The Life Cycle of the U.S. Tire Industry.

• Author: Carree, Martin A.

Martin A. Carree [*]

1. Roy Thurik [+]

We introduce a new theory of industry evolution. According to our model, the nonmonotonicity in firm numbers found in many young industries is a consequence of the gradual decline in unit costs. Early stages of the industry life cycle, when unit costs and profit margins are high, display positive net entry rates. In later stages, declining unit costs and increasing competition limit the market room for (fringe) firms accumulating in a shakeout. The model explains paths of output, price level, and firm numbers using a recursive system of equations. We apply the model to the U.S. tire industry.

1. Introduction

   A recent literature has emerged focusing on industry evolution, or the dynamic patterns that industries and firms follow as they systematically evolve over time. This literature is important because of the insights provided about how industries change, why they change, and the consequences of industrial change. The year 1982 saw three fundamental contributions made to the research on the evolution of industry. Boyan Jovanovic published the first formal model of industry evolution, Richard Nelson and Sidney Winter presented their influential book on the causes and effects of this phenomenon, and Michael Gort and Steven Klepper published their careful analysis of the stages of the product life cycle. Knowledge concerning industry dynamics and industry evolution has expanded since then. [1] Despite this progress in the field of industry evolution, considerable gaps remain. For example, we lack an adequate empirical understanding of the evolutionary process at the single-industry level from the early to the late stages of its life cycle. Shakeouts have been identified in the literature as an integral component of this evolutionary process. The sudden disappearance of large numbers of firms have been documented across a broad spectrum of industries, such as steel, airline carriers, financial intermediaries, automobiles, and tires. An important strand in the literature argues that the catalyst for these shakeouts is the introduction of a new dominant innovation. Confronted by a new technology introduced by a competitor, the inability of other firms to adopt this new dominant technology presumably forces them out of the market. Jovanovic and MacDonald (1994) made a pioneering and parsimonious contribution in this field of research by explaining patterns of number of firms, output, and prices of the U.S. tire industry. Despite the importance of their contribution, we argue that their model does not adequately describe the key historic developments that have taken place in this or many other industries that faced a shake out of producers. [2]

   The domain of relevance of the Jovanovic--MacDonald model is limited. It assumes that one innovation followed by just one refinement is responsible for the nonmonotonicity in firm numbers. This implies that the model is applicable only for those industries having experienced just two technologies in their entire history: an initial low-tech and a subsequent high-tech phase. Most industries, including the automobile tire industry that was the testing ground of Jovanovic and MacDonald, have an ongoing history of significant improvements in product quality and productivity. It seldom occurs that one innovation is dominant. This is certainly true for the tire industry. Nelson (1987), in his study on the U.S. tire industry, observed that "there was no single technical breakthrough that unlocked the industry's potential for high-speed production; nor was any individual or firm of overriding importance. The advent of mass production was a cumulative process resulting from a vast number of successive small changes" (pp. 331-2, italics added). Almost half a century ago, Reynolds (1938, p. 463) described a similar process: "The great improvement in tire quality during the past 30 years is undoubtedly due to constant repetition of [the] cycle of invention and imitation."

   We take a different approach than Jovanovic and MacDonald and explain the nonmonitonicity in firm numbers as resulting from gradual unit cost reduction over time leading to declining profit margins. In the present paper, we relate this cumulative process to the concept of learning-by-doing. We will test the model using data of the American tire industry. We do this to facilitate the comparison between our model and that of Jovanovic and MacDonald and because this industry is one of the few for which data are available for a long time period. The process of learning-by-doing leading to decreasing marginal costs over time has an important impact on the number of firms in the industry. We show that because of this process, profit margins decrease over time, making entry less likely and exit more likely. Whereas in the early stages of the industry life cycle profit margins are high and entry exceeds exit, the reverse is the case in later stages. The model predicts a shakeout of firms in case the constant inflow of new market participants leads to increasing competition pushing the profit margins even further down to a level at which fringe firms cannot survive. After the shakeout, the learning-by-doing process still leads to lower margins, but this is then (partly) compensated by less competition, as the number of firms has decreased strongly.

