Business economics: the global car industry

A great case study in The Economist, ideal for those of you wanting to link business economics theory to a clearly relevant case study.

If you read the article, you’ll immediately see the links between exam specifications and what’s happening now in the global car market. I've picked out a few key points below:

Toyota is on the brink of becoming the first member of the “10m club”. It will swiftly be followed by GM and Volkswagen. There are plenty of reasons why size matters. Besides the obvious economies of scale and the strong bargaining power with suppliers, being big makes it easier, especially with today’s flexible production lines, to offer an ample product range that can exploit every niche. And the biggest car making groups are better able to spread the heavy cost of complying with ever tougher environmental regulation. High productivity is vital.

Makers of luxurious models with strong brands, such as BMW and Jaguar Land Rover, can do well selling relatively small volumes of cars for handsome profits.

The importance of large scale innovation, investment and R+D (often said to be an important barrier to entry), VW is investing a whopping €84 billion ($114 billion) over the next five years, with two-thirds going to develop new vehicles and technology (although big doesn't necessarily mean innovative, of course).

There are ways to compensate for lack of scale. The most obvious is to get big by merging. Deals of the sort that will fully integrate Fiat and Chrysler are one way of getting bigger but the history of car makers attempting full mergers is not a happy one. Though several have been suggested recently, such PSA Peugeot-Citroën with GM Europe, they are hard to pull off. Another way of bulking up is to stop short of a merger but to build a broad alliance. Alliances are typically complicated and can come unstuck when the benefits to both sides become unclear. A more common way to exploit the advantages of scale without the drawbacks of a full merger or broad alliance is through partnerships to share the costs of specific technology.

The Hyundai-Kia group of South Korea is another maker with prospects of joining the 10m club one day. Being part of a conglomerate that includes a big steelmaker has also helped the group continue to gain critical mass, or minimum efficient scale. The rise of emerging markets is an ongoing theme: many of the big manufacturers are also enjoying continued growth, especially in the world’s largest car market, China. Location decisions are still crucial.

Size also comes with risks. Producing vehicles for every region in every segment means manufacturing a vast array of cars that add cost and complexity without necessarily contributing much profit – a good example of diseconomies of scale. The mass-market SEAT and Skoda brands bulk up VW’s sales but it makes most of its money from flashy Audis and Porsches. However, the game that the biggest car makers are in is to survive for the long term as the stragglers fall by the wayside (here's what happened to Saab). Every small SEAT that VW sells at a big discount is a sale denied to a struggling European rival, making it harder for it to stick around to compete: a great example of a clever marketing strategy in complex oligopolistic markets where firms are interdependent.