Full text of Economic Review (Federal Reserve Bank of Cleveland) : Summer 1984

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of CLEVELAND

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SUMMER

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Economic
Review
Summer 1984




The Implementation of
2
Industrial Policy ........
Proposals for a coordinated industrial policy,
designed to enhance the productivity and
competitive position of the U.S. economy,
have attracted many supporters. Industrial
policy will require the creation of an agency to
plan and execute governmental directives.
Using the American experience with national
economic planning during two World Wars and
the New Deal, economist Daniel A. Littman
discusses the ability of government to imple­
ment such a policy. The author identifies
serious problems that may frustrate govern­
ment attempts to implement an industrial
policy for the 1980s.
Voluntary Export Restraints:
The Cost of Building W a lls................. 17
At the urging of the U.S. government, the Jap­
anese restricted exports of new cars to the
United States in 1981. Designed to protect
jobs in the U.S. auto industry, these voluntary
export restraints (VERs) have done so at the
expense of American consumers. Economists
Michael F. Bryan and Owen F. Humpage
derived estimates of the restraint program’s
cost and its contribution to U.S. auto-related
employment by developing a model of the mar­
ket for Japanese cars in the United States.
The model incorporates dealers’ inventory
positions and allows for variable dealers’ mark­
ups over options-adjusted wholesale costs.
Economic Review is published quarterly by the
Research Departm ent of the Federal Reserve Bank
of Cleveland, PO. Box 6387, Cleveland, OH 44101.
Telephone: 216/579-2000.
Editor: Pat Wren. Assistant editor: Meredith Holmes.
Design: Jamie Feldman. Typesetting: Lucy Balazek.
Opinions stated in Economic Review are those of
the authors and not necessarily those of the Fed­
eral Reserve Bank of Cleveland or of the Board of
Governors of the Federal Reserve System.
M aterial may be reprinted provided that the source
is credited. Please send copies of reprinted m ateri­
als to the editor.
ISSN 0013-0281

Daniel A. Littman
is an economist
at the Federal Re­
serve Bank of Cleve­
land. The author
would like to thank
Robert Cuff, Paul
Koistinen, Barry
Mitnick, Bill Pierce,
Stephen Skowronek,
Ed Stevens, and
Gary Wyckofffor
their insightful com­
ments on drafts of
this article.

The Implementation
of Industrial Policy
by Daniel A. Littman

Federal Reserve Bank of Cleveland



A growing coalition of U.S. political, labor,
and business leaders is lobbying for a coordi­
nated interventionist national industrial
policy. This coalition advocates measures
designed to enhance the competitiveness and
productivity of the U.S. economy. The term
industrial policy means various things to var­
ious people, a fact that manifests itself in
the wide variety of policy proposals under
consideration. Industrial policy enthusiasts
agree only that the U.S. economy is expe­
riencing grave structural problems and that
the federal government has both the obliga­
tion and the capacity to implement policies to
alleviate these problems.
The industrial policy proposals range from
measures intended to enhance the long-run
efficiency of competitive markets, to steps
to allow the federal government to undertake
decisions normally handled by the private
market. Some proposals include modifi­
cations of the tax code to promote research
and development activities, and relaxation of
antitrust guidelines to permit consolidation of
production facilities in troubled industries.
More common are proposals with such ambi­
tious elements as establishing a governmentfinanced Development Bank to extend pref­
erential credit to so-called sunrise and sunset
industries; forming a nonpartisan council to
supervise the bank’s activities and coordinate
the industrial policy initiatives of govern­
ment agencies; and restricting interstate bus­
iness mobility and corporate diversification.
The existing critical literature on indus­
trial policy focuses on diagnosing the struc­
tural problems of the U.S. economy and
on the success or failure of domestic sectorspecific and comprehensive foreign industrial
policies (see box 1). However, even if a con­
sensus were to develop regarding the sources
of and remedies for the U.S. economy’s struc­
tural ailments, industrial policy still faces
an uncertain transition from law to delivery—

1. See Pressman and
Wildavsky (1973),
Mazmanian and
Sabatier (1983),
and Peirce (1981).

a process known as implementation. In this
article, our concern is the government’s abil­
ity to implement a complex and coherent array
of government actions under the umbrella of
industrial policy.
Any activity engaged in by a democratic
government requires policy choices by elected
representatives and their appointees, as well
as policy execution by civil servants. The
activities of those charged with implement­
ing policy—detailed design, delivery, perfor­
mance monitoring, and enforcement—have
been analyzed extensively, and they have
been found to be afflicted by predictable lim­
itations and imperfections.1 The ability to
implement policies legislated by a govern­
ment frequently is neglected in policymaking
and analysis. Seeming to believe that imple­
mentation is a relatively easy task, legislators
invariably are upset when policy goes awry,
or when policy results are contrary to legisla­
tive intentions. When the objectives of policy
are not realized, the possible causes are

