A Theoretical Note on the Dealer-Manufacturer Relationship in the Automobile Industry

Author(s): Anthony Y. C. Koo

Source: The Quarterly Journal of Economics, Vol. 73, No. 2 (May, 1959), pp. 316-325
Published by: Oxford University Press
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A THEORETICAL NOTE ON THE
DEALER-MANUFACTURER RELATIONSHIP IN THE
AUTOMOBILE INDUSTRY*
By
ANTHONY Y. C. Koo
I. Introduction: some terms in automobile
pricing,
316.
-
II. The theoreti-
cal basis for conflict of interest - no
unique
invoice
price,
318.
-
III.
Sliding
scale vs. flat
bonus,
321.
-
IV.
Conclusions,
324.
I. INTRODUCTION: SOME TERMS IN AUTOMOBILE PRICING
The
cyclical
nature of automobile demand and its
impact
on the
general economy
have attracted much attention from economists.
However, during
the course of
cyclical
movements of automobile
demand,
the
relationship
between dealers and manufacturers has
been
subjected
to severe stress and
strain,
as witness the voluminous
literature of dealers' and trade
journals, reports
in financial
pages
and
testimonies of both dealers and manufacturers
during Congressional
hearings.
Economists seem to have stood aloof in this
controversy,
and have shown little interest in this
aspect
of the
problem
of the
automobile
industry.
Their attitude is
understandable,
because the
dealer-manufacturer
relationship
is viewed as a
problem
of business
practice,
with no theoretical issues involved.
In the midst of the
controversy,
a mail
survey
of the dealer-
manufacturer
relationship
was undertaken to ascertain the bases of
conflict of interest. The
survey
covers such
topics
as duration and
security
of dealers'
franchise,
control over inventories and sales
quotas, practices regarding "markups"
and dealers' contribution to
advertising
costs and
freight charges.'
One issue that dominates the dealers' mind is the
"forcing"
of
cars, i.e., according
to dealers'
replies, they
have been forced to
buy
more cars than
they
would like to
take,
with
consequent prevalence
of
"bootlegging."
On the other
hand,
manufacturers view the com-
plaints
as excuses for
inefficiency
or
nonagressiveness
of dealers in
pushing
their sales. This
note, although
motivated
by
the
problem,
*
I wish to thank Professors M.
Bronfenbrenner,
F.
Child,
B.
Kemp
and
T.
Mayer
for
helpful
comments.
1. The results will
appear
as a
separate study.
Professor Donald A. Moore
of Los
Angeles
State
College
initiated and was
mainly responsible
for the
survey.
He contributed a
great
deal to
crystallizing
the issues involved in
designing
the
survey.
316
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RELATIONSHIP IN THE AUTOMOBILE INDUSTRY 317
is not intended to resolve the issue. It is an
attempt
to show that
there exists a theoretical basis for dealer-manufacturer conflict of
interest,
and to
incorporate
this
problem
into the usual
simplified
model
consisting
of
only
consumers and
producers.
To understand the
problem,
it is
important
to
explain
a few
terms used in automobile
pricing. (1)
The
price
of cars which dealers
pay
to manufacturers is known as
"price
to dealers" or "invoice
price."
This
price
is uniform
throughout
the
year except
in the
closing
weeks or months of a model
year,
at which time manufacturers
sometimes
give
dealers
special
discounts and bonuses for cars sold in
excess of normal volume. For
purpose
of
illustration,
let us assume
that the
price
to dealers of a
low-priced
car is
$1,730.2 (2)
The manu-
facturer
generally "suggests"
(he
cannot
legally enforce)
a dealer
markup
of 31.6
per
cent of the invoice
price.
This increase is also
expressed
as 24
per
cent of the
"factory suggested
list
price."
In our
present example,
it amounts to
$546.
In actual
practice
in the low-
priced field,
dealers seldom can make that much
except
in
periods
of
extreme
scarcity.
To meet
competition, they
have to sacrifice a
part
of the
markup. According
to the National Automobile Dealers Asso-
ciation,
the
markup
on such a model is close to $330.
(3)
Not counted
in the
markup
is another item to be added to the invoice
price
which
is labeled
by
various names. General Motors calls it E.O.H.
(excise,
overhead and
handling).
It is
mostly
the 10
per
cent federal excise
tax. To the
sample
car
price,
we add another $180.
