March 30, 2015

Auto Franchise Laws Restrict Consumer Choice and Increase Prices

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Arizona, Michigan, New Jersey, and Texas recently received the 2014 Luddite Award from the Information Technology and Innovation Foundation for preventing automaker Tesla from selling cars directly to consumers. These states’ efforts to ban direct sales are reminiscent of the Luddites, nineteenth-century English workers employed in the textile industry who both rejected technological development and actively worked to prevent its use through its destruction. State legislatures, rather than destroying physical plant and equipment like the Luddites, actively impede alternative distribution models, reducing consumer choice.

Auto franchise laws often include three major restrictions: mandatory dealership licensing requirements, onerous terms for terminating dealerships, and the creation of exclusive territories for incumbent dealers. Each rule carries a potential cost for consumers.

The coverage of these laws has expanded significantly during the past 30 years.

In 1979, fewer than half of all the states in the US regulated all three aspects of auto franchising. By 2014, Maryland was the lone holdout, regulating only two of the three aspects. The increase in prevalence prompts an important question: has the act of purchasing an automobile become so risky for consumers that it warrants this near universal framework of regulations?

Since state laws require manufacturers to sell new vehicles through franchised dealers, manufacturers cannot sell directly to the public. This requirement prevents new manufacturers, such as Tesla, from establishing factory-owned dealerships. Tesla believes its direct sales model could improve the dealership experience for consumers interested in purchasing an electric vehicle, but laws in most states prevent it from finding out.

Dealer termination laws typically require auto manufacturers to prove that a dealership has engaged in behavior that meets the “for cause” criteria for termination. Increasing the efficiency of a manufacturer’s distribution network is typically not regarded as a legitimate cause. Struggling dealerships benefit from this rule but likely at the expense of car-buying Americans, who face higher prices as the rule prevents increasing efficiency in dealer networks.

Exclusive territories help insulate dealers from competition. Manufacturers sometimes find it worthwhile to voluntarily offer exclusive territories to encourage dealers to invest in promoting the product. But mandatory exclusive territories can increase consumer costs. Without the threat that the manufacturer might open other competing franchises, existing dealers have the opportunity to charge consumers higher prices or may lose sales for the manufacturer through poor dealer performance.

We do not claim to know the best way of organizing auto distribution. But mandatory auto franchise laws prevent manufacturers—and consumers—from finding that out.