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Summary The U.S. automobile industry is in a crisis. V igorous import competition, drastic shifts in consumer preferences, and anemic f inal sales combined to make 1980 and 198 1 two of the most difficult years in the industry's history. The current picture is bleak: literally hundreds of thousands of people have lost their jobs; communities dependent on the industry have suffered devastating losses in employment and financial resources all the domestic producers have suffered major financial losses; large facilities have permanently closed. Future prospects are uncer- tain. If the industry is to survive, the next five years will see . , wrenching changes in its productive and financial base as new product technologies are introduced, manufacturing plants are r etooled; and new relations are established among management, labor, and government. Given its size and scope, it is not surprising that the auto industry has long been accorded significant public attention. Recent events have prompted debate about the current crisis and appropriate courses of action. Three alternative lines of inter- pretation can be distinguished; as defined in Chapter 1, they can be summarized as follows: Transient Economic Misfortune. Proponents of this view argue that while the current crisis is a serious misfortune, it is temporary. The essential problem is a lack of small-car capacity; its solution is sufficient time and money to realign the product line. .. . . . N atural Consecuence of Maturity. Based on theories of the . product life cycle, this view treats the current crisis as one episode in a long-term shift of production out of this country to lower-cost sources of supply. Fundamental Structural Change. This view challenges the notion that technology is stable. It envisions a period of rapid innovation in products and processes, where competitive advantage will depend on the ability to innovate.

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2 These three interpretations make different assumptions about the competitive cost (and quality) position of U.S. production and the role of technology in competition. Moreover, they have quite different implications for public and private policy. This report places the cost and technology issues in their historical context and examines evidence on the character of recent innovation and the U.S. auto industry's relative competitive position. It should be noted that the report makes no attempt to estimate the com- parative advantage in U.S. automobile production in the sense of classical economic trade theory (e.g., the ratio of U.S. costs of auto production relative to U.S. costs of other goods, compared with similar ratios for other countries). Rather, the report examines the competitive position of the U.S. producers relative to their major competitors within the auto industry. The focus is not only on costs of production but also on product quality and the role of technology and innovation in competition. THREE HISTORICAL THEMES A basic premise of this report is that the nature of the current crisis in the automobile industry, the specific problems faced, the patterns of observed response, the barriers to adjustment, and the strengths and weaknesses of domestic firms can be understood only if one first understands something of the history of the industry. Chapters 3-5 of the report sketch out three themes that have characterized the evolution and development of the industry in the United States: the convergence of technology, the internationalization of markets, and the growth of public demand on the industry. Convergence in Technology Anyone trying to buy a car in 1905 was confronted by considerable variety: steam cars, electric cars, cars powered by gasoline, cars with three or four wheels, open-air cabs, closed carriages, all manner of mechanical principles. By 1973 that technological diversity had disappeared. To be sure, there was immense variation in styling, but the underlying technology had become standardized. This standardization of technology r effected a change in the character of innovation as well as a particular pattern of competition. From an early stage in which technical change was rapid and fundamental, the industry evolved to a point where technical advance was incremental and almost invisible. Competition was oriented toward the mass market where cost, styling, and

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3 acceptable levels of performance were the basic dimensions of competition. In contrast to the European market where technology-based competition led to technological diversity, convergence in technology in the United States reflected a market where product technology was competitively neutral. Internationalizatio n Until the last decade the evolution of the U.S. automobile industry was largely determined by political and economic forces specific to the North American continent. In the last few years, however, the relevant industry boundaries have expanded dramatically. There have been two interrelated changes: (1 ) dramatic shifts in the volume and pattern of world trade and (2) growth in the number of viable competitors worldwide. As played out in the United States, internationalization occurred primarily in the small-car segment through import penetration; the U.S. response has been conditioned by a legacy of large-car production. Large cars were associated with luxury and prestige and commanded premium prices; in terms of cost, however, small cars were just about as expensive to make; the result: small cars, small profits. With little incentive, U.S. producers did not develop products to compete directly with the imports until the late 1970s. Internationalization has confronted U.S. producers with competitors operating with a very different competitive tradition and experience. It is now clear that success in small cars requires different capabilities than success in the large-car segment; attaining parity in subcompacts with foreign producers involves far more than realigning the product line. Public Demands on the Industry During the last 10 years the development of automotive compe- tition and technology has been strongly influenced by government mandate. Social demands on the industry are not new; manufacturers have long had to meet both the demands of the marketplace and the requirements of changing social expectation. From the early years of the industry up to World War Il. market demands and public demands coincided. In the 1950s and 1960s, however, perceptions shifted and new public demands were imposed. Concern for safety, pollution, and energy efficiency led to a variety of government initiatives. The specific form that evolved--mandated standards and agency regulation--reflects