(4)
Another
factory-suggested charge
is called the "make
ready"
or "dealer
handling" charge,
which is
supposed
to cover the time
normally spent
by
the dealer
preparing
the car for
delivery.
This amounts to $50
for the
sample
car.
(5)
There are state and local taxes
including
licensing
fees. In Detroit these taxes add
up
to $80. The list of items
to be added to the dealer's
price
to arrive at
"factory suggested price"
is as follows:
2. The
figure
is broken down into the
following components:
1. Materials, outside and inside $1,100
2. Productive labor 75
3. Overhead 125
4. Return on investment 180
5.
Freight
S5
6.
Tooling
and
engineering
50
7. Sales and
advertising
50
8. Administration 65
Price to dealer
$1,730
The
example
was taken from "Car
Pricing
-
How Auto Firms
Figure
Their
Costs to Reckon the Price Dealers
Pay,"
Wall Street
Journal,
Dec.
10,
1957.
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QUARTERLY JOURNAL OF ECONOMICS
1. Price to the dealers $1,730
2.
Markup
546
3. E.O.H. 180
4. "Make
ready"
50
5. Federal and state taxes 80
Factory suggested price
$2,586
On the basis of the
foregoing
factual
background,
we shall isolate
the central issue of the division of
profit
between the dealer and the
manufacturer.
II. THE THEORETICAL BASIS FOR CONFLICT OF INTEREST
-
No
UNIQUE
INVOICE PRICE
It is obvious that the dealer's total
profit depends upon
the
volume and the difference between what the
buyer pays
and the
invoice
price;
and the manufacturer's total
profit depends upon
the
volume and the difference between invoice
price
and the unit cost.
The issue on which economic
theory
can contribute to our understand-
ing
of the
problem
is that of whether or not there exists a
unique
invoice
price
that will maximize the
profits
of both the dealer and the
manufacturer at the same time.
If, theoretically,
one can demon-
strate its
existence,
then there
may
be a
price relationship
which
eliminates
any
conflict of interest between them.
Unfortunately
there is
generally
no
unique price relationship
which will simultane-
ously
maximize the
profits
of both dealer and manufacturer. This
can be seen from the
following analysis
which demonstrates
that,
assuming
one obtains simultaneous
maxima,
no
unique
invoice
price
can be derived.3
Let
cu
=
unit
production
cost
Cd
= unit sales cost incurred
by
the dealer
q
=
output
pl
= invoice
price
p2
= sales
price
ul
= total
profit
of the
producer
U2
= total
profit
of the dealer
c,
=
fi(q)
....................
(1)
Cd
=
f2(q)
....................
(2)
p2= f3(q)
....................
(3).
3. The
general
case of simultaneous maxima is considered
by
Emilio
Zaccagnini
in "Massimi Simultanei in Economia
Pura,"
Giornale
degli
Economisti
e Annali di
Economia,
No.
5/8, 1947,
translated and
reprinted
in International
Economic
Papers,
No. 1
(1951), pp.
208-44. Our model is based on his
special
case of simultaneous maxima for two
equations,
which is
reproduced
with
slight
change
of notation and some other modifications.
318
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RELATIONSHIP IN THE A UTOMOBILE INDUSTRY
In order to exclude
negative profit
to either
participant,
we
impose
the additional condition that
CU, pi
....................
(4)
pI + Cd
<
p2
................ (5)
so that
cu, pI p2
-
Cd
...........
(6).
Equations (1)
and
(2)
are
average
cost functions of the
producer
and
the
dealer; (3)
is a demand function
facing
the dealer.
Our
procedure
is as follows:
First, suppose
we have somehow
maximized
simultaneously
the
profits
of the
producer
and
dealer,
that
is,
ul
=
qpl- qcu
= max.........
(7)
u2
=
qp2
-
(qpl
+ qcd)
= max.
(8).
Next,
taking
increments and
letting
each differential
approximate
an
actual
increment,
we
get,
from
(7)
and
(8),
the
following, keeping
in
mind that the
independent
variables are
q
and
pi:
dcu
dui
=
(pi
-
q--
-
cu)dq
+
qdp
....................
(9)
dq
du2
=q
d+ p2
-
(pi
+
q
dd
+
Cd)dq
-qdp,. (10)
dq
dq
Since we assume that we have
already
obtained simultaneous
maxima,
dul
and du2 cannot both be
positive.
