The automobile industry must modernize through investments in order to regain its market share.   Production fell precipitously in recent years.  Ukraine's largest car manufacturer, AO AvtoZAZ, has a capacity of 150000 cars annually, and in the 1970s and 1980s uniformly sold that quantity of Tavriya-brand cars.  In 1992, 130000 cars were produced.  In 1994, 92000 cars were produced. In 1995, 59000 were produced.  In 1996, only 6900 Tavriya rolled off of the assembly line; in 1997, the number fell to 2000 -- less than 2 percent capacity utilization.

The production cost at Zaporozhye went up in line with the internal price rises on fuel and raw materials, but their quality did not improve. Therefore, Ukrainians with the means preferred to buy Russian cars or cars from further abroad.

The Ukrainian auto market is relatively well-developed.  On average, 275000 light automobiles, new and used, are brought into Ukraine each year. At an average price of $5000 per auto, these imports can be valued at $1.5 billion.   Until the beginning of 1996, the excise and customs duties on foreign car imports to Ukraine were very high.  A survey of some dealers placed the cost of taking a car across the border at more than 100 percent of the declared cost of the new car. In 1996, new legislation reduced the cost of crossing the border to approximately 35 percent of the car's value for a new car. The domestic factory's market share in Ukraine's auto market fell from 35 to 3 percent of the quantity sold between 1994 and 1996.

The plant required investment in 1998 of US$800 million to replace existing machinery and equipment.  The government wished  to attract a foreign investor willing to commit the finance necessary to increase output to 300000 autos per year. The plant employs about 29000, with a further 130 firms dependent on its survival.

Government participation.
The government has observed worriedly the progressive deterioration of AvtoZAZ's market share.  In 1994, to stem the flight to foreign cars, the Ukrainian Supreme Rada granted a temporary exemption from transport excise taxes to AvtoZAZ. In 1996, this exemption was extended to all enterprises assembling more than 1000 cars a year through the year 2007, although only AvtoZAZ (and its partners) in Ukraine meet that criterion.

The exemptions, however, did not help AvtoZAZ. The plant continued to market its product as it had under the plans, with the majority of cars not sold but exchanged for materials through a chain of intermediaries.  A new director appointed in 1996 changed the focus of the firm to direct sales and aggressively pursued foreign investors. Meanwhile, cash-flow problems brought the production of Tavriya to a practical standstill.

Foreign investors.
Two potential investors were found - Daewoo and General Motors. The final form of these company's offers crystallized by late December 1996.

• General Motors, for example, was ready to establish a joint venture for assembling their successful Opel Vectra at ZAZ by the end of 1997. The plan was for production of 25,000 vehicles a year to begin with, rising to 40,000 in the future. To achieve this, GM was ready to invest $23 million into the joint venture.   The planned investment and the scale of use of AvtoZAZ's f acilities was decidedly modest. GM was interested only in four sectors: rental, assembly, plastics, and the paint shop. They were prepared to offer ZAZ's 18,000 workers a mere 1,000 places on their line. The Americans were not actually interested in control over the whole of AvtoZAZ, but only the joint venture.
• Daewoo had more ambitious plans valued at $1.3 billion. The Koreans were ready to take the whole of AvtoZAZ under its wing. The Korean-Ukrainian joint venture would then produce 80000 Tavriyas, 25000 Opel Astras, and 150000 Nubiras a year.  Daewoo itself would invest only $150 million into joint venture's charter fund.  More would be spent clearing AvtoZAZ's debts, and the remaining $1.03 billion would be provided to the joint venture in the form of credit.

• exemption of the joint venture from payment of VAT and profit tax;
• an amnesty for the plant with regard to debts to the budget;
• a three-year exemption from payment of all taxes and import duties on approximately 100,000 Korean-assembled cars;
• exemption from social welfare payments and extra-budgetary fund payments; and
• the adoption of severe restrictive measure against imports of other manufacturers' automobiles to Ukraine

Ukraine's cabinet approved Daewoo's candidacy as AvtoZAZ's partner on 4 June 1997, although the Koreans demanded that all the proposed tax exemptions be enshrined in legislation before things got under way.  The result was "On the Stimulation of Automobile Production in Ukraine", whose provisions will be valid until 2008.