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4 public perception of the industry as a "bad guy" and the tension between divergent social and market demands. In addition to specific government policy directed at the industry, the postwar era has demonstrated the impact that general policy measures can have. In recent years, for example, the sensitivity of the industry to general economic conditions and the stance of fiscal and monetary policies has been underscored by record high interest rates, sluggish economic growth, and falling real income. Coming at a time when the industry's need for resources to meet new competitive demands has been at an all-time high, the depressed state of the automobile market has dealt the industry a severe blow. Competition in the U.S. auto industry has undergone funda- mental changes in the last 10 years, primarily because of increased market penetration by foreign manufacturers and drastic shifts in the price of oil. The events of the 1970s con- fronted a mature industry used to competing on the basis of scale economies, styling, and dealer networks. It was an industry in which technology in particular and manufacturing in general had become competitively neutral. It was an industry increasingly subject to government mandates, competing on an international basis with new competitors who emphasized superior manufac- turing performance. Moreover, growing incentives for new technology have created the opportunity, even the necessity, for competitive advantage through innovation. As we noted at the beginning, there are wide disagreements about the meaning of the current crisis. The three categories of interpretation sketched out in Chapter 1 differ in the assumptions made about the relative costs and quality of U.S. products and the stability of technology. Chapters 6-9 present evidence that bears on these issues. Product Cost and Quality Our analysis of productivity and product cost makes use of a variety of sources of information, including government reports and other published analyses as well as studies conducted within companies in the industry and made available by members of the panel. (Where use has been made of internal company analyses, trip reports, or other "industry sources," these have been explicitly noted.) Based on a variety of approaches and data sets, we find that the Japanese have a significant landed-cost advantage. Although differences in the two systems of production make precise com- parisons difficult, the Japanese advantage is likely to fall in the range of $750 to $1500 per small vehicle. Evidence on the cost

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5 differences from publicly available information is presented in Appendix A. While the data presented there are consistent with the finding of a sizeable cost advantage for the Japanese, the precise order of magnitude and the confidence that industr y members of the panel place in the cost difference (i.e., $1200-$1500) comes more from internal studies using confidential and proprietary data. The Japanese advantage reflects differences in prices as well as productivity. Compared with the U.S. firms, the major Japanese producers (Toyota, Nissan, etc.) have significantly higher overall productivity (total employee hours per vehicle); some estimates put the productivity difference as high as 40-50 percent. Employee cost per hour worked in Japan is about 50-60 percent of the U.S. average. The analysis of cost and productivity has implications for comparisons of profitability between U.S. and Japanese auto companies. Because the Japanese firms sell their cars in the United States at prices that are comparable with prices for U.S. cars, the cost advantage of the Japanese gives them a higher margin of profit on cars sold in the United States than that of the U.S. manufacturers. Evidence presented in Appendix A suggests that the Japanese firms use less capital per vehicle produced, so that the rate of profit measured as a return to capital would also be higher for the Japanese manufacturers. Thus, whether measured as a return on capital or as a margin of profit on sales, the Japanese producers earn higher profits on their U.S. sales than their U.S. counterparts. Existing evidence suggests that in the late 1970s the Japanese achieved a noticeable edge in assembly quality ("fits and finishes"; since 1980, U.S. producers have made improvements in quality performance. Consumer ratings of vehicle condition at delivery and counts of defects per vehicle shipped in 1979, for example, show a significant import (i.e., Japanese) advantage; on a scale of 1-10, imports rated 7.9, while domestics averaged 6.4. When asked, "Would you buy the same make or model again?," 77.2 percent of domestic subcompact buyers answered yes; among import buyers the comparable percentage was 91.6. Despite the popular image of Japanese superiority in advanced technology, explanation of the Japanese productivity advantage seems to be more a matter of differences in management-- process systems, workforce management--than superior automa- tion or faster work pace. Because of a production control system that emphasizes minimum inventory and elimination of downtime and a job structure that places responsibility for quality on workers, the Japanese operate processes at a high level of good output over extended periods of time. While several elements of the Japanese system are refinements of practices developed in the United States, certain critical aspects of their approach are