Box 1 Critical Views on Industrial Policy

The critical literature on industrial policy has focused
on two sets of issues. First, analysts have questioned
the extent to which the U.S. economy is experiencing
grave structural problems. Advocates maintain that the
structural difficulties of the U. S. economy are reflected
in the following phenomena:
(1) a progressive deindustrialization that could harm
m anufacturing industries and union workers in the
short run and could threaten national economic growth
in the long run;
(2) a secular deterioration in productivity, capital invest­
ment, and international competitiveness;
(3) a national capital market that discriminates against
infant industries, research and development ventures,
and investm ents in public infrastructure.
Since these assertions have been analyzed in recent
literature, it is not our purpose here to provide an exten­
sive review. Critics cast doubt on assertions that the
U.S. economy is burdened with unparalleled difficulties
of a structural nature. The literature also suggests that
the government would, even under ideal conditions,
lack the inform ation necessary to make responsible
and potentially effective policy decisions?
Second, researchers have examined comprehensive
foreign and domestic sector-specific industrial policies

Economic Review • Summer 1984




many. The fault could lie in a misdiagnosis
of the problem, or problems, to be solved.
Legislative intent might have been defective:
the objectives of policy may have been unat­
tainable, or the policy targets poorly selected.
Another explanation may be that implemen­
tation was faulty: the mandated activities
were improperly executed or experienced
damaging delays.
Policy implementation is complex. It begins
with the passage of legislation; works through
establishing an administrative structure to
initiate policy and select objectives, targets,
and instruments; and ends with delivery.
The process involves an intricate web of rela­
tionships among policy advisors, legislators,
executive branch officials, and superiors and
subordinates within the agencies charged with
execution. It must be recognized that gov­
ernments and their component bureaucratic
institutions are not monolithic (Downs 1967),
a fact of considerable importance in the
translation of policy directives into policy

used as models by advocates. They maintain that indus­
trial policy was a crucial factor in the rapid postw ar
grow th in Japan, West Germany, and France. Critics
point out that such research has failed to dem onstrate
a causal relationship running from industrial policy to
economic growth. Using standard and quantifiable eco­
nomic, cultural, and demographic measures, advocates
have not been able to explain all of the postw ar eco­
nomic grow th of the three countries. The often large
and unexplained residual is then attributed to the effec­
tiveness of industrial policy.b Regarding sector-specific
industrial policies in the United States, Nelson (1982)
argues that failures have been at least as common as
successes, and that success has occurred under special
circum stances, suggesting that policy replicability
may be limited? For instance, government support of
research and development in American agriculture (the
quintessential sector-specific policy) is a poor model of
centralized planning for the m anufacturing sector.
a. See Daniels and Kieschnick (1978) and Industrial Change and Public
Policy (1983).
b. See Maunder (1979), Trezise (1983), Burton (1983), and Pavitt and
Walker (1976).
c. See Nelson (1982) and Wescott (1983).

2. For further dis­
cussion of the prin­
cipal/agent model
and its applications,
see Mitnick (1974),
Mitnick and Backoff
(1983), and Banfield (1975).
3. The potential
implementation
problems of modern
industrial policy
might be identified
via three avenues,
only one of which—
historical evidence—
is pursued in this
article. The imple­
mentation difficul­
ties encountered by
policymakers in
Japan, France, and
West Germany could
be relevant, despite
the substantial dif­
ferences in culture,
political systems,
and economic struc­
ture between these
nations and the
United States. Alter­
natively, the imple­
mentation experience
of domestic sectorspecific industrial
policies could be
examined for appli­
cable problems.

outcomes. Within each bureau, for instance,
high echelon officials are charged with the
design and execution of policy directives.
Because officials consider numerous policies,
each single policy is defined in general terms.
Deputies are left to work out the details.
These deputies, in turn, typically delegate
much of the detail work to individuals below
them in the organizational structure. Orders
from the top are expanded and made more
specific as they move downward. Since each
participant has some discretion in selecting
alternatives, the policies of an organization
(or a government) are defined at all levels, not
simply at the top.
The theory of agency has been employed
by researchers from a variety of social and
behavioral science disciplines to examine the
kind of complex problems that surface in the
implementation process. An agency relation
exists when one party, the agent, is acting for
another party, the principal. The agent gen­
erally is construed to be acting for the benefit
of the principal. Since the principal is sep­
arated from the activities conducted by the
agent on his or her behalf, he or she must
establish systems of monitoring and control
to assure that the agent behaves as desired.2
The implementation process consists of
many layers of responsibility and delegation.
In this article we examine industrial policy
based on three layers of delegation, from
objective-setting to the delivery of policy. The
topmost officials, including the president,
cabinet members, and congressional commit­
tees, are the principals for whom industrial
policy is implemented. Although they often
possess contradictory policy preferences,
the principals must provide the organizing
direction and general objectives of policy to
agents employed to design and execute policy.
The officials and staff of the industrial policy
bureau, a second group, are the primary

