and fuel price elasticities, and show suggestive and interesting links to the producers characteristics.

* Affiliations: Professor, School of Economics, Georgia Institute of Technology, Atlanta, GA 30332, USA; Research Fellow, CESifo. Contact: vivek.ghosal@econ.gatech.edu

1. Introduction The papers central objectives are to examine the nature of competition and innovation in the US automobile markets over a long period of time, 1969 to recent years. The US has had one of the highest per capita incomes in the world, a relatively large population, and lack of public transportation. These factors in combination have resulted in a relatively high demand for automobiles (currently the US averages about 22% of global sales), and a market where almost all the major firms in the world seek to compete for market share and profits. The US has also had a relatively open markets, allowing entry by a wide range of foreign producers. In a sense, the US market serves as a microcosm of the global automobile market, and the dynamics in US market have implications for the global industry. Before 1973, US automobile market was a relatively serene playground. The 1973-80 oil price increases changed rules of the game. US fuel-inefficient cars lost competitive advantage and automobile imports increased. The US manufacturers faced significant actual and potential competition from foreign brands. A more open playground lead to a race to compete and innovate. Figure 1 displays the oil prices and import-shares in the US market. The 1970s oil price spikes acted as a significant technology shock for the US producers. The existing larger engines and designs become obsolescent. My data reveals that the US producers first rushed to introduce smaller-engined cars and fill new market segments. Second, the data shows that they made composition changes with less larger-engined cars and more smaller-engined cars. They also switched their product lines to include more light trucks and sports utility vehicles (SUVs), as well as sharp increase in new models and smaller cars. Larger engine sizes constituted a much smaller share of the market.

Based on an extensive dataset for a wide range of producers selling in the US market, my estimation results reveal the following: 1. The income and fuel price elasticities vary widely across the producers in my sample. The income elasticities are negative for the US firms, and generally positive for all other producers. The fuel price elasticities are generally negative for the US producers and positive for the foreign producers. 2. My results suggest that superior quality was an important driver of the long-run gains in market share by the Japanese firms in the US market. Popular belief is that it was the higher fuel-efficiency of the Japanese cars that drove their supremacy. The data shows that the US firms had largely caught up with the Japanese firms by the late-1980s (Figure 2). Further, the Japanese firms had to make their cars bigger and heavier to meet with the demands of the US consumers and US geography. So fuel efficiency related arguments are not a consistent factor explaining the Japanese supremacy. My results suggest that the primary race was in product quality. In contrast to the Japanese firms, the German firms had mixed fortunes in the US market: BMW was the most successful; VW and Daimler had mixed fortunes. Once again, my data suggests that the primary cause of the shortcoming of the German firms in the US (mass) market segment is related to their lower quality on average. 3. My estimation results reveal that the Japanese ratcheted up their innovation profile to meet the demands of the US market and to shore up their competitive position. Their overall patenting profiles increased significantly, and their patenting profile in critical segments such as engines and motors increased sharply. The US firms saw some increase in patenting and overall innovation, but the rate of increase was clearly less than the

Japanese. The German firms patenting profile (in the US) was relatively low and flat. I model feedback effects and find that Japanese increases in innovation an important driver of the innovation race. 4. Finally, my results shed some light on the current crisis in the industry. The current financial crisis hit the automobile industry hard. While the big-3 US firms, General Motors, Chrysler and Ford, were affected the most, the crisis has had a profound effect on virtually all the global players in the market. Perhaps the defining moment of the current crisis was the declaration of bankruptcy by General Motors (henceforth, GM), the worlds largest automaker, on June 1, 2009. Following this, Chrysler filed for bankruptcy on May 1 2009, and Ford was barely surviving. This collapse of the US industry opened the markets for the Japanese firms, as well as other players such as Volkswagen, to take on even more dominant positions in the US and global markets. My results show that the current problems faced by the US firms are largely unrelated to the ongoing crisis. The problem lies in the fundamental inability of the US firms to meet the Japanese, and to some extent, German, competitive, quality and innovation challenges in the 1980s.