But in the mathematical
system
involving equations (9)
and
(10),
dui and du2 can be
arbitrary
in
sign.
The
only way
to fulfill our economic condition of
having
attained
simultaneous maxima is for the
system
not to admit a solution in
q
and
pi.
In other
words,
dcu
Pi
-
(q
dc
+ cu) q
dq
=
0
(P.+A -P-
-Cd
--q
(p2 + q ) -
pi
-
q
Cd
-- Cd
dq dq
After
simplification,
we obtain:
dp2 dc,
dCd
p2 + q--d (Cu + q )
-
(Cd + q- )
=
0. ..
(11)
dq dq dq
(11)
is an
equation expressing
the
equality
between
marginal
revenue
and
marginal
costs.
Solving
the
system
of
equations (1), (2), (3),
319
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QUARTERLY JOURNAL OF ECONOMICS
and
(11),
one can determine the values for
q,
c,, Cd,
and
p2,
but
pi
remains undetermined
although subject
to
(6),
i.e.,
cu,
p
p p2
-
Cd.
It
may appear
that we have a situation of bilateral
monopoly.
However,
dealers are not
organized
to act as a
single bargaining unit,
and we are
justified
in
treating
the
problem
as a case of
simple profit
A K
MC
P2
P,
AC
B Q0 R
M
FIGURE I
maximization on the
part
of the manufacturer.
Suppose
an auto-
mobile
producer
X has 25
per
cent of the market. In
Figure
I the
average
revenue curve AR
represents
25
per
cent of the market of an
industry
demand curve.
AC, MC,
and ADM stand for
average cost,
marginal
cost and
marginal
revenue curves
respectively.
To maximize
his
profit,
a manufacturer will
produce OB(
=
p2G)
and set the
sug-
gested price
Op2(
=
BG).
Since
pi may
be
arbitrary
as
long
as it is
320
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RELATIONSHIP IN THE AUTOMOBILE INDUSTRY
within the interval
cu
<
pl p2
-
Cd,
the
margin
or the invoice
price
becomes the first and the basic source of conflict of interest
between
producer
and dealer.
III. SLIDING SCALE VS. FLAT BONUS
Next let us assume that a
markup
for
dealers, say
GE
per car,
has been settled so that the dealers are
expected
and in some cases
required
to take a standard volume OB from the
producer.
Since
each car
up
to OB will be billed
by
the
producer
to the dealers at the
invoice
price Opl(
=
BE)
which is identical for each
car,
the
pro-
ducer's net
receipt
for the
marginal
car is EB while the
marginal
cost
at
output
OB is DB. It is to be noted that there exists a
divergence
between the two with EB
(marginal
invoice
revenue) higher
than DB
(marginal cost). Accordingly,
there is a sort of "excess
capacity"
and it becomes
profitable
for the
producer
to
push
sales
beyond
the
output
OB. This
may
become a second source of conflict of interest.
Manufacturers
encourage
dealers to sell more cars
by giving
special
discounts and bonuses in the
closing
months or weeks of a
model
year
so that dealers
may
cut
prices
and thus clear out unsold
cars. A few observations
concerning
this
practice
are in order.
First,
since discounts or bonuses are
given by
all manufacturers
to their dealers and this
practice
is
generally
followed
during
the end
of the
season, therefore,
for the
purposes
of our
discussion,
the 25
per
cent market share of the
industry
demand curve
facing producer
X is still a valid
assumption.
In other
words,
we
suppose
that the
group equilibrium
will not be
upset by
this
price competition. Second,
we treat
special
discounts and bonuses as a form of
price
discrimina-
tion which starts a month or two before the introduction of new
models;
such
bargain prices
to consumers are not
supposed
to affect
the
prices
of cars sold
previously.4 Keeping
these
simplifications
in
mind,
we shall show
diagrammatically
two
ways
of
encouraging
dealers to take on more cars in addition to normal volume:
(1) Sliding
Scale Invoice Price
Assume that the
producer
will reduce the invoice
price
to dealers
on a
sliding
scale for cars sold in excess of OB
(on
Figure I).
For
example,
the first car sold in excess of OB will
get
a
special
bonus of
4. There are
exceptions
to this
general
rule. Some dealers
get
discounts or
bonuses even
during
the middle of the model
year
if sales are too slow. For
example,
"Edsel dealers
report
the
factory (that
is Ford
Motor)
is
granting
them
sales bonuses under a new
policy.