Federal Reserve Bank of Cleveland




responsible for developing a detailed
policy design and directing the instruments
of policy. For industrial policy to be poten­
tially effective, it required that another layer
of secondary agents—the individual firms and
plants in each regulated industry—actively
buy into and participate in the implemen­
tation process.
In the implementation of public policy, prin­
cipals must concern themselves with four
agent-control strategies, to assure that the
policies implemented conform to initial direc­
tives. First, principals must determine the
degree to which the policy preferences of
their selected agents diverge from their own.
The combination of differing preferences,
a normal amount of responsibility delega­
tion, and agent discretion concerning policy
alternatives can result in policies that bear
little resemblance to the principals’ original
directives. Second, principals must transmit
detailed, intelligible, and feasible policy speci­
fications to their agents. Agents may then
be expected to discriminate between actions
that are desirable and undesirable in the prin­
cipals’ eyes. Third, principals must be able
to monitor the behavior and performance of
agent actions on their behalf, by establishing
information feedback mechanisms and by
identifying performance measures that pos­
sess a predictable relationship to the desired
final policy outcomes. Finally, principals need
to formulate a system of rewards and penal­
ties to help assure that agents are implement­
ing the proper policy with a minimum of
delay and deviation.
The existing literature on industrial pol­
icy overlooks the implementation process.
Potential barriers to industrial policy cannot
be analyzed directly, since examples of coordi­
nated and interventionist policy envisioned
by advocates are not in place to provide a
basis for study. The history of U.S. economic
interventions, however, provides a useful
laboratory for examining industrial policy.3
agents

In three episodes of national crisis during the
twentieth century, the federal government
established powerful executive agencies
to coordinate and direct a broad range of pri­
vate economic activities. Today’s proposals
envision a similar agency. In World War I,
President Woodrow Wilson formed the Coun­
cil of National Defense (CND) and the War
Industries Board (WIB) to mobilize the pri­
vate economy for war. During his celebrated
first 100 days in office, President Franklin
Roosevelt formed the National Recovery
Administration (NRA) to plan and stimulate
the private economy. Finally, early in our
involvement in World War II, President
Roosevelt established the War Production
Board (WPB) to plan and supervise our
industrial and transportation sectors. Each
of these agencies closely resembled, in struc­
ture and responsibilities, the proposed delivery
agency for contemporary industrial policy.
None was designed to serve exclusively parti­

War Industries Board

Sudden involvement in World War I forced the first
U.S. attem pt at economic and social control on a com­
prehensive national scale. For almost two years, the
national governm ent sought to command the major
industrial and manpower resources of the United
States; recruited, trained, and armed an expedition­
ary force; and served the financial, ordnance, and eco­
nomic needs of our European allies. The governm ent’s
wartime economic powers required some central coordi­
nation, although public officials had no familiarity with
large-scale economic planning. Established in 1917, the
Council of National Defense (CND) and the War Indus­
tries Board (WIB) were charged w ith the coordination
of industries, resources, and transportation facilities
for the national security and welfare. The WIB replaced
the m arketplace where large industry was concerned,
employing persuasion, threats, and calls to patriotic
duty to gain “acceptable” prices, adjustm ent of com­
peting claims for scarce resources, and priorities in
m ilitary and civilian contracting. Among its specific
duties were advising the president, executive agencies,
and Congress on appropriate and necessary courses of
action to mobilize the private economy; coordinating
transportation, communication, and production facili­
ties; acquiring strategic raw materials; establishing and
enforcing priorities in production and delivery of w ar

Economic Review • Summer 1984




san interests, and senior staff included rep­
resentatives from government, business, labor,
and the public. All three were assigned broad
responsibilities to direct and coordinate the
related activities of other executive agen­
cies. Each was associated with a government
agency whose responsibilities included lending
to the private sector. Finally, all three were
conceived as clearinghouses for information,
research, and planning of public and privatesector activities.

I. Agents and
Institutional Capacity

The enabling legislation for the WIB, NRA,
and WPB gave unprecedented and unfamiliar
powers to the federal government. In the
world of public policy, there is, however, no
assurance that implementation will be effec­
tive, or that governments will only choose
policies that feasibly can be executed. Institu-

materials; fixing prices of military and civilian goods
ranging from bullets and machine guns to coal and grain;
directing the conversion and/or construction of m anu­
facturing and transportation facilities for defense pro­
duction; and coordinating the purchases of Allied gov­
ernm ents in the United States. The WIB worked closely
w ith other agencies established in the national em er­
gency, including the Emergency Fleet Corporation, the
United States Railroad Adm inistration, the U.S. Food
and Fuel administrations, the War Finance Corporation,
and the National War Labor Board. The WIB was dis­
solved in December 1918, just one month after the w ar
ended. While the WIB established a semblance of order
in economic mobilization by the sum m er of 1918, the
agency never secured unified control over that mobili­
zation. It lacked clear authority to set civilian and mili­
tary prices and to coordinate transportation, duties
that were covered, in part, by other agencies. Through­
out the war, its officials rem ained unsure of their legal
authority to coerce businesses and to enforce contracts
w ith m ilitary agencies. The WIB’s rapid dissolution
prevented wide public aw areness of the serious w eak­
nesses and inconsistencies of government economic
controls during the war. For greater detail on the WIB
and its sister agencies, see Cuff 1973, Garfield 1921,
and Willoughby 1934.