2. Theoretical Modeling * To be completed later Automobiles are highly differentiated products. The elements of differentiation include product quality, design, engine characteristics, safety, environmental characteristics, among others. Consistent with previous modeling in the literature, the industry is best characterized as oligopolistic with Bertrand price competition with differentiated products.

In terms of consumers decision making, the factors that influence purchase decision include: price (and prices of competing brands/models); income; costs of ownership fuel, routine maintenance, repairs; reliability; resale value; comfort; features; performance; and design One of the most critical variables is quality. Enhancing quality entails costly investments, a significant fraction of which are likely to be sunk. Given the importance of this, I model costly investments and technology adoption within a Bertrand price competition framework.

3. Data and Related Information In my study of competition and innovation in this industry, I use both quantitative data as well as qualitative information gathered from my visits to various factories and meeting executives in different countries.

3.1. Quantitative Data I have compiled data on every single model sold in the US by every single US and foreign manufacturer from 1969 to 2006. (I am in the process of completing this to 2008/09.) The main brands I consider are: the US firms Ford, GM and Chrysler; German firms BMW, Daimler and VW; the Japanese firms Toyota, Nissan and Honda. I have data on several other brands like Mazda, Subaru, Mitsubishi, Volvo, Saab, among others. For each brand, I have data on all the models. The data on each model includes: all the engine characteristics including engine size, fuel efficiency and horsepower; safety features; quality as measured by repair records and cost of maintenance; number of units sold in the US; list prices; among several other variables. The dataset also includes the market shares.

3.2. Qualitative Information To complement my quantitative data and obtain a deeper perspective of the firms, I have visited BMW and Audi production facilities in Germany, and Toyota and Nissan production facilities in Japan. During these visits, I interviewed executives as well as got a detailed tour and description of the production process. (** The key findings from these visits will be detailed.) In my interviews with executives, I sought to understand the important factors that influence purchase decisions. The Executives, in different countries and companies, repeatedly referred to consumers falling into two broad groups: 1. Rational those who primarily seek value, reliability. 2. Emotional those who seek performance, design, and technology. While companies like BMW seek to serve a niche market, firms like Toyota, GM, etc, seek to serve the mass markets. In the mass market segments, reliability of brands and models is a critical variable. From the perspective of the typical consumer, a car is the most expensive durable product they will buy (probably even more expensive than a house over their lifetime). The current median US household income is about $60K. Average new car costs between $20-$25K plus financing cost. Around 90K miles, maintenance costs can rise sharply, and resale values become quite low. The average US driver drives about 12.5K miles per year and on average, this gives roughly 7.5 years of effective life. The average car replacement rate in US is in the 6-7 year range. This cost works out to a significant fraction of annual income, plus expenditures related to operating costs fuel, maintenance, repairs add more Largely due to cost (purchase and ownership), consumers search for information on quality of car before making purchase. Cars, therefore, tend to be an experience good. If you

purchased a brand/model and had a good experience, you are likely to continue with same brand. This explains the (historically) relatively strong brand loyalty. We assume that the automobile producers know this and they strive to deliver reliability and quality. With change in (foreign) competition since the 1970s, we assume this aspect became more important to attract and retain buyers. To deliver reliability and quality, producers have to make costly investments. They also have to make costly investments in, for example, product design, engine design, optimize production line dynamics, optimize functions and efficiency of robots. These have significant implications for firms business strategy and implementation of strategy.

3.3 Quantitative Data on Reliability Given the importance of quality, I collected data from the Consumer Reports. For each model sold in the US, they use consumer surveys, testing, and other information, e.g., repair records, cost of maintenance. The Consumer Reports is a consistent and reliable publication of data available over a long time period. These data are cited in academic, and industry publications, and touted by manufacturers. In Figure 3 I display the aggregated quality measures by country. These data show that the US firms consistently have the lowest quality ratings. The Japanese have the highest quality ratings. And the German firms are in-between. In the underlying disaggregated data, GM, Ford and Chrysler have the lowest quality ratings. Volkswagen quality ratings are also low. In contrast, virtually all the models by Toyota, Honda and Nissan are above average quality. Discuss Tables 1 and 2.

