US – Japanese Auto Makers Competition
and the Dollar in the 1980s.
(Copyright: Nouriel Roubini and David Backus, Stern School of Economics, New York University, 1997.)
I. Introduction.
We will discuss the role of exchange rate in the competition between US and Japanese car makers in
the 1980s. To understand the importance of exchange rate note that the dollar had a dramatic
appreciation between 1980 and 1985 and a major depreciation from 1985 to 1989. Specifically, the
corresponding exchange rates were:
1980:
1984:
1989:
Yen / Dollar = 200, Dollars / Yen = 0,005
Yen / Dollar = 250, Dollars / Yen = 0,004
Yen / Dollar = 139, Dollars / Yen = 0,0072
The data above show that the $ appreciated relative to the Yen by 20% between 1980 and 1984 and
depreciated relative to the Yen by 44% between 1984 and 1989.
Let us consider now the effects of exchange rate on the pricing policies of domestic (US) and foreign
(Japanese) car makers. Consider the competition in the car industry in 1980. Let us suppose that the
prices of American and Japanese cars in 1980s were:
Price of a U.S. car in the U.S. in Dollars:
Price of a Japanese car in Japan in Yen:
$10.000.
2 million Yen.
These numbers are not exact but are used here for the sake of the exercise. Since the price of a good is
equal to the cost of production times the gross profit margin (the mark-up rate, m)
2m Yen = (1 + profit margin) x (production cost) = (1+ m) x C = (1+ 0,2) x 1,66
when
m = 0,2 (= 2/1,66 -1) = 20%
C = 1,66m Yen (production costs, mostly wages).
The price of a Japanese car exported to the U.S. in Dollars, given the exchange rate of 1980 was then:
$ 10.000 = 2m Yen x 0,005 = 2m Yen / 200
II. Response to the appreciation of the Dollar between 1980 and 1984.
Suppose that the dollar appreciates by 20%, as it did between 1980 and 1984. Japanese exporters have
now two options:
1. Since the dollar has appreciated, they can maintain their Yen prices (2m Yen) and sell the car at a
much lower price in the U.S. in this case:
$ 8.000 = 2m Yen x 0,004 = 2m Yen / 250
In this case, the appreciation of the dollar reduces the competitiveness of US cars since now you can
import the Japanese cars at a much lower price (20% lower). This loss of competitiveness is the typical
effect of a domestic currency appreciation: imported goods become cheaper than domestic goods
and the trade balance will worsen as we buy more foreign goods.
So, in this case a 20% appreciation makes foreign good 20% cheaper in the US: there is a full passthrough of the exchange rate to the domestic (US) price of imported goods. From the Japanese point
of view, selling cars in the US at $8.000 (with the exchange rate at 250) means that they receive in Yen a
revenue of 2m Yen so that their profit margins remain the same as before (m = 20%). While their profit
margins are not increasing, the benefit of reducing the $ price of cars in the US is that Japanese cars
become cheaper, their demand is higher and the market share of the Japanese in the US market
becomes larger.
Note: This is a case where the PPP (purchasing power parity) does not hold since the price of US cars ($10.000) is different from the
price of Japanese cars ($8.000). Such a failure of PPP is not surprising since the two goods, American and Japanese cars, are not
homogenous so that the consumers do not consider the two goods as being perfectly substitutable in demand. If the two goods were
homogenous (as in the case of raw materials, oil, gold, agricultural goods) then we would expect that the PPP would hold for them.
2. The second option for the Japanese following the appreciation of the dollar would have been to
maintain the $ dollar price of the cars sold in the US at $10.000 in spite of the appreciation of the $.
This option implied that the Japanese cars would not become cheaper than US cars and therefore the
Japanese would not gain market shares in the US. However, the benefit of the strategy was that by
selling at $ 10.000, the profit margin of the Japanese car makers would increase a lot. In fact in this case
the revenue in Yen of the sale of a car in the US would be:
2,5m Yen = $10.000 / 0,004 = $ 10.000 x 250
Since Japanese cars sold in Japan would still be priced at 2m Yen while Japanese cars sold in the US
would have a value in Yen equal to 2,5m Yen, the Japanese would have much larger profit margins on
their US sales. Such a profit margin is equal to the Yen revenue of a US sale divided by the cost of
production (C):
Profit margin on the sale of a Japanese car in the US:
2,5/1,66 -1 = 0,51 (51 %)
Profit margin on the sale of a Japanese car in Japan:
2,0/1,66 - 1 = 0,2 (20 %)
Note that this second strategy implied that the Law of One Price would not hold since the price of the
same good is different in two different marktes: the price of a Japanese car in the US ($10.000 = 2,5m
Yen) would be much larger than the price of a Japanese car in Japan (2,0m Yen). So, for the second
scheme to work it is necessary that you can price discriminate across markets. Otherwise, it would have
been optimal for someone to buy Japanese cars in Japan and sell them for less than $10.000 in the US.
Of course a third option that is in between the first two is possible as well: cut somewhat the $ price of
Japanese cars in the US below $10.000 but not by the full 20% $ appreciation. In this middle case, profit
margin would increase somewhat (but not as much as in option 2) and market share will increase as
well (but not as much as in option 1).
In the 1980-1984, Japanese car makers followed mostly the second option (that significantly increased
their profit margins). In fact, the quotas on Japanese car exports to the US introduced in 1981 (VER =
Voluntary Export Restrictions) implied that the first strategy was not optimal since the quotas did not
allow Japanese car makers to increase their market share in the US. Actually, given the presence of
numerical quotas on the number of cars to be exported to the US, Japanese car makers moved to
upgrade the quality of their car exports to the US (sell higher value added, higher price, higher quality
cars).
III. Response to the depreciation of the Dollar between 1984 and 1989.
While US car makers lost competitiveness in the 1980-84 period of $ appreciation, they regained it in the
1985-1989 period in which the dollar depreciated by 44% (the Yen/$ rate went from 250 to 139).
Suppose that in 1985, the $ price of Japanese cars was still $10.000 as Japanese car makers followed
option 2 in the 1980-84 period; suppose also that US cars in the US were also sold at $ 10.000.
What were the possible strategies to be followed by Japanese car makers given the $ depreciation and
what effects would they have on market shares and profit margins?