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Wednesday, October 4, 2023

Is the Florida Government Enforcing Middlemen in the Auto Industry?

Can banning direct sells really foster competition?

Image Credit: Milan Suvajac via Wikimedia | CC BY SA 4.0

This week I have a question from Heath who frequently writes to me for Ask an Economist. He has a question about a specific policy out of Florida. Heath writes:

Recently Florida passed House Bill 637 which requires automobile manufacturers to use independent dealerships to sell cars instead of selling direct to consumers. The claim through the years is that having independent dealerships will help create more competition which would be better for the consumer. Do you think that is the case or do you think it just requires another middleman and more regulation which just increases the cost of automobiles for the consumer?

So what is the logic behind the bill on direct sales? Will the bill improve things for consumers? To understand, we have to think about the logic behind so-called middlemen.

“Middlemen” in Economics

One of the claims you’ll hear as a consumer is that a certain store is “cutting out the middleman” by buying directly from producers and selling directly to customers. While this may sound good, it’s inherently not very sensible.

To see why, ask yourself a simple question—if a middleman were purely superfluous, why would any middlemen exist in the economy?

Imagine Toyota is willing to sell a car for $8,000. A middleman buys the car for $8,000 and sells it for $12,000. The final customer, then, buys the car for $12,000. Notice the problem here. The final customer spends $12,000 and the original seller, Toyota, only gets $8,000. Both Toyota and the final customer would be better off if the final customer bought directly from Toyota. If the final customer agreed to pay $10,000, for example, the customer would spend $2,000 less and Toyota would receive $2,000 more.

Neither Toyota nor the final buyer benefit from the middleman in this case. But that cannot be true. Why? Because if it’s true both the final buyer and seller would be better off without the middleman, neither would opt to use the middleman in the first place! It improves the final result for both parties to cut out the middleman, so it makes no sense to assume they wouldn’t.

The only way the middleman makes sense is if it is too expensive for the customer to buy directly from the producer.

For example, maybe it would be expensive for Toyota to hire people in-house to specialize in explaining why a Toyota Camry is better than a similar car of a different brand.

Imagine it costs Toyota $5,000 per car to hire the right personnel and build the right corporate infrastructure to sell directly. If that’s the case, Toyota would have to sell the car for $13,000 to break even. They’d need to charge $8,000 for the car and an additional $5,000 to engage in the costly direct sale. If the original buyer is only willing to pay $12,000, then Toytota cannot afford to sell the car. The $5,000 cost of selling directly is too high!

On the other hand, the middleman was willing to sell the car for $12,000 after buying directly from Toyota at a price of $8,000. So the cost of selling by using a middleman is only $4,000 ($12,000-$8000).

Economists often call this cost associated with buying and selling a transaction cost. A fundamental insight of UCLA economist Armen Alchian is that the role of a so-called middleman is to reduce transaction costs. How do they do that? Well, in our example, we imagined Toyota had to build up company infrastructure to do things like convince the customer that the Camry is better than comparable cars. Car dealerships fix this because they specialize in techniques and knowledge about the differences in cars.

By specializing, car dealerships have their pulse on the correct prices and cars for buying direct, and they can use those skills and that infrastructure to facilitate transactions with the final buyer and seller.

Essentially, selling an asset like a car is very difficult. That’s why car dealerships leverage complicated formulas and commission systems to move cars. If Toyota took all these systems and their administration on, it would be more costly than it is for the specialized dealerships in many cases. In that way, dealerships essentially are brokering transactions between car companies and final buyers to make the cost of those transactions lower. By lowering the costs of transactions, dealerships enable trades that would otherwise be too expensive, and in doing so they create value in the economy.

Middlemen are often disparaged because they seemingly do nothing to create a product. But if it is prohibitively costly for customers to obtain an already-existing product, it may as well not exist. In this sense middlemen are actually essential in the production of products they are involved with.

Direct Sales

In industries where middlemen enable more transactions to happen, using them creates value. However, this doesn’t mean middlemen are always desirable. Many of the products you purchase are made by the same company that sells them. How do we explain this? Well, when the cost of transacting is low, it isn’t difficult for the producer and consumer to deal by themselves, and so it isn’t worth it to have a middleman.

For example, Walmart doesn’t need to invest a lot of money to convince me I should buy kidney beans. I already know I want them for my chili. Walmart’s brand Great Value can fulfill my desire to buy kidney beans by simply putting them on the shelf. No need to spend resources to convince me.

Similarly, I’d expect that industries where consumers spend a lot of time researching themselves will be relatively less likely to need middlemen. The more information the typical consumer knows about a product, the less advantage a middleman can provide by specializing in learning that information.

This is why I’d say it isn’t surprising to see direct sales occurring in the electric car industry. Electric cars are a relatively new product, and oftentimes the consumers of new products have invested time to learn about those products. Who were the first people to buy Teslas? They were people who were already excited for and interested in the prospect of electric cars. They are enthusiasts who follow news about electric cars!