3.4. Quantitative Data on Innovation As the US firms faced competitive challenges, their incentives to innovate increased. As the Japanese firms took on a stronger foothold in the US, their incentive to innovate also increased in part to meet the competitive challenges and to make improvements in their products and engines to meet US conditions. To address these innovation issues, I collected data on total patent counts for all the firms in my sample, as well as by specific categories. The data reveal the following: 1. Patents by the US firms first increase, then are stable, and then show additional increases; overall a mixed pattern. 2. German patent count is relatively low and stable. 3. Patents by the Japanese firms show a steady upward trend. In my econometric analysis. I estimate dynamic equations with feedback effects to study the interrelationships. I find that increases in US and Japanese patents feed of each other, in the sense that increase in one leads to an increase in the other. The patents by the German firms in contrast in basically non-responsive to changes in US or Japanese patents. In a sense, these results are consistent with what we observe during the early-1970s to early-2000s. The main battle is between the US firms trying to maintain their market share; the Japanese firms making significant inroads; and the German firms mainly playing a peripheral role.

4. Market Share Dynamics: Specification and Estimation. I begin by examining the dynamics of market shares using an Autoregressive-Distributed lag, AD(n,m), specification (1): 1

The AD(n.m) specification is derived from a standard partial-adjustment model where firms decisions are subject to adjustment and disequilibrium costs; see Jorgensen, 1989.

( 1 ) st = c + i2=1 st i + 2 =0 rpcdit j + 2 =0 rpumpt j + t , j j

where s represents the firms market share, rpcdi is real disposable per capita income and rpump is the real price per gallon of regular unleaded fuel. Due to constraints imposed by the total number of time-series observations per firm, I only used a maximum of 2 lags to estimate (1). Once this parsimonious specification was estimated for each firm, I reduced the lag-length if the longer lags were insignificant. In this manner, I derive an optimal lag-length structure for each firm. Apart from each firm in the sample, I also estimate (1) for country-wide averages for the US, Japan and Germany. Discuss the results in the two tables: Table 3 presents the country averages regressions and Table 4 presents a sampling of the firms regressions. Based on the estimates from the firms regressions, and the mean values of the market shares and the income and fuel price variables, I compute the implies income and fuel price elasticities. Discuss Table 5. The results in Table 5 show: 1. The US firms have negative income elasticities, implying that as per capita disposable income increases in the US, GM, Ford and Chrysler see their market shares drop. 2. Toyota and Nissan have positive and statistically significant income elasticities. Hondas income elasticity, while positive, is imprecisely measured. 3. The German cars also have positive elasticities. When we examine the fuel price elasticities, the estimates are more dispersed. The main findings are as follows:

1. While Ford and Chrysler have meaningful negative elasticities, GMs shares are not responsive. 2. Toyota and Nissan see their market shares increase when fuel prices rise. Hondas shares are not responsive. 3. VWs market shares benefit from increase in fuel prices, but the effect for the other German car makers are not statistically significant. To examine the fuel price effects in more detail, I estimated some ancillary specifications with the following feature: the fuel price time-series was decomposed into meaningful positive and negative changes. The objective was to examine whether fuel price decreases tend to restore the lost market shares by the US firms when the fuel prices went up. My initial findings are that when fuel prices increase, the US car makers see noticeable drop in shares, but they do not gain back as much when fuel prices drop. Discuss implications.

4.1. Income and Fuel Price Elasticities and Firms Characteristics

I examine what might be some of the underlying reasons for the wide differences in the income and fuel price elasticities. The specific factors I examine related to: (1) quality of the cars; (2) number of models in the fleet; and (3) innovative activity as captured by patents. Discuss the reasoning behind this. The data limitations are quite severe and this precludes a detailed analysis at this pint. For a quick look, in Table 6 I present the Pearson and Spearman correlation coefficients. Discuss the findings.