4. See Skowronek
(1982) and Fine
(1956). For com­
parisons with the
European political
and institutional
tradition, see Hartz
(1964) and Batchelder and Freudenberger (1983).

tional capacity, defined here as a combination
of the government’s organizational manage­
ment skills and technical knowledge, is an
important influence on the speed of the
implementation process and the potential for
successful outcomes, particularly with respect
to new policy directives. Finegold and Skocpol (1982, p. 260) observe, “Governments that
have, or can quickly assemble, their own
knowledgeable administrative organizations
are better able to carry through interven­
tionist policies than are governments that
must rely on extragovernmental experts and
organizations.” In addition, new agencies
are usually influenced disproportionately
by the regulated groups that lobbied
for their creation.
The interventions authorized by the

National Recovery Administration

Created in 1933 under the National Industrial Recovery
Act, the NRA was modeled on the WIB of World War I
and included key personnel of the WIB among its staff.
The NRA’s prim ary feature was the organization and
adm inistration of industrial self-government, suspend­
ing antitru st enforcement and allowing governmentsponsored cartelization of industry. Elaborate codes of
business behavior for employment, investment, output,
wages, and prices were to be established by mutual
agreement. Eventually, over 500 individual industry
codes were developed, and signatories to these agree­
m ents were allowed to display the NRA blue eagle insig­
nia. While the NRA lasted for two years and vanished
w ith hardly an institutional trace, it was the center­
piece of government recovery policy in the early New
Deal. The codes were intended to encourage cooperation
that would eliminate overproduction and the resulting
downward pressure on prices and wages—that is, to
stem deflation. Conservatives believed that the end of
destructive competition, as they viewed it, would bring
optimism and a renewal of private investm ent. More
am bitious proponents reasoned that if codes could be
drafted to keep prices down but deliberately increase
wages, industry, in effect, would be forced to come up
with the money to revive U.S. purchasing power. Having
failed for many reasons, some of its own making, the
NRA was repudiated by many of its early supporters
by the tim e the Supreme Court declared it unconstitu­
tional in 1935. For greater detail on the NRA, see Finegold and Skocpol 1982, Bellush 1975, Hawley 1969,
and Brand 1983.

6

Federal Reserve Bank of Cleveland




industrial policy legislation of 1917, 1933,
and 1939 presented the federal government
with serious technical and organizational
capacity problems. No ready-made administra­
tive structure existed within the federal gov­
ernment to design and implement such pol­
icies. Compared with our allies in Western
Europe, the federal government was handi­
capped by a historical tradition that empha­
sized decentralized decisionmaking and
“anti-statist” rhetoric.4 Elected representa­
tives, civil servants, and political appointees
did not have the vast technical and bureau­
cratic knowledge necessary to design and
implement industrial policy. By World War I,
the evolution of large private companies and
industry trade associations had given some of
these important skills to the private sector
(Chandler and Galambos 1970). The Wilson
and Franklin Roosevelt administrations
desired rapid implementation of industrial
policy, but could not easily assemble from the
government’s own resources either the nec­
essary administrative apparatus or the tech­
nically skilled personnel needed to direct and
staff the agencies. In what should be consid­
ered classic cases of regulation by the regu­
lated, both presidents turned to the private
sector for their industrial policy agents.
The CND and the WIB were essentially
exercises in improvisation. The proposals to
establish the two agencies were put forward
by a coalition of major defense contractors
and other private businessmen and did not
originate with the president or Congress.
Once the agencies were operational, initia­
tives for administrative change and new
powers came, once again, from the business
community. President Wilson used his con­
siderable emergency powers to work out
interim agency arrangements with private-

sector interests. The WIB was directed and
staffed primarily by businessmen, financiers,
and trade association lobbyists from the pri­
vate sector, although labor and government
had token representation.
The WIB was disbanded immediately after
World War I, with its staff returning to privatesector employment. The Harding and Coolidge administrations dismantled most of the
formal institutional legacy of the World War I
era (with prominent exception of informal
planning activities conducted by the newly

War Production Board

The mobilization of the U.S. economy in World War II
was an achievement w ithout precedent in magnitude,
complexity, or duration. The defense mobilization and
production requirem ents greatly exceeded those of
World War I, and w rought sweeping changes in the
operations of government and in the structure of the
U.S. economy. The federal government established
a num ber of agencies w ith overseeing authority over
the huge effort, beginning w ith the War Resources
Board (1939), the National Defense Advisory Commis­
sion (1940-41), the Office of Production M anagement
(1941-42), and the Supply Priorities and Allocations
Board (1941-42). The evolution toward a centralized
economic planning agency culminated in the War Pro­
duction Board (1942-45). The WPB had considerably
greater powers to mobilize the national economy than
either of its predecessors—the WIB or the NRA. It was
given authority to divide resources between civilian
and military claim ants, establish production and deliv­
ery priorities w ithin the two groups, coordinate and
oversee the building of production facilities and the con­
version of existing facilities, and coordinate manpower
needs. The WPB was dissolved shortly after the cessa­
tion of hostilities in the Pacific theatre in August 1945.
The WPB’s responsibilities were often ambiguous, and
they frequently overlapped with the jurisdictions of
other emergency agencies, w ith predictable confusion
resulting. The demands of World War II on the U. S. econ­
omy and on the governm ent’s planning agencies were
so great that even an abundance of internal and exter­
nal experts could not fashion a coherent set of govern­
ment institutions or policies. The economic planning
agencies of World War II were rarely effective as long­
term strategic planners, but relatively successful at
crisis m anagem ent. For greater detail on the WPB, see
C ivilian P roduction A d m in istratio n 1947, N ovick,
Anshen, and Truppner 1949, Koistinen 1980, and
Rockoff 1984.

