Is discount control by auto firms justifiable?

A recent judgment by the Competition Commission of India (CCI), penalising Maruti Suzuki India Ltd for indulging in what is considered anti-competitive behaviour, by way of practising resale price maintenance (RPM), warrants further inquiry into the economic rationale behind the original equipment manufacturers’ (OEMs’) actions. A similar case had happened with Hyundai Motors, where the discount control policy practised by the company, was alleged to be denting intra-brand and inter-brand competition and harming consumers. A heavy penalty was imposed.

While any form of vertical restraint can limit competition, RPM, i.e., fixing up the retail price by imposing a price ceiling or floor, is often criticised and considered unethical as the practice is seen to harm competition and limit consumer welfare by limiting entry and raising prices for consumers, in three possible ways. One, if it has arisen out of cartelisation by a sub-group of dealers or OEMs themselves. Two, price ceilings can hinder intra-brand competition by restricting entry into dealership markets. Three, price floors can increase the retail prices faced by consumers.

The case of Maruti Suzuki, or Hyundai, are not cases of cartelisation by dealers to maintain a high price, rather the auto companies were found having a discount control policy, i.e., establishing a uniform retail price to be offered by all the dealers. Commercial wisdom suggests against doing so by the companies, as maintaining a high price will deter consumers and they might shift to other brands, in a highly competitive and elastic passenger vehicles market. In fact, allowing discounts is in the interest of OEMs to increase sales.

Demand uncertainty

What makes companies resort to discount control policies then, should be the central point of any assessment. One plausible explanation lies in the uncertainty of demand in the economic cycle sensitive passenger vehicle segment, resulting in high inventory costs for dealers who are unable to fathom demand correctly. Such costs matter much more in periods of low demand, since it is during such periods that dealers with high inventories must accept a cut in their margins, while those with better foresight, can carry low inventory, and will be able to offer a discounted price in the absence of extra costs of holding inventories.

Automobile dealerships are often exclusive, require heavy investments and offer low margins, creating a lock-in for the dealers. In a survey of automobile dealers across the country, conducted by the Federation of Automobiles Dealers Association (FADA), the highest ranked concern of dealers was business viability.

For the manufacturer the issue is that some dealers are disincentivised from holding large stocks by the ability of others (dealers) who hold lesser stocks to undercut the price in low demand times. Large stock holding dealers will earn adequate returns only in periods of high demand. And they would tend to charge higher mark-ups during high demand periods to recuperate the loss from low demand periods. This could mean less consumer demand and less business overall for the manufacturer.

It therefore incentivises the manufacturer to impose a restraint in the form of a retail price that averts the overall loss of demand and induces inventory holding so that high demand States can be serviced more effectively. Uniform prices, thus, in a way, promote the broadest possible distribution of the product both ways, across periods of varying demand, and spatially, across locations with varying demand. Dealer competition may otherwise cause less holding of inventory, limiting consumers’ access to the product.

Another often mentioned reason for automakers to possibly resort to such policies is to limit the problem of ‘Free Ridership” by some dealers, since there are strong positive externalities associated with promotional activities taken up by them to differentiate themselves in the intra-brand market. For automobiles, with the specific impact of pre-sale information sharing on final sales, it is possible that the consumers collect the information about the brand from one dealer, and then purchase the goods from another, offering a price discount.

Over the long run, such practices will drive those dealers out of the market who offer better service quality and experience. This has a negative externality for the brand in the longer run and prompts the manufacturer to fix the dealer mark up over the manufacturing price. Whilst this is plausible, in the auto industry it is manufacturers who do the promotion campaigns and advertising for cars and dealers invest miniscule amounts in pre-sale service to improve sales.

Unlike the CCI contention we posit that a possible reason for RPM is the manufacturer attempting to preserve demand that is deterred by dealers with unsold inventory who increase mark-ups in high demand States. Regulatory principles should be aligned with the realities of business where manufacturers prevent heavily discounted retail prices to improve inventory holdings that enhance welfare. We should be circumspect in defining anti-competitive practices so that the regulatory teeth bite the right way.

D'Souza is a Professor of Economics and Director at IIM Ahmedabad, and Agarwalla is Associate Professor at the Adani Institute of Infrastructure Management. Through Foundation of The Billion Press

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