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Figure 1. Oil Prices and Market Shares.

Levels: Oil Prices and Car Market Shares
100

Oil Price (Real $) Import Share (%)

90 80 70 60 50 40 30 20 10 0 1965 1970 1975 1980 1985 1990 1995

Oil Price

2000

2005

Year

Import Share

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Figure 2. Fuel Efficiency (miles per gallon).

Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Federal Chrysler 27.5 27.8 26.0 27.8 26.0 27.5 26.0 28.5 26.5 28.0 27.5 27.4 27.5 27.5 27.5 27.8 27.5 27.8 27.5 26.3 27.5 28.4 Ford 26.6 27.0 26.9 26.6 26.6 26.3 27.6 27.4 28.3 27.7 27.4 GM Japanese 25.8 40.5 26.6 35.2 26.9 35.2 27.6 34.4 27.3 32.7 27.1 32.9 27.1 32.8 26.7 32.7 27.4 32.5 27.7 32.4 27.4 31.6

Japanese cars got bigger in size and heavier, and their engines got bigger and less fuel efficient. US firms largely caught up with fuel efficiency differences.

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Figure 3. Quality Rating of Cars Country Averages.

Figure 3. Quality Comparisons by Country
3.00

Poor

Quality

Germany US Japan Sw eden

Good
1.00 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Year

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Table 1. Quality Index. Indicator Air Conditioning Body, Exterior Body, Hardware Body, Integrity Brakes Clutch Drive Line Electrical, Chassis Engine, Cooling Engine, Mechanical Exhaust System Fuel System Ignition System Steering Suspension Transmission, Automatic Transmission, Manual Overall Record Score

Weighted Score

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Table. 2. Quality Patterns: Examples by Manufacturer. Summary Statistics Trend Regressions Mean C.V. (%) const. t t2 2.21 13.1 1.453* 0.073* (0.001) (0.002) 2.29 3.6 1.766* 0.062* (0.001) (0.001) 1.12 5.1 1.501* -0.046* (0.001) (0.001) 1.91 20.1 2.051* -0.033 (0.001) (0.326)

Manufacturer VW GM Toyota Volvo

-0.001* (0.025) -0.001* (0.001) 0.001* (0.001) 0.001 (0.208)

Note: 1. The quality (trouble) index is as follows: Score=3 is below average Score=2 is average Score=1 is above average Therefore, a higher value of the index implies lower quality. 2. Observations: VW: Low mean quality with high variance. Quality trending down. GM: Low mean quality and high variance. Quality trending down. Toyota: High mean quality with low variance. Quality trending up. Volvo: Average mean quality with very high variance. Quality trending up. * All trends are marginal in nature.

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Table 3. Regression of Market Share on Income and Fuel Prices, 1970-2006. By Country US const. sharet-1 sharet-2 rpcdit Income rpcdit-1 Income rpcdit-2 Income rfuelt Pump Price rfuelt-1 Pump Price rfuelt-2 Pump Price Adj-R2 Notes: 1. Estimated regression is: st = c + i = 1 st i + j = 0 rpcdit j + j = 0 rpumpt j + t .
2 2 2

Japan -10.2338* (0.001) 0.6435* (0.001) -0.0013* (0.017) 0.007 (0.360) 0.0013* (0.011) 1.4075* (0.022) 0.96

Germany -2.1084 0.534 1.2194* (0.001) -0.4128* (0.017) -0.0048 (0.326) 0.0021* (0.003) -0.0014* (0.005) 0.2789 (0.718) 0.88

124.2428* (0.001) 0.1103 (0.279) 0.0020* (0.001) -0.0021* (0.011) -0.0025* (0.001) -3.4435* (0.001) -1.7432* (0.045) 0.98

Insignificant deeper lags were dropped to determine optimal lag-length of each variable. 2. Two-tailed significance levels, computed from robust standard errors, are in parentheses. 3. Variables: rpcdi: real per capita disposable income (net of taxes). rfuel: real price per gallon of regular unleaded fuel (US average per year).