In Tesla’s case, adding a middleman dealership would be redundant because the cost of transacting with these expert buyers is already low. The whole purpose of a middleman is to reduce transaction costs. If transaction costs are very low, the middleman actually makes the exchange more costly.

Thus, in situations where transaction costs are low, preventing direct sales will actually raise the cost to consumers. When the government mandates the use of middlemen in a market that would not otherwise demand them, the middlemen actually become the thing that critics believe they are—superfluous members of the transaction which create no value and sponge benefits off both sides of the transaction! Again, this isn’t usually true of middlemen. In a free market, companies and customers would not hire middlemen if they had the option of engaging in a direct sale which benefits them more.

But when two parties agree a direct sale is mutually preferable to a middleman, forcing a middleman into the transaction adds costs. This is precisely the problem with Florida House Bill 637.

Who Supports Bills Like This?

If both the final buyers and the original sellers are made worse off by mandatory middlemen, who would support such a bill? The window dressing argument is that by having more dealerships, there is more competition, and competition means lower prices for consumers. But with the logic we discussed above, we know there’s something fishy about this argument.

While it’s true two Toyota dealerships must compete with one another, they cannot compete below a price at which they would break even. Returning to our prior example, if it costs $8,000 to buy a car, and facilitating the transaction costs the dealership $4,000, they cannot sell for less than $12,000 or they will make a loss. (Note this does not mean costs are determining prices. You can read more about that here).

In this case, if the customer is willing to pay $11,000 and there is no cost of buying directly from Toyota, the company would much rather sell directly to the customer because they make $3000 more than selling to the dealership for $8,000. Notice, the competition between dealerships is irrelevant! If the cost of selling direct is less than the cost of selling through a dealership, lower prices are always available by buying direct, no matter how stiff the competition in the dealership industry.

Middlemen don’t lower prices by “creating competition,” they lower prices by lowering the cost of transacting. Therefore, laws which require companies and consumers who would normally prefer to buy direct to instead utilize a middleman can only increase the price, all else equal.

Florida House Bill 637 does not increase competition. It eliminates the competition that exists between the producer and the dealership to lower the cost of transacting. The bill effectively tells producers they cannot enter the market of sales to customers. Preventing entry in the market is reducing competition by definition.

So who wins here? It should be obvious now that the supporters of this bill are the middlemen! CBTnews reports, “the Florida Automobile Dealers Association (FADA) was heavily involved in writing and pushing the legislation through the state government.” As usual in bills like this, the foxes are set to guard the hen house.

One puzzling thing about this legislation, though, is it exempts electric car companies, like Tesla. Interestingly, companies like this are the most common auto manufacturers to engage in direct sales. So what’s the deal?

Well, as the CBTnews story reports, the bill’s supporters hoped for a complete ban with no exemptions, but it appears this is the best they could get.

But our puzzle remains. Why would FADA care about stopping direct sales from companies like Toyota, Ford, Honda, etc. if those companies are already utilizing dealerships rather than direct sales? It seems redundant.

I think the answer comes via the concept of learning-by-doing. As more electric car companies refine their direct sales techniques, they build organizational structures and human knowledge on how car companies can most effectively engage in direct sales. This knowledge will not all be company exclusive.

For example, what happens if Toyota is able to hire Tesla’s leading direct sales managers and have them build a direct sales model at Toyota? In this case, the knowledge of the experts, developed by Tesla, may be enough for Toyota to learn how to lower transaction costs better than the current middlemen.

If auto manufacturers who currently utilize dealerships learn enough from Tesla’s direct sales model, they may be able to learn enough to lower transaction costs more than the dealership. In this case, dealerships would be rendered superfluous, and thus their entire business model would be put in jeopardy.

Seeing the potential writing on the wall, dealerships lobby to prevent this from happening. They may not be able to stop newcomers like Tesla from utilizing direct sales, but it seems like they can prevent legacy manufacturers from adopting these techniques. Somewhat ironically, Tesla benefits as well, since this means legally they are able to utilize organization techniques that their opponents cannot.

Unfortunately, the benefit to middlemen and Tesla comes at the expense of the consumer and other producers. Middlemen are economically beneficial when their services lower the cost of buying and selling, thereby enabling value-creating transactions to take place. However, when middlemen are made mandatory by government fiat, they only serve to be another hand in the wallet of consumers and businesses.

Ask an Economist! Do you have a question about economics? If you’ve ever been confused about economics or economic policy, from inflation to economic growth and everything in between, please send a question to professor Peter Jacobsen at [email protected]. Dr. Jacobsen will read through questions and yours may be selected to be answered in an article or even a FEE video.

  • Peter Jacobsen is a Writing Fellow at the Foundation for Economic Education.