Do Japanese automakers maximize profits? A systems analysis of the pricing of automobile inventories

American Economist, Fall, 1996 by Catherine C. Langlois

Introduction

This paper investigates the pricing practices of Japanese automakers on the U.S. market of the 1980s. Japanese companies are often pictured as seeking market share rather than profitability, and using pricing to achieve that goal. If such behavior is to be confirmed, it is necessary to compare prices set by the Japanese to the prices they would want to set if they were to maximize short run profit. This is the objective of the paper. Empirical tests of aggregate Japanese automaker behavior are performed using quarterly data over the decade of the eighties. These tests suggest that the Japanese were pricing to maximize short run profit during that period. The eighties were marked by switches in circumstance and product mix. In particular, Voluntary Export Restraints imposed in 1981 limited Japanese exports to the United States until 1987 when the yen's appreciation made production in the United States just as cost effective as production in Japan. However, the development of Japanese transplant capacity in the U.S. provides us with data to test the pricing behavior of a Japanese automaker in the absence of any constraint resulting from trade restrictions: By the latter part of the eighties, Honda's productive activities in the United States had developed sufficiently for U.S. operations (hereafter Honda U.S.) to be considered in isolation. This allowed for an examination of the pricing practices adopted by Honda U.S. in the latter part of the 1980's using monthly data. These tests find Honda U.S. to also be pricing to maximize short run profit, thus providing confirmation of the results obtained, over the decade of the eighties, for Japanese automakers taken as a whole. The first part of this paper discusses the issue of Japanese competition on U.S. markets, while part two outlines the methodology used to test for short run profit maximization on the part of the Japanese. Finally part three presents the empirical evidence.

1. The Issue of Japanese Competition

Japanese penetration of world markets is a theme of central importance in international business. The market for automobiles in the United States is a case in point. In 1971, the Big Four Japanese automakers; Honda, Nissan, Toyota and Mazda held a negligible share of the United States (U.S.) domestic automobile market. According to Ward's Automotive Yearbooks, by 1990, combined car sales of these four companies exceeded two million units in the United States, and represented 26.8% of the U.S. domestic car market.(1) Such rapid market penetration has raised questions about Japanese and U.S. pricing practices. As conventional wisdom would have it, "Detroit is following the old rule: charge whatever the traffic will bear . . . maximize profits on each car sold rather than sell more cars" (Wall Street Journal January 8, 1985) while Japanese firms may be "ignoring profits while pouring all their resources into expansion" (van Wolferen, 1990, p. 397). In this paper we ask: Is it true that Japanese automakers are sacrificing short run profits to achieve market share? Or could it be that Japanese market penetration is compatible with short run profit maximizing prices?

Japanese car makers arrived on the U.S. market with a distinct price advantage. While the average Chrysler was priced at $8,496 in 1982, the average Japanese import cost only $7,210 to the American consumer. And Chrysler automobiles were cheaper on average than cars produced by Ford or General Motors (GM) in 1982. By 1990 the average Japanese import was priced at $14,312. The Japanese had increased prices almost two fold, but they were still ahead in the pricing game with the average Chrysler (still cheaper than a Ford or a GM in 1990) costing $15,433. Such average price differences are, at least partly, explained by differences in product mix across companies. Yet, facts such as these have been used to support the hypothesis that Japan's primary goal on foreign markets is to gain market share. Blinder [1992] claims that managers of large Japanese firms are willing to "sacrifice profits indefinitely for the sake of greater size." His hypothesis is based on anecdotal evidence, as is much of the evidence against the standard assumption of profit maximization for Japanese firms, and it makes reference to return on equity rather than any other measure of profitability. It has also been shown that Japanese automakers vary profit margins to compensate for currency fluctuations (see for example Marston [1990] and Feenstra [1988b]). Preserving market share is assumed to be the motive for such "pricing to market" behavior. But Ohnoe [1990] shows in a duopoly model that pricing to market is consistent with profit maximization if the duopolists do not discount the future too much. Ohnoe's work suggests compatibility between profit maximization and the observed growth in Japanese automaker's market share.

The fact that Japanese exports were limited under the Voluntary Export Restraint (VER) agreements reached in 1981 and revised in 1983 certainly limits the extent to which market share maximizing behavior can be reflected in actual market share growth for Japanese automakers. Thus, until the yen's appreciation made manufacturing in the United States just as cost effective as manufacturing at home, Japanese market penetration is limited by the VERs. But this does not mean that the issue of pricing strategy is moot. Indeed, the Japanese could price below profit maximizing levels prior to 1987 in anticipation of increased productive capacity in the United States and the possibility to bypass the VERs by producing locally. Or they could price to maximize short run profit made on the limited supply of Japanese cars prior to 1987. It is well documented that VERs led to quality upgrading by Japanese automakers, and this increased prices (Feenstra [1988a]). But Feenstra (Feenstra [1987]) also documents that the trade restraint, by creating an artificial shortage, did have an upward effect on Japanese car prices over and above the price rises that are attributable to quality upgrading. Nevertheless, Japanese car prices on average are lower than those practiced by the Big Three, and although this is due at least in part to product mix differences, it could also be pointing to a pricing policy that favors market penetration. The low prices practiced by the Japanese, at least in the early 1980s, may also reflect a perceived need by Japanese automakers to compensate for such factors as a relative lack of image in the U.S., or consumer concern over spare parts availability. Such factors would determine a shift inward and a possible flattening of demand for the Japanese product as compared to an equivalent U.S. product. If this were the case, low pricing by the Japanese would be a response to the particular demand conditions they faced, and could well be profit maximizing in the face of demand conditions that were less favorable than those enjoyed by their U.S. rivals. But profit maximization also requires that costs be taken into account.