President Trump’s new tariffs on cars will raise prices and also reduce hard information about car deals. Even astute car dealers may be confused, and consumers have little chance of understanding what is really happening when they buy a new car—except prices are higher. In many cases, though, car dealers will enjoy higher profit margins.
The economics of tariffs is well understood by economists—until the specific details of a transaction are considered. The deeper one goes into the arcane world of car manufacturers’ terms of sale, the more complicated pricing becomes. But we can get a solid understanding that reaches two conclusions: car buyers will pay more, and dealer profit margins for U.S.-made automobiles will increase.
The Basic Economics Of Tariffs
Take a simple situation, in which American-made products compete against comparable imported goods. In the United States, about 60% of new cars are assembled in the U.S. and the rest imported. A tariff on imports has several effects. First, some foreign manufacturers would accept lower pre-tariff prices to prevent too steep a sales decline. They would likely continue to cover their variable costs, such as the cost of materials and direct labor required to make a car. They would not meet their previous profit margin, and possibly not even their fixed costs. Generally, we expect most but not all of the tariff to be passed through to consumers. The specific amount passed through depends on consumers’ demand elasticity as well as the cost structure of the manufacturers.
The second effect would be that prices facing American buyers for imported cars would rise. This price increase would equal that portion of the tariff that foreign manufacturers do not absorb, probably well over half.
The third impact will be a price hike for American-made cars. (And note that the nameplate—Ford or Fiat—does not tell us where the car was actually assembled.) The rise in domestic car prices results from what economists call “The Law of One Price,” which states that two similar products sold in the same market will trade at the same price. In simple terms, the sellers of domestic cars will raise their prices because they can. If they did not, nobody would buy the imported cars; everyone would buy the domestic cars. This is one reason that foreign manufacturers will cut their prices somewhat. Domestic prices will rise because manufacturers will not be able to serve all buyers at their previous, pre-tariff prices. The primary way to ration the excess demand is to raise prices. (Below we consider President Trump’s admonition to car companies not to raise their prices.)
With higher prices for new domestic and imported cars, used car prices will rise. Some car buyers are on the fence between a new car and a late-model used car. Higher prices on new cars will tip them toward used. The used car price increases will be highest for the most recent used cars. Very old used cars will see a much smaller price increase.
Economists have studied tariffs for over 200 years, and this description reflects a very strong consensus. But we can add further information for a more accurate—and complicated—conclusion.
Tariffs On Materials Used In Domestic Production
The complete tariff policy of the Trump administration will likely change after this writing, but here we consider tariffs on imported materials used by domestic manufacturers. In some cases, car makers use imported steel and aluminum. They may also import whole engines, transmissions and other components.
The foreign companies that sell the materials may eat some of the tariffs themselves. This will be more common for complicated manufactured products, such as engines, and less common for commodities, such as steel. Commodity producers can route their materials to countries without tariffs, or with lower tariffs. A company that makes a particular type of engine may not have good options, in the short-run, to sell engines somewhere else. That business would be more likely to pay some of the tariff themselv, especially in the short run.
With higher costs of production, domestic manufacturers would pass some or all of their tariff expense on to consumers. With a tariff on imported cars at the same time, a higher percentage of the materials tariff would be passed on to buyers.
The tariff on input materials further adds to the increase in domestic car prices that the car-specific tariff would trigger. The price increase for domestic cars would enable foreign producers to pass on to consumers more of their tariffs.
Domestic Car Prices Cannot Be Kept From Increasing
President Trump told car manufacturers not to raise their prices after he imposes tariffs. Although the president may not have authority to enforce that request, he certainly can make life very unpleasant for companies that ignore him. But here is where complications arise.
When a car dealer buys a vehicle from the manufacturer, the deal is very complicated. We begin with an invoice price, which sounds simple. This is a price that dealers may show to customers to emphasize the low profit margins.
However, “dealer holdback” is the common practice whereby a discount of two to three percent is provided to the dealer some months after the transaction. The sales person at the car lot can show an invoice price but conceal this kickback. The holdback percentage varies with the make and model of the vehicle, and not all manufacturers offer it.
Some manufacturers offer floor plan assistance. This is a short-term loan to enable the dealer to buy cars that will be available to consumers for immediate purchase. The manufacturer can help the dealer by offering a below-market interest rate.
“Factory to dealer incentives” give further discounts to dealers for specific makes and models. They come and go as the manufacturer needs to move certain products.
Most manufacturers run cooperative advertising programs. They encourage dealers to advertise the brand, and they may want dealer support for regional or national advertising. This is another movement of money between manufacturers and dealers.
Volume bonuses are paid to dealers by manufacturers when they want to move a particular make or model car. “Dealer cash” is another program that manufacturers use to incent dealers to sell particular models.
Destination charges are typically shrugged off by consumers as a necessary expense, representing transportation charges as the vehicle moves from factory to dealer. But they may exceed actual costs, another way to add to manufacturer revenue without increasing invoice prices.
Speaking to car dealers recently, I said, “I’m just a simple boy with a Ph.D. in economics. Your deals with manufacturers are too complicated for me.”
The bottom line is that dealers can conform to the president’s request for them not to raise prices, while raising prices in a myriad of obscure ways.
Dealer Profit Margins Will Rise On Domestic Cars
Car dealers will face significant changes, some positive and some negative. Dealer margins on domestic products will certainly increase. Prices will rise so that the quantity demanded matches the supply. Manufacturers will capture some of the higher price, but pressure from the White House will probably prevent them from pushing prices all the way up to the market-clearing level. That will leave dealers to allocate the limited supply. They will forget about all of the discounts that have been offered to buyers in the past. They won’t discount from the manufacturer’s suggested retail price and will even add additional margin. They may bundle a basic car with dealer-supplied add-ons, with no bare-bones alternative available.
Foreign-made cars brought in before tariffs will be priced high, generating high dealer profits. But some dealers will have committed to buying cars only to learn that the vehicles have tariffs slapped on them, sometimes while the ship is anchored waiting to unload. Dealers will probably take a loss on those cars. And if they have to keep some tariffed cars in stock, because that is their brand, they will have to accept low profit margins.
Dealers with plenty of late-model used cars in stock will enjoy the tariffs, which will enable them to boost their prices.
Getting the right mix of cars on the lot will be critical for car dealers’ success.
Tariffs On Cars: Conclusion
President Trump’s tariffs on imported cars and light trucks, combined with general tariffs that include materials used to make cars, will raise prices that buyers face, whether they are buying foreign or domestic cars, or even used cars.
Dealer profit margins will increase on domestically-produced cars, but drop on imports. Dealers with late-model used cars on their lots will pocket extra cash.