   This paper presents a new theoretical model of industry evolution for homogeneous goods industries, tests it on historic data of the U.S. tire industry, and finds reasonable estimates of the various parameters. The model is capable of explaining key common industry life cycle elements as for example discussed by Porter (1980, pp. 157-62). The remainder of our paper is organized as follows. In the next section, we describe the theoretical foundations of our model of industry evolution. The model is applied to the tire industry in section 3. The model explains the demand for automobile tires, the price of tires, and the net entry rate of firms producing tires. The shakeout in the number of producers is derived as a consequence of a continuous decrease in the profit margin per tire. Small producers can only survive in case this margin exceeds a certain critical value. We claim that the strong and persistent price competition in the U.S. tire industry in the 1920s followed by a strong decline in demand for tires during the Great Depression generated a rapid shakeout of the number of producers (Reynolds 1938). The model consists of three equations. The first equation relates the demand for automobile tires to the number of motor vehicles, the price index of tires, and a quality index. The second equation describes the decomposition of the price index of tires into a competition effect and a marginal cost effect. The third equation relates the net entry rate to the one-period lagged profit margin and growth of demand for automobile tires. Because of this lag, the model is a system of recursive equations. In section 4, we present the empirical results for the U.S. automobile tire industry over 1913-1973, and in section 5, we conclude.

2. A Model of Cournot Oligopoly

   In this study, we use a simple recursive three-equation model of industry evolution. The first equation relates total demand to the price level of the good ([P.sub.1]) and to exogenous variables. In this section, we introduce the assumptions behind our evolutionary model and derive the second and third equations. The industry is assumed to have a large fringe of small (potential) firms. Each entering and exiting firm is assumed to come from this group of market participants.

   Price Level

   We assume that the strategic interaction between firms in the tire industry can be modeled with a Cournot quantity competition game. Cournot rivalry is generally thought to be an adequate representation of strategic interaction in oligopolistic industries where capital investment is important, production capacity is relatively fixed, and a largely homogeneous good is produced (Tirole 1989, chap. 5). Kreps and Scheinkman (1983) show that the one-stage Cournot game is equivalent to a two-stage game in which firms simultaneously choose capacities and then, knowing each other's capacities, simultaneously choose prices. Hence, a valid interpretation of quantity competition is "a choice of scale that determines the firm's cost functions and thus determines the conditions of price competition" (Tirole 1989, p. 218). We assume that the industry has two groups of producers. The first group consists of a handful of large-scale producers that do not exit. This group may change over time, for example, because of mergers, or small-scale producers growing into large-scale producers or because of group members declining in size and becoming small-scale producers. However, we assume that new entrants and exiting firms are no part of this group. The second group is a fringe of (many) small-scale producers in which entry and exit does take place. [3] For simplicity, we assume, in contrast with the large-scale producers, that these firms have the same capacity ([q.sup.F]) and identical cost functions. The profit of firm i in period t with a production capacity [q.sub.it] equals:

   [pi] = [P.sub.t]([Q.sub.t][q.sub.it] - [C.sub.it]([q.sub.it]) [q.sub.it] [greater than or equal to] [q.sup.F] (1)

   where [C.sub.it], is the period t cost function of firm i and [Q.sub.t], = [[sigma].sub.i] [q.sub.it] is total market output of the homogeneous good. Small-scale producers have a production capacity equal to [q.sup.F] and total costs in period t of [C.sub.t],([q.sup.F]). The large-scale producers optimize their own output assuming that competitors do not change their production. That is, the market can be described as a (static) Cournot oligopoly. [4] Assuming a Cournot oligopoly, Cowling and Waterson (1976) derive the following relation between price ([P.sub.t]), the weighted average of marginal costs (here, [C.sub.t] =...