Bonuses
per
car sale
range
from $100 to $300
according
to a
complicated
schedule. Such
payments,
of
course,
enable dealers
to offer
bigger
discounts to
buyers."
Wall Street
Journal,
Jan.
9,
1958.
321
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QUARTERLY
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$50,
the second
$75,
the third
$100,
and so forth. To illustrate the
case
graphically,
we assume such cuts in invoice
prices
to dealers are
continuous. Let us draw a line ELN
slanting
downward to the
right.
It intersects the
marginal
cost curve at N. ELN is both an
average
and a
marginal
invoice revenue curve because the
producer
is assumed
to
practice perfect price
discrimination under this
sliding
scale scheme.
To maximize his
profit,
he would like to
produce,
and
expect
his
dealers to sell. an additional
quantity
BT.
(2)
Flat Bonus
On the other
hand,
if the bonus after OB is a flat rate
of, say,
$150
a
car,
then the
average
and
marginal
invoice revenue curve
facing
the
producer
will be
JKF,
which intersects the MC curve at F.
This means that in order to maximize the
profit
of the
producer,
a
quantity
BW of cars is to be taken over
by
the dealers. In fact the
flat bonus scheme is no different from the
profit
maximization
pro-
cedure we discussed earlier in connection with
determining
the initial
optimum output
OB. This can be demonstrated
by drawing
a
marginal
revenue curve GLKV which intersects the MC curve at V.
Erect a vertical line at V
(not
shown in the
graph)
and the
point
of
intersection of this vertical line and the
average
revenue line AR
may
be called the second or
year-end suggested price.
Then the JKF line
can be considered as the
year-end
invoice
price,
and the difference
between the second
suggested price
and the invoice
price
can be called
the
markups
for
year-end
cars.
Theoretically,
this
procedure
can be
repeated
for several times as
long
as there is "excess
capacity."
But
this
simply
has not been done
by
the
producers.
Possible
explana-
tions are as follows. To
publicize
a revised
suggested price might
be
interpreted
as another round of
open price competition
in the
industry,5
and such action could be
misinterpreted by competitors.
Although
much of
year-end competition by
dealers exists in the form
of
special discounts,
more liberal trade-in allowances and free acces-
sories,
this
competition
is somewhat
concealed,
and
knowledge
of such
a market is
imperfect. Furthermore,
when the
producer
reduces the
suggested prices
on the models at the
year end,
the
suggested price
on
new cars at the
beginning
of the next model
year may
be measured in
the minds of the
public
from the reduced
suggested price
of the
previ-
ous
year,
and this will somewhat
exaggerate
the
price
increase for
new models.6 Dealers also will not welcome a second and lower
sug-
5. The initial
suggested price
is considered the first round.
6. See the letter written
by
H. H.
Curtice,
President of General Motors
Corporation
to
Life Magazine, protesting
the method used
by
the editor in calcu-
322
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RELATIONSHIP IN THE AUTOMOBILE INDUSTRY
gested price
known to the
public,
because
buyers
will measure their
discounts on the basis of the
suggested price.
A lower
suggested price
means lower discounts can be offered on the
part
of dealers to the
consumers.
Now we shall discuss these two schemes from the dealers'
point
of view. To
simplify
our
graphic representation,
we assume that the
only major
cost item to dealers is the
price
of cars to dealers and that
other costs are
insignificant. Accordingly,
the
marginal
cost to
dealers is JKF under the flat bonus scheme and ELN under the
sliding
scale.
Next,
we shall direct our attention to the
marginal
revenue
curve of dealers
GLKV,
which intersects ELN
(the marginal
cost
curve to dealers under the
sliding scale)
at L and JKF
(the marginal
cost curve to dealers under the flat
bonus)
at K. This means that
dealers would take
BQ
additional cars under the
sliding
scale and
BS cars under the flat bonus. It is to be noted that in each
case,
the
quantity they
are
willing
to take falls short of
producers' expecta-
tions,
as shown in the
following
table:
Dealers' Manufacturers' Difference between
preference
preference manufacturers' and
(additional units) (additional units) dealers'
preferences
Flat Bonus BS BW SW
Sliding
Scale
BQ
BT QT
A word of
explanation concerning
the outcome is
perhaps
in
order. One
may
wonder
why
our results on dealers'
preference
are
arrived at with the use of the
marginal
revenue curve GLKV and
why
we made no mention of
marginal concepts
in
regard
to the
quantity
OB which the dealers
agreed
to take on
initially.
