1. Objectives: Analyze effects of a tariff on a foreign monopolist exporter; similar to the large-country case in Chapter 8.

2. Foreign Monopoly
For simplicity, assume the Foreign firm sells only in the Home market and that there is no Home competitor.
a. Free-Trade Equilibrium
Foreign firm exports the quantity where MR = MC (assumed constant), so P > MC.
b. Effect of a Tariff on Home Price
The tariff raises MC. Exports fall. Price increases, but by less than the tariff (assuming that MR is steeper than demand), so the price net-of-tariff falls: Home enjoys an improvement of its terms-of-trade.
c. Summary: Intuitively, the firm allows the Home price to increase by less than the tariff, in order to reduce the reduction in exports.
d. Effect of the Tariff on Home Welfare: Consumer surplus falls, tariff revenue increases, (with no effect on Home producer surplus), but there is a net welfare loss. Part of the tariff is being paid by the Foreign firm because the net-of-tariff price it receives has decreased. This is a TOT gain similar to that in Chapter 8. It follows that, if the gain in tariff revenue from the Foreign firm exceeds the deadweight loss, then the tariff will increase Home welfare; there is an optimal tariff here too.

They are so habituated to the linear case that this might require a little explanation.

Highlight this analogy. Use it to infer that there must also be a TOT gain to partially offset the loss in consumer surplus.

Do foreign exporters actually absorb part of the tariff in order to reduce the increase in Home prices? Case study: U.S. tariff of 25 percent on Japanese trucks since the 1980s. Only about 60 percent of the tariff was passed through to American consumers; the rest was absorbed by Japanese automakers. There is a substantial TOT benefit, so this is an example of a strategic trade policy that might improve U.S. welfare.

This is a great story to tell in class.

Import Tariffs on Japanese Trucks

We have found that in the case of a Foreign monopolist, Home will experience a terms-of-trade gain from a small tariff. The reason for this gain is that the Foreign firm will lower its net-of-tariff price to avoid too large an increase in the price paid by consumers in the importing country. To what extent do Foreign exporters actually behave that way?

To answer this question, we can look at the effects of the 25% tariff on imported Japanese compact trucks imposed by the United States in the early 1980s and still in place today. The history of how this tariff came to be applied is an interesting story. Recall from the application earlier in the chapter that in 1980 the United Automobile Workers and Ford Motor Company applied for a tariff under Article XIX of the GATT and Section 201 of U.S. trade law. They were turned down for the tariff, however, because the International Trade Commission determined that the U.S. recession was a more important cause of injury in the auto industry than growing imports. For cars, the “voluntary” export restraint (VER) with Japan was pursued. But for compact trucks imported from Japan, it turned out that another form of protection was available.

At that time, most compact trucks from Japan were imported as cab/chassis with some final assembly needed. These were classified as “parts of trucks,” which carried a tariff rate of only 4%. But another category of truck—“complete or unfinished trucks”—faced a tariff rate of 25%. That unusually high tariff was a result of the “chicken war” between the United States and West Germany in 1962. At that time, Germany joined the European Economic Community (EEC) and was required to adjust its external tariffs to match those of the other EEC countries. This adjustment resulted in an increase in its tariff on imported U.S. poultry. In retaliation, the United States increased its tariffs on trucks and other products, so the 25% tariff on trucks became a permanent item in the U.S. tariff code.

That tariff created an irresistible opportunity to reclassify the Japanese imports and obtain a substantial increase in the tariff, which is exactly what the U.S. Customs Service did with prodding from the U.S. Congress. Effective August 21, 1980, imported cab/chassis “parts” were reclassified as “complete or unfinished” trucks. This reclassification raised the tariff rate on all Japanese trucks from 4% to 25%, which remains in effect today.

How did Japanese exporters respond to the tariff? According to one estimate, the tariff on trucks was only partially reflected in U.S. prices: of the 21% increase, only 12% (or about 60% of the increase) was passed through to U.S. consumer prices; the other 9% (or about 40% of the increase) was absorbed by Japanese producers.7 Therefore, this tariff led to a terms-of-trade gain for the United States, as predicted by our theory: for a straight-line demand curve (as in Figure 9-7), marginal revenue is twice as steep, and the tariff will lead to an equal increase in the Home import price and decrease in the Foreign export price.8 The evidence for Japanese trucks is not too different from what we predict in that straight-line case.

