In many areas of the Chinese economy, from refrigerators to computers and banking to consumer goods, domestic players have captured the lion’s share of the enormous market. There is only one glaring exception: autos. Even after the government plowed billions into building up domestic champions, Chinese auto makers account for fewer than 30% of the new cars sold in China each year. This week’s Shanghai Auto Show is a good time to consider why that is and how local firms can change it.

Chinese auto makers have achieved impressive success, building their 30% market share from virtually zero 15 years ago mainly by delivering relatively inexpensive cars to a large number of first-time car buyers. They also are closing the quality gap with their international peers in surveys such as the J.D. Power and Associates Initial Quality Survey, although a gap still remains.

But their share has remained relatively flat in the past five years. This suggests they already have plucked the low-hanging fruit in the marketplace. Further success will hinge on their ability to adapt to a more sophisticated auto market.

China is the world’s largest car market, and it’s growing rapidly. As the market expands, new opportunities also will arise for car makers. They’re currently focused almost exclusively on selling new cars. But as the number of cars in circulation increases, consumers will have new needs. For instance, if auto makers can help develop a used-car market, they would boost resale values, encouraging car owners to trade in their older models for newer ones more often.

However, to capitalize on all this potential, car makers need to navigate around several speed bumps. One is the possibility that Beijing may impose stricter emissions, fuel efficiency and quality standards in response to broader environmental worries. Such a move would require Chinese car makers to develop costlier engines, but without the kind of brand reputation that would allow them to offset the costs with higher car prices.

APShanghaiMotorShow

Associated Press
Visitors look at a Dongfeng EQ2050 at the Shanghai International Automobile Industry Exhibition.

Consumers also will place new demands on auto makers as they become more sophisticated shoppers. While earlier generations of car buyers tended to focus mainly on exterior styling, today’s buyers are paying more attention to safety features and the overall driving experience. Today’s buyers also seek better customer service both in the showroom and in the dealer’s garage after a purchase. Chinese car makers still lag their foreign competitors in providing such after-sales service.

Another competitive threat is that foreign car makers increasingly are muscling into the budget-car segment traditionally dominated by domestic manufacturers. This will accelerate as the foreign companies boost their presence in lower-tier cities where budget buying is more prevalent.

Compounding all of these challenges is the declining profitability of domestic car makers. Although the demand is huge, local firms don’t always meet that demand in the most efficient way, and produce too many models that aren’t quite right for Chinese auto consumers while being costly to manufacture. Narrower profit margins and less support from local governments will make it ever harder for companies to invest in developing new products.

None of these challenges is insurmountable, but car makers will need to act quickly to address them. They should focus on three areas when doing so.

Especially with lower profitability eating into R&D budgets, car makers need to focus on delivering cars consumers want, and only cars consumers want. One problem has been the strategy of underpricing and overdelivering on starter cars. Almost all China-branded budget cars include expensive features such as anti-lock braking systems and luxury touches such as leather seats that consumers don’t really want at that level anyway. Car makers should invest more heavily in market research to understand their consumers.

Also on the theme of efficient investment, Chinese car makers need to be more willing to collaborate with other companies, including their competitors. It’s not unheard of for competing car companies in the West to strike deals whereby, say, one offers to the other a license on one technology in exchange for a license to use one of the second company’s technologies. China’s GAC and Chery recently signed such a three-year agreement to collaborate on certain R&D projects, but in general domestic firms still are too unwilling to work together with their peers.

Finally, car makers need a change in product strategy. They still offer too many models in a futile attempt to be all things to all consumers. Chery, for instance, offers 10 models but only three sold more than 40,000 units in 2012, and those three accounted for 76% of total sales volume. Focusing on such winners will reduce costs by cutting down on manufacture of cars no one wants to buy, and also enable much higher R&D spending to improve models consumers do want.

China’s auto makers have made great strides in a short period of time. But if they hope to compete with international players, even on their own turf, they’ll need to rethink how they design, build and market cars. Opportunities abound. New customers and new businesses are waiting to be created. The market is theirs to lose.

Messrs. Wang, Gao and Krieger are partners with McKinsey & Company’s automotive practice in China.