John Bridgeman, the Director General of Fair Trading, referred the pounds 24bn industry to the Monopolies and Mergers Commission after finding evidence of anti-competitive practices.
The MMC will look at the huge differences in prices between the UK and the Continent, and the exclusive relationships between car makers and dealers allowed under European competition rules.
Mr Bridgeman criticised the recommended resale price (RRP) mechanism which he said led to higher prices and subsidised inefficient dealers.
He said people were paying too much for their cars because dealers were unable to negotiate discounts for bulk purchases in the same way as fleet managers.
Mr Bridgeman also launched an attack on the industry for its "dilatory and uncooperative" response to his investigation. He warned that from next month he would be able to prosecute anyone who blocked an Office of Fair Trading inquiry.
"It is clear the market isn't working properly and that there is an imbalance of power between manufacturers and dealers which is distorting competition," Mr Bridgeman said.
"This is characterised by suppliers' continued refusal to give volume discounts to dealers which could be passed on to the consumer as lower prices, and by other practices designed to exert a strong influence over selling prices."
"I believe that this, coupled with a general reduction in basic dealer margins and a greater emphasis on discretionary bonuses, is limiting the ability of dealers to offer consumers lower prices."
The MMC should consider whether the practice of RRPs should be outlawed in the same way it was abolished for electrical goods, he said.
The motor industry said it would co-operate fully with the MMC inquiry, saying manufacturers and dealers "had nothing to hide". The Society of Motor Manufacturers and Traders said the European market was "highly regulated and competitive" and the industry worked within UK and European rules.
The Prime Minister's official spokesman said the Government welcomed the decision. "Hopefully it will lead to a better deal for British consumers in line with the approach we intend to take on this."
The Consumers' Association said the "cosy" relationship between manufacturers and dealers produced unjustifiably high prices for UK consumers. "We will show the MMC inquiry our detailed evidence of the scale of the problem as part of our campaign to end the great British rip-off," said its director Sheila McKechnie.
Retail car dealerships said the inquiry would ease the stranglehold that motor manufacturers had on prices. The National Franchised Dealerships Association said ordinary motorists were being charged more to subsidise fleet car sales.
The MMC's inquiry, which will take nine months, is the second investigation by the commission into the industry in nine years.
Next year the member states of the European Commission start to negotiate the motor industry's block exemption from the competition rules under the Treaty of Rome. The exemption, which was last ratified in 1995, expires in 2002 and MPs say it should not be renewed.Mr Bridgeman's investigation follows a number of surveys showing that many new cars are far cheaper in Europe than they are in the UK.
Outlook, page 21
Where to drive a bargain
Country Renault Ford BMW
Clio1.2 Fiesta1.2 520i
Austria 13,803 10,030 35,172
Belgium 12,115 8,723 31,169
France 12,874 9,590 30,950
Germany 12,638 10,358 29,757
Netherlands 15,378 10,508 37,181
Ireland 16,748 13,631 39,425
Italy 11,483 9,038 31,183
Luxembourg 11,514 8,723 29,375
Portugal 11,389 10,103 38,432
Spain 12,912 8,698 31,517
UK 14,112 10,858 32,201
Source: European Commission
Prices in pounds as at May 1 1998. Converted into euros at rates fixed on January 1. UK floating rate as at 1 January.Reuse content