Wednesday, April 2, 2014

New Jersey v. Economic Liberty

Praised Vertical Integration; Won Nobel Prize 

Thinks It Knows Better

A free society allows its citizens to engage in voluntary commercial exchange, so long as such exchange does not impose economic harm on unconsenting third parties.    Unfortunately the State of New Jersey takes a different view.  Last month the Garden State's Motor Vehicle Commission announced that Tesla Motors may only sell its cars in New Jersey via franchised automobile dealers.  (See this story in the New Jersey Star-Ledger describing the new rule).  The rule effectively bans Tesla's strategy of forward vertical integration.  Pursuant to this strategy, the firm operates two company-owned show rooms in the state, thereby "eliminating the middleman" and taking direct responsibility for explaining the virtues, limitations and prices of its products   Such vertical integration is a widespread practice, to say the very least. 

For the first several decades of the 20th Century, economists were hostile to most vertical integration, preferring the more fragmented market structure endorsed by New Jersey.  Indeed, as previously explained on this blog,

"[Early in the 20th Century] economists identified two, and only two, possible reasons for complete vertical integration. First, such integration could create technological efficiencies and thus reduce production costs. Second, integration could foreclose rivals from important sources of inputs, thereby creating or fortifying the integrating party's market power.  Thus, when economists, or, for that matter, antitrust courts or enforcement agencies, could not identify any efficiency purposes for such integration, they naturally inferred that the conduct was anticompetitive."

However, as Ronald Coase (pictured above) explained long ago, such vertical integration can produce other, non-technological benefits as well.  In particular, such integration can eliminate the costs of relying upon more decentralized markets, that is, "transacting," to conduct economic activity.  Such "transaction costs" can take many forms, including the risk that one's trading partner will engage in opportunistic behavior.  Indeed, Tesla recently asserted that franchised automobile dealers have a vested interest in promoting the sales of gasoline-powered automobiles over electric powered vehicles like Tesla's, with the result that reliance upon a system of franchised retailers will result in under-promotion of Teslas.

To be sure, franchised dealers can provide valuable services to consumers both before and after the purchase of a new or used automobile.   It is thus no surprise that many consumers prefer to purchase automobiles from such dealers instead of from other individuals or from Tesla.  However, such services are not free.  Instead, dealers quite properly pass along the costs of such services to consumers by marking up the price of the vehicle sold.   Apparently Tesla and some consumers believe that these additional services are not worth the additional price, leading both to embrace a different method of distribution.

As previously explained on this blog when discussing a (failed) effort in North Carolina to impose similar limits, free societies respect the rights of entrepreneurs and consumers to make such choices absent any apparent harm to third parties.  Moreover, given Telsa' tiny share of the automobile market there is no plausible risk that such integration is an anticompetitive tactic designed to gain or maintain market power.  It thus makes sense to interpret Tesla's innovative approach to marketing as an effort to minimize the cost distribution, a result that would enhance Tesla's welfare and the welfare of the consumers it serves.    Tesla's appraisal of the relative costs and benefits of relying upon its own show rooms instead of independent dealers may turn out to be incorrect, but free societies leave such decisions to firms and consumers, without coercive paternalistic intervention by state legislatures.  (See also this excellent discussion by Daniel Crane, on the Truth on the Market Blog last summer, that makes some similar points.)

Nonetheless, some continue to claim that such interference with basic economic freedoms serves legitimate purposes.  For instance, a recent story in CNN Money cites unnamed "advocates of the law" saying it aims "to encourage price competition and ensure customers have access to warranty and recall services."    Last week, 70 economists and law professors, including this blogger, signed a letter condemning the ban on Tesla's direct distribution.  The letter expressly considers the various rationales that proponents of the legislation have proffered and concludes, quite properly, that:

"We have not heard a single argument for a direct distribution ban that makes any sense.  To the contrary, these arguments simply bolster our belief that the regulations in question are motivated by economic protectionism that favors dealers at the expense of consumers and innovative technologies."

I should add that banning Tesla's preferred method of distribution may also protect other manufacturers of automobiles, by forcing Tesla to employ a more expensive and less effective method of distribution and thus discouraging procompetitive entry into the New Jersey market.  If so,  the ban may produce even more harm than initially supposed. 

Hopefully New Jersey will rethink  this unjustified interference with basic economic liberty.