What do a Ford Transit Connect, Subaru BRAT, and VW have in common?

"E. Julius" (soonerfrommi) 12/16/2014 at 22:56 • Filed to: Random

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Here's a paper I wrote about a year ago on the subject of the infamous "Chicken Tax" and some of the vehicles it affects. The assignment was to take an "economic enigma" and explain it using the ideas we'd covered in my intermediate microeconomics class. Looking back at it now, there's definitely some things I would improve with the writing, but I'll just go ahead and publish it in unedited form. Footnotes were deleted, but those were just citations.

For what it's worth, the professor selected it as a top 3 paper and the class voted mine the best, netting me $30 in Starbucks gift cards.

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The Chicken Tax

In 2012, Ford Motor Company sold 35,216 Transit Connect cargo vans in the United States . Each one of these common commercial vehicles started its life at a Ford factory in Turkey, equipped with carpet, seats, and windows for passengers who will never occupy it. These vehicles are then shipped to Baltimore, where, after being approved by U.S. Customs officials for importation, they are immediately taken to a contractor's facility and stripped of all passenger trim in eleven minutes. The workers there replace the floor and windows with metal panels and remove the seats entirely. Only after this process will these vehicles be sold to American customers, exclusively as cargo vans. This ostensibly superfluous process exists for one reason: to circumvent what is known as the "chicken tax" .

Ford and other automobile manufacturers have been using schemes such as the one just described to circumvent this tax for decades. Naturally this curious practice evokes a number of questions: why do companies do this? Why does this tax exist? Why have auto manufacturers made no use of their immense political power to change this tax? While confusing at first glance, this situation and all of the attendant questions can be explained using the basic tools of microeconomics.

To begin with, one must know why firms such as Ford go to these lengths. The answer is simple: cost. Light trucks, the classification that a bare Transit Connect falls into, are subjected to a 25% value added tariff, as opposed to 2.5% for passenger vehicles. This means that despite spending hundreds of dollars per vehicle on this conversion process, the savings for Ford are in the thousands. This includes other costs, such as the higher price of shipping heavier vehicles, and the construction and installation of the interior fittings (which are actually cheaper to ship to Ohio and recycle than to ship back to Turkey to be reinstalled) .

Obviously it does not take a degree in economics to understand that it is advantageous for companies to minimize costs at a particular level of output, but economic principles can help explain why firms do not take other courses of action. For example, why does Ford choose to manufacture these vehicles overseas given its substantial domestic manufacturing capacity? This can be explained using the economic concepts of demand and costs combined with an understanding of the market for this particular product.

Historically, small commercial vans such as the Transit Connect have been more popular in Europe, given the denser population and smaller roads. It follows then that Ford would want to place manufacturing facilities close to the large European market to minimize transportation costs, and locations such as Turkey offer cheap labor compared to American workers. The reason Ford chooses to forgo any sort of domestic manufacturing could perhaps be for reasons of flexibility. In the current arrangement, selling the Transit Connect in America involves a number of labor costs; the vans must be shipped and converted, parts must be recycled, and of course on top of that the 2.5% tax must be paid. Producing the vans domestically would shift a number of these costs from labor to capital, in the form of manufacturing facilities or production line retooling. This would mean that overall, Ford would have a lesser ability to change costs in the short run, something that they may value given the relative volatility of demand for these vehicles in the American market compared to the European market.

All of this of course makes one wonder why this tax exists in the first place. Officially, the "chicken tax" is a tariff that was created by President Lyndon B. Johnson in 1963 with an executive order, Proclamation 3564 . In this act tariffs were levied on potato starch, brandy, dextrin, and of course light trucks. It was issued in response to heavy European tariffs on chicken, which were themselves responses to a dramatic upheaval of the market for chicken caused by the introduction of factory farming techniques in America. As a result of this tariff, foreign auto manufacturers pulled a number of previously successful products from the American market, most notably the commercial version of Volkswagen's Type 2 van.

The intended effect of this tariff was of course to compensate for the losses of the agricultural sector by shifting more automobile sales toward American manufacturers. In this regard the tariff was initially successful, however, much like Ford would do later, the tariff was countered by a number of foreign companies in the subsequent decades. For example, in the 1970's Subaru's BRAT truck came with two removable plastic seats in the bed to classify it as a passenger vehicle. Other manufacturers such as Mazda exploited a now–closed loophole that exempted trucks with no bed from the tax.

Over time, the other components of the tariff were repealed, but the section regarding automobiles stayed in place. So, given that the modern globalized economy complicates the application of the tariff, illustrated by its effects on Ford's ability to sell its vehicles in its home country, and the fact that the tariff is frequently circumvented, why does it still exist? This question can be answered perfectly using more of the tools of microeconomics.

Since the automobile market is an oligopoly, it can be very effectively analyzed using the tools of game theory. In this case, one assumes that as very large firms American automobile manufacturers have some ability to manipulate the political process. One can then consider any efforts to have the tariff repealed or modified to be a decision that the firms face. Even today the tariff has a large effect, substantially impacting production decisions and, in many cases, becoming the deciding factor in competitor firms' decisions to sell a product in the United States or not. For these reasons, this situation can be considered analogous to an "Entry Prevention" game. Therefore it should be observed that American companies follow the strategy prescribed by the game: lobby for retaining the tariff, thereby deterring the entry of foreign firms until it is more costly for them to do so than to allow competitors to enter the market. This matches up quite well with what has actually happened, both historically and in the present day.

When the tariff was originally introduced, almost all vehicles made by American companies for domestic sale were produced in American factories, thus the tariff had the intended and actual effect of increasing foreign competitors' costs, strengthening the American companies; this situation persisted into the next decade. At this time, as the commercial and diplomatic climate that originally brought the tariff about faded into history during the 1970s, Americans were demanding more foreign automobiles than ever before. One would think that given these conditions it would be a popular move to repeal the tariff, but, not wanting to lose a competitive advantage, American firms successfully lobbied against any movements to do so.

Continuing into the 1980s, advancements in communication and logistical technology, in concert with the large–scale trend toward globalization, had allowed very large firms such as Ford to spread manufacturing capacity around the world. This set the stage for American companies being increasingly subjected to the tariff that was originally intended to strengthen them. This apparent conflict of interest of course continues into the present day, but as long as it is in the American firms' best interest to maintain the barriers to competition they will continue to do so.

The American automobile industry's complacency with a long outmoded tariff and the Transit Connect's idiosyncratic supply chain are both results of the same fundamental force that motivates all business decisions: profit maximization. For this reason, the principles of microeconomics serve as an excellent analytical tool. This is vindicated by the fact that what has been observed is aligned with the prediction this analysis offers. Most importantly, however, once these tools are applied it becomes apparent that these enigmas are not enigmas at all.