Trump’s Tariffs

On March 26, President Trump imposed 25% tariffs on “all imported vehicles and parts.” The tariffs go into effect April 2, perhaps with an eye to the irony of imposing them on April 1. Mr. Trump comments,

“You’re going to see prices going down, but going to go down specifically because they’re going to buy what we’re doing, incentivizing companies to—and even countries—companies to come into America,” he said at the event. 

The next day the Wall Street Journal reported on a phone call from Mr. Trump to auto executives. He

… issued a warning: They better not raise car prices because of tariffs.

Trump told the executives that the White House would look unfavorably on such a move, leaving some of them rattled and worried they would face punishment if they increased prices, people with knowledge of the call said. 

This makes no sense at all. The entire point of tariffs is to raise prices. Initially the price of imports will rise. That will reduce import quantities. To handle the resulting excess demand, automakers will  raise prices.

The Wall Street Journal has an excellent presentation that breaks down imports by model, country, market share, and bilateral trade balance for the major countries exporting to the US.

Here’s a simple model of imports and tariffs.

Autarky

Under autarky, a country consumes only what it produces domestically. There is no interaction with the rest of the world. In this case, US buyers would only buy cars made in the US. (I’ll add that today this includes quite a few “foreign” cars now made here. The simple supply-demand model tells us what market equilibrium will look like:

(click for larger image)

We know this market is not perfectly competitive because the supply curve slopes upward. Which is appropriate for the U.S. car market until 1957. P_a is the autarky price of a car and Q_a is the quantity produced and bought.

The First Imports

Let’s hear Toyota’s story:

In August 1957, Toyota sent three ambassadors to Los Angeles to survey the US market. They arrived ahead of the first two Crown models, which docked in California on 25 August (see below). In compliance with local law, headlights and other safety features suitable for this left-hand drive market were fitted after arrival. Two months later, on 31 October 1957, Toyota Motor Sales (TMS) was established in a former Rambler dealership in Hollywood.

And the car was a doozy: the Toyopet Crown:

Fig02 Toyopet Crown

Anyone interested in the full history should follow the link above. Here, however, we’re interested in the economics.

International trade

From now on certain subscripts have specific meanings:

h: the home economy
g: the global economy
t: the amount of the tariff
s: quantity supplied
d: quantity demanded

For example, Q_sht is the quantity supplied by the home country with a tariff.

The standard model of international trade adds the global supply curve to the autarky model above:

(click for larger image)

The global supply is the horizontal line at P_g. At that price, US buyers will purchase Q_dh cars and domestic producers will produce Q_sh vehicles. The difference Q_dh − Q_sh will be imported.

The implicit assumption is that the global price (P_g) is less than the home country autarky price (P_a). If the global price was above the autarky price, there would be zero units imported.  The horizontal supply curve implies perfectly competitive import supply. In most markets, that makes sense.  The global economy is huge. This is the source of a common recommendation for antitrust regulators:

To get more competition into a home market, the cheapest way is to open the market to international competition.

Tariffs

Now let’s add a tariff. This tariff is a specific tariff, a charge based on the quantity imported. The alternative, an ad valorem tariff, charges a tax based on the dollar value of the quantity of the imported product. The analysis is similar, but the ad valorem price line will not be horizontal.

(click for larger image)

The tariff works by raising the domestic price of the imports. Those efficient domestic producers who sold their produce at P_g will, of course, raise their price to P_gt. Not doing that would be leaving money on the table. Demand falls to Q_dht and supply increases to Q_sht. The quantity of imports falls, but consumers pay a higher price. I could show how this leads to a decrease in economic welfare, but I’ll postpone that for another day.

What About Pres. Trump’s Request?

We can now see the difficulty presented by President Trump’s request that the automakers not raise prices. Tariffs only work by raising prices. Does he really mean the domestic producers must lower their price to P_g? That would actually reduce domestic production (to Q_sh) and increase domestic demand. But imports must charge P_gt. The demand for domestically produced cars will be Q_dh. There will be excess demand that will not be filled by imports. That means there must be non-price rationing. Scarce cars must still be sold, but there is more demand than available cars. Here are common solutions:

1. Queuing, keeping a list of potential buyers sequenced by when they placed the order. The enterprising car dealer will demand a deposit to keep their spot in the queue. $10,000 seems like a reasonable amount.
2. Favored customers are folks that the seller likes for whatever reason. They might be old pals, frequent buyers, college roommates, members of a social organization, or any other reason.
3. Required add-on item is something the seller forces you to buy before you can buy a car. During the gasoline shortages of the 1970s, an enterprising gas station owner told customers they could buy all the gas they wanted, but first they would have to buy a Teddy bear. The price was a modest $50. (That’s about $350 in today’s dollars.)

You get the idea. And it’s as old as the field of economics. Scarce products must be rationed somehow. Price rationing is pretty efficient because changing prices is easy so excess supply or demand can be quickly offset.

Conclusion

President Trump’s attempt to keep prices down has been roundly mocked by virtually every economist worthy of the title. Those who believe tariffs will not raise prices (including Peter Navarro, written about frequently here) should turn in their economist union cards. There will be a ritual burning of all submitted cards at Stanford in a month. Contact me for details.