Economic Review • Summer 1984




formed U.S. Department of Commerce in the
1920s). The federal government thus faced
the Great Depression with little more inter­
nal administrative and technical capacity
than it possessed in 1917. President Franklin
Roosevelt and his advisors employed the
WIB as a model for the NRA, asking several
WIB veterans to form the staff nucleus of the
agency. Although the staff included represen­
tatives of government and organized labor,
the NRA came to reflect the interests of large
U.S. private corporations and their execu­
tives. The deputy administrators were drawn
almost entirely from the ranks of business,
and were often assigned to direct code negoti­
ations with their own industries. Likewise,
the code authorities formed to monitor com­
pliance were staffed by business executives
and by trade association personnel (the NRA
promoted the formation of trade groups in
industries with no pre-existing association).
The U.S. government entered World War II
with a large organizational structure, cour­
tesy of the New Deal. The government, how­
ever, did not have the technical expertise
necessary to prepare the private economy for
war. The NRA was disbanded in 1935, and
major segments of the business community
were alienated from the Roosevelt program.
The WPB staff was recruited from the pri­
vate sector, and often conducted procurement
and price-fixing negotiations with their own
industries.
The federal government established princi­
pal/agent relationships to implement indus­
trial policy in 1917, 1933, and 1939, largely as
a result of technical and organizational defi­
ciencies. Such arrangements are (and were)
not unusual in public policy: the relation
between the president and government bu­
reaus staffed by professional civil servants

5. Cuff (1973),
Koistinen (1980),
Solo (1959), and
Christman (1973)
show that the WIB
and WPB had fre­
quent policy dis­
putes with the pres­
ident, his cabinet,
and congressional com mittees responsible
for agency oversight.
Serious conflicts
took place between
the two agencies
and other bureaus
of government, espe­
cially the military
procurement depart­
ments. Himmelberg
(1968) discusses the
attempt, by WIB
supporters, to estab­
lish a peacetime
price-fixing agency
(the Industrial Board
of the Department
of Commerce) in
1919, while Presi­
dent Wilson was in
France. Hawley
(1969) and Bellush
(1975) reveal signif­
icant and acrimo­
nious policy differ­
ences between the
congressional com­
mittees, many New
Dealers, small busi­
nesses, and the NRA
policymakers.

is also one of principals and agents. However,
the industrial policy episodes were unusual
in certain respects. Government officials
found it necessary to assemble the required
staff from private-sector resources, and relied
little on the existing administrative and per­
sonnel resources of government. Indeed, the
federal government sought and found the
necessary expertise among the very indus­
tries and corporations that would ultimately
be subjected to industrial policy regulation.
More important, evidence reveals that the
preferences of these agents differed from
many businesses in regulated industries
(especially small business), from the pres­
ident and congressional committees (princi­
pals), and from alternative agents (civil
servants and military officers employed by
other government entities).5
The Wilson and Roosevelt administrations
were aware of these important policy differ­
ences and sought to develop strategies and
control procedures that might prevent such
differences from distorting public policy. The
control procedures involved three elements:
instructions, performance monitoring, and
incentive systems.

haps to the perception of external threats to
the nation and the resulting urgency in pol­
icymaking.
The consensus was an illusion. The three
agencies only superficially satisfied the
diverse interest groups that had supported
enactment. With respect to the NRA, Haw­
ley (1969) comments:
As written, the National Industrial Recovery Act
could be used to . . . cartelize the economy, estab­
lish overhead planning, or attempt to eliminate the
market riggers and enforce competition. There
were those who would move in each [direction] and
it was not surprising that a conflict ensued (p. 35).

Since the principals—the president, cabi­
net, and congressional committees—were
unclear initially about the role, responsibili­
ties, and powers of the industrial policy agen­
cies, they could not transmit clear and intel­
ligible policy instructions to their agents.
As a result, the bureaus themselves became
battlegrounds for the definition and details of
policy—a divisive phenomenon that delayed
the design and execution of policy initiatives.
The NRA was plagued by serious internal
conflict over powers and responsibilities from
the beginning. The conflict interfered with
the NRA’s efforts to develop a coherent policy
and stabilize the economy. The continuation
of wartime crisis and the effectiveness of
II. Instructions and
government-engineered
propaganda muffled
Consensus Problems
the external criticism of, and, to a lesser
The public and political debates that pre­
extent, the vocal conflict within, the WIB
and WPB. Nevertheless, Cuff (1973), Kois­
ceded the establishment of the WIB, NRA,
and WPB occurred in an atmosphere of
tinen (1984), and Novick, Anshen, and Truppimpending crisis. Advocates of all persua­
ner (1949) show that the internal policy
sions recognized that a rapid policy response debates of the WIB and WPB were haunted
was imperative. In the charged environment, by philosophical conflict. Goldman (1971),
Willoughby (1934), Solo (1959), and Garfield
legislative and executive actions to create
(1921) show that internal contradictions also
an industrial policy apparatus were hasty.
Congressional debate and media comment of handicapped other wartime agencies, which
the day show that the objectives, powers,
often delayed or precluded the implementa­
and policy instruments available to the three tion of important policy initiatives.
agencies were not clearly defined. Given the
The NRA never seems to have received
dramatic expansion of state power sanctioned clear instructions from the Roosevelt admin­
by the legislation, the absence of controversy istration about the details of policy. The prep­
seems remarkable, being attributable peraration of the industry codes consumed a
tremendous amount of time, and sketchy evi­
dence of code compliance did not arrive on the
president’s desk until the spring of 1934. By
Federal Reserve Bank of Cleveland