The Koreans signed an agreement with the government of Ukraine in September 1997 setting up a joint venture between Daewoo and AvtoZAZ.  Shares in the joint venture were divided equally between Daewoo and AvtoZAZ. Daewoo was required to invest $150 million as charter capital, and AvtoZAZ contributed its factory. The additional $850 million promised by Daewoo in December 1996 will be invested gradually from the profits of the newborn joint venture.

After the document had been signed, the EU was swift to warn Ukraine that the tax exemptions and even more so the law "On the Stimulation of Automobile Production in Ukraine" were in contravention of WTO rules. The new joint venture faces a stiff battle for the right to ship its products into Europe.
 
Chapter I:  Supply of and demand for new automobiles in Ukraine.

The Zaporodzhye plant has experienced a striking difference in demand for its automobiles in the last 25 years.  This difference in demand tells us a great deal about the way that markets work and the effect of price-fixing on the market outcome.

    A.  The Soviet period.

The market for new automobiles (e.g., Tavriyas) in the Soviet period could be illustrated as in the accompanying figure.  In the Soviet period, consumers from all over the Soviet Union demanded Tavriyas.  In fact, there was an excess demand for Tavriyas during that period -- at the selling price of the equivalent of $5000, many more consumers were willing to buy Tavriyas than could be accommodated from the output of the Zaporozhye factory.  While we don't know exactly how many disappointed consumers there were, the figure indicates that only 150,000 consumers received the autos while another 150,000 consumers went home without a Tavriya.

Excess demand is a feature of markets for which the selling price is fixed.  The Soviet government established the price at which the Tavriya would be sold.  Since the price did not adjust to the excess demand in the market, there were many consumers who wanted to buy the car but were unable because of a shortage.  In situations of shortage, a rationing rule is necessary.  The auto salespeople established lists of prospective purchasers, and sold the cars when available to the next person on the list.

    B.  The market for new Tavriyas in 1997.
 

By 1997, the excess demand for Tavriyas was a thing of the past.  While the capacity of the Zaporozhye factory remained at 150,000 autos per annum, the demand for these cars had declined remarkably.  This is illustrated in the accompanying figure.   While the supply curve remains in its previous position, the demand schedule indicates much less demand for Tavriyas at any given price.  The actual outcome is illustrated with price of USD 8000 and quantity demanded of 2 thousand autos.  The factory is far from its previous situation of excess demand.  Now, there is substantial excess capacity for production of these autos.
 
 
 
 

    C.  What caused this shift?

We have studied the concept of demand schedules.  We recall that these schedules are drawn "ceteris paribus", and that changes in the consumer's environment will lead to shifts of the demand schedule.  There were a number of quite important shifts in the consumer's environment that occasioned this shift:

•     In the Soviet period, the only substitutes for Tavriyas were autos manufactured elsewhere in the Soviet Union and used cars (either Tavriyas or other Soviet makes).  There were strict restrictions on the import of cars that effectively made these imports extremely high priced.  With independence these restrictions were greatly relaxed, thus lowering the cost of imported cars -- a substitute good.  Lower prices of substitute goods will cause an inward shift in the demand schedule.
•    The prices of tires, batteries and gasoline have risen since the Soviet days.  These goods are complements to autos.  Higher prices of complementary goods cause the demand schedule to shift inward.
•    The purchasing power of potential consumers has declined greatly for two reasons.  First, per capita income in the Ukraine has declined.  Second, in the Soviet days consumers had large accumulated wealth in bank accounts.  The hyperinflation of recent years greatly reduced the real purchasing power of those savings.  Both these changes lead to a contractionary "income effect" on the demand schedule.
•    Production cost has risen.  This has forced the Zaporozhye factory to charge more for its product even though it is operating so far below capacity.   This is evident in the price charged for the Tavriya:  USD 8000 rather than the USD 5000 of the previous case.

    The textbook explanations of production decisions begin from an assumption of full employment.  The Zaporozhye factory provides an alternative paradigm -- decisions on production in a situation of excess capacity.  The concepts of marginal cost, and average cost will be derived using simulated data for the factory, with consideration of strategies to return to full employment.  Daewoo's plans provide one such strategy, but others can be considered.
 
Chapter X:  International Trade and Protection.

    The Zaporozhye factory case can also be used to discuss the impact of protection on consumers and producers.  This description will take off from the Daewoo agreement, and will describe the impact of trade restrictions on consumer demand and on the production choice.