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6 accorded much less emphasis in U.S. practice. The policies and procedures connected with workforce management are a case in point. The labor-management relationship established in the 1 930s had its roots in the early years of the industry. The innovations in machinery and process design of the World War I era were accompanied by a system of workforce management char- acterized by highly structured rules and procedures. Planning and control of work were vested in staff groups far removed (organizationally) from the process. Workers were not involved in production beyond a narrow range of assigned tasks. The principal connection between the worker and the firm was the supervisor, and the relationship was essentially adversarial: supervisors were under pressure to meet production and cost targets, and that pressure for production at low cost was trans- mitted to the work force. Unionization of the industry in the 1930s introduced a system of industrial jurisprudence into the workplace and changed the terms and conditions of employment in many ways. But the basic relationship between the worker and the firm remained adver- sarial in nature. Changes in the character of competition in the 1970s have highlighted weaknesses in that kind of relationship: it inspires no loyalty or commitment, and it fails to tap information and experience in the work force. The last few years witnessed important changes in the employment relationship. Since the early 1970s, General Motors (GM) and the United Auto Workers (UAW) have worked to develop "quality of working life" programs; various approaches have been developed and extensively diffused in the organization. During the past year, "employee involvement" programs have been initiated at over half of Ford's facilities; Chrysler also has developed such efforts in connectic~n with its O' tA I itV_i mnr~v-- ment efforts. ~~ -a ~ r ~~~ The kinds of changes under way are akin to a cultural revolu- tion; where attitudes are deep seated, a true reformation is likely to require some period of time. Yet recent events suggest a good measure of adaotabilitv in the collective bargaining _ , , relationship and thus reason for optimism. TECHNOLOGY AND COMPETITION A key issue separating the alternative interpretations of the industry's present and future condition is the role of technology in competition and the character of innovation. The "transient" and the "maturity" perspectives assume a stability in technology, that is, a relatively standardized technology that changes only incre- mentally and that is competitively neutral.

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This description fits the condition of the industry prior to the initial OPEC shock of 1973, but there is some evidence that the role of technology in competition is shifting. Using the data before (1977) and after (1979) the Iranian oil shock, we find a substantive shift in the market's valuation of technology. Performance and technology characteristics associated with new Designs "package efficiency, driving range, diesel engines, front-wheel drive) carried premiums in 1979, while the same characteristics were discounted in 1977. In terms of market premiums the evidence implies that technology became more visible in the aftermath of the Iranian oil shock and a more important aspect of competition. . . . . . If technology becomes a more critical element of competition, innovation is likely to become more rapid and fundamental. Indeed, it appears that the development of product technology in the 1970s constitutes a sharp reversal of the pattern of technical change that dominated from 1900 to 1950. The earlier era was dominated by standardization: first in engines, then the chassis, then components. In the 1 970s, however, innovation spawned diversity in engine configuration, control systems, drive trains, and materials. The pattern of technical development suggests that innovation is becoming less incremental in its impact on the production unit. Recent changes have not just refined existing ideas but have also introduced new concepts; downsizing, trans-axles, and new materials are examples. Future technologies carry the possibility of significant change in production facilities; advanced engine concepts, materials, and control systems require radically different equipment, skills, and organization. Increased diversity and increasingly radical innovation leave a k ey assumption of the "transient" and "maturity" perspectives-- stability in technology--open to question. Because future development is uncertain, and because some systems (at least in small cars) have achieved dominance (front-wheel drive, four- cylinder engines), it is not possible to make precise and definitive statements about the course of technical change. If the incentive for innovation remains strong, however, it is likely that the market will see increased diversity of technology as new designs in engines, bodies, and other systems compete for market acceptance. If so, we may be at the beginning of a period of intense technology-based competition. CONCLUSION: THREE SCENARIOS AND THEIR IMPLICATIONS This report identifies the historical context and the industry's current position in terms of product cost and quality and