then, the NRA codes were under strong attack
from major segments of the business com­
munity, and many of Roosevelt’s close advi­
sors had lost faith in the agency’s ability to
stabilize the economy. In May 1935, the NRA
was declared unconstitutional by the U.S.
Supreme Court. Bellush (1975) suggests that
the Roosevelt administration adopted a handsoff attitude to the NRA, given the public and
legal controversies that surrounded its short,
ineffectual existence. In contrast, the agents
in charge of the WIB and WPB succeeded in
their persistent quest for clearer instructions
from Presidents Wilson and Roosevelt, in
large part because their planning activities
were essential in wartime (in contrast to the
NRA). Such instructions usually applied to
quite specific regulatory and crisis-related
matters, yet at times concerned long-term
strategic planning issues. Although the two
agencies continued to be viewed by their prin­
cipals as long-term planning agencies, the
force of unpredictable events compelled prin­
cipals and agents alike to concentrate plan­
ning resources and regulatory efforts on
crisis management.

Clear lines of communication and authority
between principals, primary agents, and sec­
ondary agents obviously are necessary for
effective monitoring. These communication
lines must also be used at frequent inter­
vals to discuss substantive matters of perfor­
mance and policy. The historical record sug­
gests that Presidents Wilson and Roosevelt
and their advisors held frequent, substan­
tive discussions with their wartime economic
planning agents. During most of 1917, for
example, Wilson (or his close advisors Colonel
Edward M. House and Secretary of War New­
ton D. Baker) met with WIB and CND officials
as often as once a week. Such meetings fea­
tured discussions of WIB powers, relations
with other government and military agencies,
and Allied purchases in the United States.
NRA officials appear to have communicated
on a frequent basis with President Roosevelt
and his advisors, but the content of discus­
sion seems to have been oriented, to a greater
extent than in the wartime agencies, toward
the political repercussions of policy actions.
During the first six months of 1919 Presi­
dent Wilson was absent in Versailles nego­
tiating the peace, the only identifiable period
that frequent communication subsided be­
III. The Monitoring of
tween the principals and agents of industrial
Agent Performance
policy. It is not mere coincidence that dur­
The industrial policy principals had to mon­ ing this period WIB supporters, freed from
close supervision, established a peacetime
itor the behavior of their implementation
price-fixing agency in the Department of Com­
agents, to assure a minimum of delay, policy
merce—the Industrial Board. The board was
deviation, and corruption. Principals and
dissolved
upon Wilson’s return from France,
primary agents alike had to select and moni­
in
part
because
the president believed that
tor quantifiable measures of policy perfor­
wartime
powers
were not consistent with a
mance, to assure that policy was yielding the
peacetime
economy.
desired economic results. This information
Communication between the industrial pol­
could later be used to modify agent instruc­
icy
agencies and participating businesses—
tions, to discipline agents who performed in a
the
primary and secondary agents of policysubstandard fashion, and to reward agents
possessed
unusual characteristics. Frequent
whose performance exceeded expectations.
and substantive discussions were typically
confined to major defense contractors, large
private corporations, and trade associations—

Economic Review • Summer 1984




6. The difficulty of
measuring the value
of government out­
put to society is not
peculiar to industrial
policy. Indeed, such
problems afflict most
government policies.
For further discus­
sion of the prob­
lems of measuring
public-sector output,
see Wolf (1979)
and Olson (1973).
It should also be
noted that contem­
porary theories of
marketfailure would
not accept the mar­
ket imperfection argu­
ments made by
NRA proponents.

the former and future employers of many toplevel agency staff members. In some indus­
tries, the WIB, NRA, and WPB officials made
few attempts to communicate with the sec­
ondary agents of industrial policy (especially
small and medium-sized businesses), leav­
ing such efforts to trade association person­
nel and other industry spokesmen. Such
practices exacerbated existing splits within
industries, hampering policy execution by
reducing the level of secondary agent compli­
ance with directives.
The second aspect of monitoring concerns
the ability of principals and agents alike to
measure the performance of industrial policy—
that is, the effect of policy execution on policy
targets. Ideally, planners would have liked
to have measured the value to society of margi­
nal changes in policy targets resulting from
policy execution. However, the three indus­
trial policies were designed to remedy compet-

Table 1 An Illustration of
Performance Measurements

Tiers

Policy
objectives
Final phys­
ical outputs
Final
physical
inputs
Interm edi­
ate physical
inputs

WIB

Defend the
homeland
and Allies

Enemy
casualties
Number
of rifles
and tanks
Number of
procure­
ment con­
tracts
Size of
strategic
stockpile
Crude phys­ Dollars in
ical inputs budget
Number of
employees
Number of
contracts
negotiated

10

NRA

Stabilize
price and
employment
levels
None

Defend the
homeland
and Allies

Enemy
casualties
Number
None
of rifles
and tanks
Number of Number of
complaints procure­
settled
ment con­
tracts
Number of Number of
signatories product pri­
ority orders
to codes
Dollars in Dollars in
budget
budget
Number of Number of
employees employees
Number
of codes
w ritten

