Why Remaking the Auto Industry Makes No Sense

There are two competing theories on how to reset the auto industry. One is that entrepreneurs can create auto companies from scratch by outsourcing major component systems and abandoning traditional dealers. The other is that five or six giant companies should rule in a globally consolidated auto industry.

Neither theory makes sense.

The Entrepreneurs First, take the entrepreneurs—people such as co-founders Elon Musk and Marc Tarpenning of electric car maker Tesla Motors. The theory is that entrepreneurs can quickly integrate new technologies (mostly electric propulsion systems) and cobble together cars from outsourced design and components. But assembling cars this way cannot reach the scale necessary for mass volume. Small production volumes result in high prices that can't compete with those of the large auto companies. Although they might be late in adopting a technology, they will have the advantage of scale.

The San Carlos (Calif.)-based Tesla Motors sells the only electric vehicle legal for highway use. But the price of the current model, the Tesla Roadster, is $101,500. That's in the range of the ultra-luxury Porsche Carrera. Despite the high price, Tesla probably loses money on each Roadster it sells. Fisker Automotive, based in Irvine, Calif., prices its Karma model, which uses a hybrid drivetrain, at $87,900. Deliveries will begin next year, but at that price Fisker, owned by former BMW and Aston Martin designer Henrik Fisker, is unlikely to sell many of these imported vehicles assembled in Finland.

Entrepreneurs focus on building a car, but that's half the challenge of success in the auto industry. Car developers often ignore the reality of how mass-market cars are sold, financed, and repaired, and they forget how important resale values are to establish a brand permanently in the market. Cars stay on the road for 10 to 15 years, and owners expect a car to have a predictable value throughout its lifetime. That means the supporting infrastructure is as important to the broad base of consumers beyond the elite collector, who is impressed when Tesla sends a technician to his home to fix a part.

The Consolidators On the other end of the spectrum from the entrepreneurial approach is Sergio Marchionne's vision of a globally consolidated automotive industry. Marchionne, the CEO of FIAT (FIA.MI) and Chrysler, believes that eventually there will be only five or six large global automobile companies serving the mass market.

The consolidation theory has its roots in the mid-1970s, when the Arab oil embargo resulted in a global recession. Under the theory, excess production capacity, which today approaches 30 million units annually, would be eliminated through the thinning of vulnerable companies and the closing of uncompetitive assembly plants. Production would shift from high-cost locations to low-cost areas as part of this global restructuring, increasing the efficiency of the enterprises.

But this theory only makes sense on paper—not in practice. The auto industry is a special case, with enormous political clout. It doesn't work by the basic laws of the market—and never has. Near-dead auto companies are recycled instead of given a quiet send-off. Saab (SAABB.ST), Land Rover, Volvo (VOLVA.ST), Jaguar, and others have been on life support since the 1990s, yet there is always an investor or auto company ready to argue about the brand's relevance—and pour more money into keeping it alive.

GM's Opel (OPL.BE) division is a perfect example of why auto companies don't die. By economic measures, Opel should die or be restructured, with the high-cost plants shut down. Instead, the German government has persuaded GM to sell Opel to Canadian parts maker Magna International (MGA) and has paid for jobs to stay in Germany. That means excess capacity stays in place and Opel's new owners will have to increase production to make a return on their investment.

The notion of survival by consolidation doesn't take into account the determination of governments: They will defend their local champions fiercely, particularly when they are vulnerable to downsizing, takeover, or oblivion. The economic reach of the industry, its ability to spur technological development, the high-paying jobs it supports, the politically powerful unions that represent its workers, and, not insignificantly, the industry's impact on trade deficits and surpluses—all these factors motivate governments to protect their automakers. These same arguments were used by the Obama Administration to preserve Chrysler and General Motors.

National self-interest keeps market forces from working properly.

Global Auto Glut—and Consequences For decades, Japan managed to keep foreign brands out of its market so it could nurture its industry. Now China, through ownership limitations on foreign companies and tariff and tax structures, will create a competitive automotive industry of its own. Each foreign company in China must have a Chinese partner, effectively transferring technology to a Chinese partner that will ultimately emerge as a global competitor.

This year, governments around the world have invested well over a hundred billion dollars to keep their auto champions afloat. Taxpayers everywhere lost, and auto companies, like Ford (F), were placed at a competitive disadvantage as a result of government self-interest. The only consolation may be that we can get back some of our money when we buy cheap cars made possible by excess capacity.

All this simply means that the future of the auto industry will look like the past: Neither theory of remaking the industry will come to pass. Upstart entrepreneurs will never achieve the mass scale necessary to produce vehicles at relevant prices for most consumers. While the startups may pioneer the use of some technology, any successes will be copied by the large manufacturers, which have greater resources, including government support, as well as an existing infrastructure. The startups will fail or remain relegated to niche markets. At the same time, governments around the world will continue to prop up their domestic automakers (either directly or through domestic market protections), thus distorting natural market forces.

Excess auto production will always be with us, vehicles will remain affordable, and record profits in this business will be short-lived without constant reinvestment in the vehicles of tomorrow.

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