The
answer lies in the nature of the
pricing
of the automobile
industry.
As we indicated
above,
the
producer
announces the
suggested price
to the
general public,
and it is
difficult, though possible through
manipulating
trade-in allowances and
accessories,
for the dealers to
sell cars at
prices higher
than the
suggested
ones. Therefore,
the
marginal
revenue curve is a
straight
line
p2G
for volume
up
to
OB,
while the
marginal
cost curve
(again ignoring
other
costs)
is
p1E,
and
lating
the
percentage
of
price
increase of automobiles from 1957 to 1958. "Your
editorial,
'The Trouble with the
Slump' (Life,
Feb.
10),
is incorrect when it
says
' . . . Detroit . . . raised its new car
price 11.5%
in November.' ... The Bureau
of Labor Statistics calculates the increase
(1958
vs.
1957)
at
only 4%.
The
11.5%
is the difference between 1958 new model
prices
and the discounted
prices
at which 1957 models were
selling
in October at the
tag
end of the model run."
Life,
Mar.
3, 1958, p.
13.
323
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QUARTERLY
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the former is
higher
than the latter
by
EG.
However,
consumers view
the
suggested price
as a sort of
ceiling,
and at the
closing
months of
the
season, they expect
to
pay
less than that. In other
words,
the
downward
sloping
demand curve becomes
operative. Therefore,
equality
of
marginal
revenue and
marginal
cost curves enters into
our calculation as the criterion for
profit
maximization.
IV. CONCLUSIONS
Another
point
which deserves mention is as we stated earlier
that the first and the basic conflict of interest lies in the invoice
price
while the second source of conflict concerns the volume. The differ-
ence between
these, however,
is more
superficial
than real. Since the
dealer's
marginal
revenue curve GLKV is downward
sloping
to the
right,
the
producer
can make dealers take more cars under both
schemes if
they give
dealers more bonuses or
larger
discounts. To
demonstrate the
point
in terms of our
graphic language,
this means
that under the flat
bonus,
if the
producer
lowers the line
JKF,
it will
intersect the dealers'
marginal
revenue curve GLKV at a
point
to the
right
of the
present
intersection
point
K. Thus more cars will be
taken
by
the dealers. Under the
sliding scheme,
if the
producer
makes the line ELN move in the clockwise direction
(steeper
sliding
scale of discounts to
dealers),
then the new and the
steeper
ELN line
will
surely
intersect the dealers'
marginal
revenue line GLKV at a
point
to the
right
of the
present
intersection
point
L.
Again
this
means that the dealers will be
willing
to sell more cars. In the last
analysis,
the basic reason for the conflict of interest between the
dealers and the
producer
lies in the lack of a
unique
invoice
price
that
will maximize the
profit
of both
simultaneously.
Other issues are
simply
manifestations of this fundamental difference.
The
arguments
advanced so far are
designed
to focus the atten-
tion of readers on the
problem
of dealers and manufacturers. It is
likely
that we
may
have
overemphasized
the area of interest diver-
gence,
because account should be taken of such
dynamic
considera-
tions as the
possibility
that the demand for automobiles for the
industry
as a whole
may
turn out to be
larger
than
anticipated.
More-
over,
if
producer
X
puts
out a model with
style
and
design
that
appeal
to
buyers
more than those of other
manufacturers,
then the demand
for X's cars will be
larger
and there should be no serious
problem
of
interest conflict. The issue will more
likely
come to the
open
when
the
general
demand for cars as a whole is low.
In addition to the
magnitude
of the area of
divergence
of
interests,
there is the
question
of distribution of shares of additional cars
among
324
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RELATIONSHIP IN THE AUTOMOBILE INDUSTRY 325
dealers of various
sizes,
makes of cars and
geographical
locations.
This we cannot infer from our
simple diagram.
The statistical find-
ings
of these
problems
will be the
subject
of a later
paper,
but this
note will serve as a sort of
beginning
in
exploring
a source of conflict
of interest in dealer-manufacturer
relationship.
MICHIGAN STATE UNIVERSITY
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