Federal Reserve Bank of Cleveland




WPB

itive market failures through the use of nonmarket instruments. National defense, a public
good, could not be provided in sufficient quan­
tities by the private sector in World Wars I
and II. While there was certainly a public
demand for national defense, it possessed no
market price, since national defense was (and
is) provided by government outside the mar­
ket mechanism. Without an explicit price,
the marginal value to society of government
actions to enhance U.S. defense capabili­
ties, and triumph in war, could not be calcu­
lated. The NRA also was designed to correct a
market failure: New Deal planners and cor­
porate executives argued that U.S. businesses
were too self-centered to recognize that “cut­
throat competition” was causing a very dam­
aging deflation in prices and wages. They
believed only government sponsorship of
explicit collusion might remedy this market
imperfection.6
Since government could not calculate the
marginal value to society of policy-induced
changes in targets, principals and agents had
to settle for output or cost measures of perfor­
mance. Wolf (1979) indicates, however, that
nonmarket outputs are usually hard to define in
principle, ill-defined in practice, and extremely dif­
ficult to measure independently of the inputs which
produce them. They are generally intermediate
products which are, at best, only remote proxies
for the ‘real’ or final intended output. Measuring
outputs by their inputs becomes accepted because
measuring outputs directly is so difficult (p. 113).

Table 1 depicts stylized performance mea­
surement problems that were confronted by
principals and agents engaged in the three
industrial policy efforts. It is reasonable
to assume that proximity to final output and
value is associated with superior performance
measurement capabilities. Thus, well defined
measures of final physical inputs contain
more information about final output and
value than crude physical inputs.
The NRA could not measure the amount
of price and employment stability created by
an industrial policy designed to affect those
economic variables. In the absence of output
quantities, the NRA could not derive a mea­
sure of cost effectiveness in the delivery of

output. The New Dealers also had no appro­
priate measure of final inputs, or the percent
of national output, employment, and business
firms complying fully with industry codes.
The Roosevelt administration and the NRA
staff settled for intermediate and crude prox­
ies in their quest for performance measures,
such as the number of industry codes writ­
ten, business signatories to the codes, and
code compliance actions taken and resolved.
Yet, these input measures bore little relation
to performance. While the NRA staff could
count the number of businesses that had
signed the codes, they could calculate neither
the weight of those businesses in each indus­
try nor the proportion of signatories actu­
ally complying with the codes. Likewise, the
number of code violations that came to the
attention of authorities was a poor perfor­
mance measure. Bellush (1975) suggests that
the largest numbers of code violations came
from industries where compliance seems to
have been more widespread, while smaller
numbers came from industries where little
compliance was evident.
Like the NRA, the WIB and WPB could not
estimate the marginal value to society of
their defense mobilization efforts. The mil­
itary services have sometimes measured their
performance (a final physical output of the
planning agencies) on the basis of enemy cas­
u alties; yet, as observers of th e V ietn am con­
flict noted, casualty rates may not be a satis­
factory measure of output. The wartime
industrial policy agencies had, as their pri­
mary responsibility, the design and execution
of policies that would assure the maintenance
of adequate supplies for the war machine.
Therefore, performance could be (and was)
measured by simply counting the number of
physical units such as ordnance, uniforms,
medical supplies, and fighter aircraft deli­
vered to the military establishment. If neces­
sary, such final physical inputs could be used

Economic Review • Summer 1984




to calculate measures of cost effectiveness.
In wartime, such measurement may not have
mattered (in peacetime, however, military
and civilian agencies share measurement
problems). Novick, Anshen, and Truppner (1949, p. 16) argue
in the war economy, the prices of products needed
for the military machine are of no importance.
Failure to provide the necessary weapons results
in national calamity. . . . It is true that part of the
attention of government is devoted to price controls
and the avoidance of inflation. Those concerned
with this problem are looking out for the general
health of the economy during and after the war.
Price is never a factor in influencing the satisfaction
of the needs of the war machine. Industrial out­
put for military needs is taken outside the sphere
of peacetime economic operations.

Although principals and agents shared the
problem of performance measurement, the
agents possessed an advantage—one that
could have been used to exaggerate (inten­
tionally or unintentionally) their own per­
formance. The agents selected to implement
policy possessed a better understanding of
business conditions and industry practices
than principals. The historical record con­
tains no definitive evidence suggesting that
the agents employed to implement industrial
policy intentionally sought to conceal evi­
dence of poor performance from their prin­
cipals. Not surprisingly, the industrial policy
agents did argue that the policies they had
devised and im p lem en ted w ere responsible

for favorable turns of events, but not for
unfavorable outcomes. Thus, the moderate
expansion of the economy and the relative
stability of prices that occurred from 1933 to
1935 was attributed to the NRA. Yet, subse­
quent analysis has shown that the NRA was
not effective in either area. Given their own
inexpert knowledge, principals had few ways
to judge such assertions on the part of their
agents, and therefore were not adequately
prepared to issue new instructions to correct
the defects in industrial policy design. To
measure agent performance, principals had
to rely on the observed behavior of agents (cor-

ruption, for example, or ability to get along
in the bureaucracy) rather than on the effi­
ciency of agents in carrying out their policy
assignments.