Notice that the terms-of-trade gain from the tariff applied on a Foreign monopolist is similar to the terms-of-trade gain from a tariff applied by a “large” country, as we discussed in the previous chapter. In both cases, the Foreign firm or industry absorbs part of the tariff by lowering its price, which means that the Home price rises by less than the full amount of the tariff. If the terms-of-trade gain, measured by the area e in Figure 9-7 exceed the deadweight loss d, then the Home country gains from the tariff. This is our first example of strategic trade policy that leads to a potential gain for Home.

In principle, this potential gain arises from the tariff that the United States has applied on imports of compact trucks, and that is still in place today. But some economists feel that this tariff has the undesirable side effect of encouraging the U.S. automobile industry to focus on the sales of trucks, since compact trucks have higher prices because of the tariff.9 That strategy by U.S. producers can work when gasoline prices are low, so consumers are willing to buy trucks. At times of high prices, however, consumers instead want fuel-efficient cars, which have not been the focus of the American industry. So high fuel prices can lead to a surge in imports and fewer domestic sales, exactly what happened after the oil price increase of 1979 and again in 2008, just before the financial crisis. Some industry experts believe that these factors contributed to the losses faced by the American industry during the crisis, as explained in Headlines: The Chickens Have Come Home to Roost.

...and a great example to make the theory concrete.

The article recounts the strange history of the tariff on Japanese trucks, and argues that it has perverse effects on the U.S. auto industry.

The Chickens Have Come Home to Roost

Although we call them the big three automobile companies, they have basically specialized in building trucks. This left them utterly unable to respond when high gas prices shifted the market towards hybrids and more fuel efficient cars.

One reason is that Americans like to drive SUVs, minivans and small trucks when gasoline costs $1.50 to $2.00 a gallon. But another is that the profit margins have been much higher on trucks and vans because the US protects its domestic market with a twenty-five percent tariff. By contrast, the import tariff on regular automobiles is just 2.5 percent and US duties from tariffs on all imported goods are just one percent of the overall value of merchandise imports. Since many of the inputs used to assemble trucks are not subject to tariffs anywhere near 25 percent—US tariffs on all goods average only 3.5 percent—the effective protection and subsidy equivalent of this policy has been huge.

It is no wonder much of the initial foray by Japanese transplants to the US involved setting up trucks assembly plants, no wonder that Automakers only put three doors on SUVs so they can qualify as vans and no wonder that Detroit is so opposed to the US-Korea Free Trade Agreement that would eventually allow trucks built in Korea Duty-Free access to the US market.

What accounts for this distinctive treatment of trucks? An accident of history that shows how hard it is for the government to withdraw favors even when they have no sound policy justification.

It all comes down to the long forgotten chicken wars of the 1960s. In 1962, when implementing the European Common Market, the Community denied access to US chicken producers. In response after being unable to resolve the issue diplomatically, the US responded with retaliatory tariffs that included a twenty five percent tariffs on trucks that was aimed at the German Volkswagen Combi-Bus that was enjoying brisk sales in the US.

Since the trade (GATT) rules required that retaliation be applied on a nondiscriminatory basis, the tariffs were levied on all truck-type vehicles imported from all countries and have never been removed. Over time, the Germans stopped building these vehicles and today the tariffs are mainly paid on trucks coming from Asia. The tariffs have bred bad habits, steering Detroit away from building highquality automobiles towards trucks and trucklike cars that have suddenly fallen into disfavor.

If Congress wants an explanation for why the big three have been so uncompetitive it should look first at the disguised largess it has been providing them with for years. It has taken a long time—nearly 47 years—but it seems that eventually the chickens have finally come home to roost.

Source: Robert Lawrence, guest blogger on Dani Rodrik’s weblog, posted May 4, 2009. http://www.rodrik.typepad.com/dani_rodriks_weblog/2009/05/the-chickens-have-come-home-to-roost.html.