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8 technology. Evidence on the three main lines of interpretation is presented, but the report draws no strong conclusions. Some evidence in favor of all three interpretations has been found, and there have been a number of assumptions made along the way. To f urther identify the implications of alternative patterns of development, the concluding chapter of this report presents three scenarios of the industry's f uture based on the three lines of interpretation. The scenarios depict possible chains of events and the likely impact of those events on broad public policy options. While the scenarios are intended to offer a realistic assessment of the development of the industry under given assumptions, they are not based on an extensive analysis of business strategy. And although some' very general views about public policy are indicated, an in-depth analysis of policy options was not carried out. The strategies of particular firms and detailed policy analysis ar e important areas for further work but were outside the scope of this report. The three scenarios have quite different predictions for the future evolution of the industry. Transient Economic Misfortune: The United States maintains a viable domestic industry, but the U.S. share of value-added declines, competition occurs much as before on the basis of styling, scale economies, and distribution. Natural Consequence of Maturity: Local content of U.S. sales declines substantially; 65 percent of all cars sold in the United States are produced in foreign countries; U.S. firms survive but with substantial offshore production and only sDecialtv vehicle production in the United States. ~ . . -A ~r~ ~ ,~ fundamental Structural Change Industry moves from full-line products and cost competition to more performance-oriented competition; the United States recoups market share with innovative vehicles, but the U.S. share of value-added declines because of losses in standard models. Using two general categories of policy measures ("internal"-- deregulation, tax incentives: "external"--temoorarv nol Irish tn 7 -' ~~ ^ - _& ~ ~~& ~& 7 ~~ ~~ reduce imports), it is clear that predictions about the impact of policy depend on what scenario is assumed to pertain. . . . . . . . . internal policies have a major impact under the "transient" scenario, while both internal and external policies have a major impact under "restructuring." . . . . ~ However, without permanent restrictions on trade, policy has no lasting impact under the "maturity" scenario; cost disadvantages in standard models are too large to be overcome through investment.

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9 A s in the case of public policy, implications for management's competitive and organizational agenda are somewhat different under the three scenarios. Under "maturity" the key to compe- tition is the ability to manage a worldwide production and distribution system, with worldwide sourcing and technical innovation that extends and refines existing concepts. Under "restructuring" the essential tasks are improving quality and productivity in existing models and the development and introduction of radically new products and processes. These differences in competitive environment should not be glossed over, but it is also clear that both of these challenges require substantial changes in the way the business is managed. Som e critical elements of that change are as follows: An emphasis on manufacturing as a major competitive factor. A more open agenda between management and labor. A move to engage the work force (all levels) in the competitive activities of the firm. An increased emphasis on the management of change; greater adaptability and openness to innovation, both organiza- tional and technical. For both public and private policy, prediction about what will be effective depends fundamentally on what is assumed about the industry's development. Both carry the potential for significant influence on the future of the industry. The future of the industry is by and large in the hands of its participants--the firms, the unions, the suppliers--but public policy has a critical supporting role to play, particularly in mitigating risks and facilitating necessary change during the period of transition.