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Table 4. Regression of Market Share on Income and Fuel Prices, 1970-2006. By Manufacturer US GM const. sharet-1 sharet-2 rpcdit Income rpcdit-1 Income rpcdit-2 Income rfuelt Pump Price rfuelt-1 Pump Price rfuelt-2 Pump Price Adj-R2 Notes: 1. Estimated regression is: st = c + i =1 st i + j =0 rpcdit j + j =0 rpumpt j + t .
2 2 2

Japan Ford 37.6177* (0.001) 0.3532* (0.008) -0.2187* 0.045 0.0006* (0.017) -0.0011* (0.001) -2.7485* (0.005) -1.3780 (0.201) -1.5982* (0.085) 0.87 Toyota -5.5050* (0.001) 0.5621* (0.001) -0.4128* (0.017) -0.0003 (0.288) 0.0000 (0.896) 0.0007* (0.002) 1.1892* (0.001) 0.0323 (0.949) -0.7087* (0.049) 0.96 Nissan -1.9291* (0.025) 0.3123* (0.038) 0.2724* (0.031) -0.0009 (0.001) 0.0006 (0.073) 0.0005* (0.065) 1.2277* (0.001) -0.8276 (0.057) 0.6285* (0.047) 0.83

Germany VW -1.7739 (0.534) 0.8141 (0.001) 0.0005 (0.042) 0.0000 (0.900) -0.0005 (0.011) 1.0301 (0.001) -0.6658 (0.013) 0.87 Other -2.026 (0.534) 1.0953 (0.001) -0.4776 (0.002) -0.0010 (0.072) 0.0020 (0.001) -0.0009 (0.032) 0.1465 (0.814) 0.84

38.5678* (0.001) 0.4500* (0.001) 0.0012* (0.082) -0.0022* (0.006) -0.0025* (0.001) 0.6958 (0.301) 0.97

Insignificant deeper lags were dropped to determine optimal lag-length of each variable. 2. Two-tailed significance levels, computed from robust standard errors, are in parentheses. 3. Variables: rpcdi: real per capita disposable income (net of taxes). rfuel: real price per gallon of regular unleaded fuel (US average per year).

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Table 5. Implied Long-Run Elasticities of Market Shares to Income and Fuel Price Income By Country US Japan Germany By Manufacturer GM Ford Chrysler Toyota Honda Nissan Volkswagen Other -1.16* 2.44* 6.55* Fuel Price -0.17* 0.37* 0.94 0.06 -0.57* -0.41* 0.28* -0.02 0.89* 1.27* 0.10

-1.07* -0.63* -1.34* 2.75* 2.09 1.56* 2.55* 1.77*

Notes: 1. The above elasticities were computed from the regression specification (XX) estimated for each manufacturer as well as country averages, and the sample means of the respective variables. 2. An * indicates that the elasticity is significant at conventional levels; an indicates the estimate is not significant.

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Table 6. Correlations between Income and Fuel Elasticities and Producer Characteristics Income Pearson Income Fuel Spearman Income Fuel 1.00 0.66 (0.98) 1.00 0.62 (0.06) Fuel 0.66 (0.98) 1.00 Quality -0.69 (0.05) -0.18 (0.65) -0.74 (0.03) -0.18 (0.65) Models -0.81 (0.01) -0.45 (0.25) -0.61 (0.10) -0.45 (0.25) Patents -0.19 (0.64) -0.17 (0.68) -0.19 (0.66) -0.17 (0.68)

0.62 (0.06) 1.00

Notes: 1. Above are the Pearson product-moment correlation and Spearman rank correlation coefficients between the income and fuel price elasticities repotted earlier, and three indicators of the producer characteristics: quality of cars, number of models, and patents. The three characteristics variables used are the means for each producer over the sample period. 2. The significance levels are reported in parentheses. 3. The sample size (8 obs for 8 producers) is very small, so the above correlations are only suggestive of some patterns.

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