IV. Rewards and Penalties

The relations between industrial policy prin­
cipals, primary agents, and secondary agents
can be guided, in part, by a system of rules
promising rewards for performance or behav­
iors that exceed expectations, and penalties
for substandard performance or malfeasance.
Information assembled through the monitor­
ing process ideally is used to operationalize
such an incentive system. Two distinct sets of
relations and incentive systems occurred in
the implementation of industrial policy. Indus­
trial policy principals (the president and con­
gressional committees) operated an incentive
system as part of their relations with primary
agents—individuals employed by the federal
government. The policing of behavior and per­
formance of secondary agents was, in turn,
delegated by principals to their primary agents.
Businessmen and others consented to serve
as primary agents of industrial policy for
many of the same reasons that individuals
enter government service today—income, job
security, status and prestige, amenities, and
power. In addition, the government promoted
policy as a chance for active participation in a
patriotic fight against an external foe. Another
incentive may have been the ability to manip­
ulate the business environment to benefit
ones’ own industry. All three agencies con­
structed elaborate codes of conduct for indus­
try, regarding output, wages, prices, material
costs, collective bargaining, and investment.
All three featured price controls as a key ele­
ment of policy (minimum prices in the NRA,
and maximum in the two wars). Cuff (1973)
and Koistinen (1980) agree that the codes and
price controls may have favored companies
and industries that were well represented in
the wartime agencies. Likewise, since truly

Federal Reserve Bank of Cleveland




competitive bidding did not characterize war­
time procurement procedures, representation
may have helped secure military contracts.
Finegold and Skocpol (1984) argue that, while
business leaders sought to benefit through
participation and representation in the NRA,
wide divisions in the ranks of secondary
agents prevented success.
The system of agent incentives constructed
by principals suffered from important defects.
Although senior agency staff were not offered
civil-service protection, the president found
it difficult to fire, demote, or transfer agents
who exhibited substandard performance or
behavior. Agents were protected by their close
alliances with powerful private-sector inter­
ests and congressional leaders, and by the
presidents’ inability to assemble clear evi­
dence of unacceptable behavior or inadequate
performance. In addition, many industrial
policy agents possessed divided loyalties—
divided between their industries and compa­
nies and the principals by whom they had been
hired. Agent actions that, implicitly or explic­
itly, favored an industry or a company over
another were frowned on by principals on
the few occasions that they came to light.
Yet agents could expect to be rewarded by
private-sector interests for such actions.
Primary agents were responsible for estab­
lishing and maintaining an incentive system
for secondary industrial policy agents. In
wartime, secondary agents were offered such
incentives as cost-plus and/or fixed-price con­
tracts with progress payments prior to deliv­
ery, a guaranteed market for their output
through government procurement, and pro­
duction priority schemes that legalized sales
in the rationed and shortage-ridden civilian
economy. Penalties for misbehavior or sub­
standard performance included the cancella­
tion of procurement contracts, legal action,
and inability to secure high-priority assigna­
tions. The incentive scheme was not, how­
ever, administered in an evenhanded man­
ner. First, primary agents possessed a set of
industry-specific contacts that could not
encompass all of the companies and produc­

tion facilities in an industry. Thus, imper­
fect information about production capacity,
prices, and other industry characteristics led
to the appearance of prejudice in the admin­
istration of incentive systems. Second, regula­
tion by the regulated did not mean that all of
the regulated had an equal voice in the main­
tenance of self-serving policies. Asymme­
tries in primary agent representation could
have biased policy and served to accentuate
pre-existing industry divisions (as small and
large firms or single- and multi-plant com­
panies). Third, although incentives existed in
regulated civilian markets, industrial policy
agencies concentrated their policing in the
government-procurement area. The develop­
ment of a sizable black market during both
world wars was one result. Clinard (1969)
cites several World War II studies, conducted
by the Office of Price Administration, that
suggest that 5 percent to 25 percent of civil­
ian foods and gasoline were sold on the black
market in 1943 and 1944.
The incentive schemes developed by the
WIB, WPB, and their sister agencies were
intended to establish “orderly” markets in
periods of extremely high demand, by spon­
soring industry-by-industry collusion and
dampening competition. While the schemes
may not have been equitable, neither did
they seriously retard government-procure­
ment efforts or transform the entire civilian
market into an underground economy. The
NRA codes also sought to establish orderly
markets, yet the agency was not granted the
same degree of legal enforcement power
available to the WIB and WPB (even though
the wartime agencies’ enforcement powers
over the civilian economy were little used). In
addition, the encouragement of wartime eco­
nomic collusion wras intended to benefit, first
and foremost, the government and the mil­
itary machine. In the peacetime NRA, the
benefits were supposed to accrue to those
who engaged in collusive activities, with a

Economic Review • Summer 1984



positive spillover to price and employment
levels (objectives of government policy). The
NRA could offer few rewards for collusion,
and possessed limited ability to enforce disci­
pline among secondary agents. Moreover,
NRA policies served to accentuate existing
industry divisions, preventing sufficient
numbers of secondary agents from buying
into the program.

V. Contemporary Industrial
Policy Proposals

The current proposals for government inter­
vention in the private economy, under the
industrial policy umbrella, contain social
and economic objectives quite different from
those of the WIB, NRA, and WPB. Never­
theless, the proposals bear a remarkable resem­
blance to the historical record. Policy is con­
ceived as a broad, coordinated, and highly
interventionist attempt by government to
manipulate the private economy. The policy­
making and implementing agencies proposed
today are structured in a nearly identical
manner to the agencies of World Wars I
and II and the Depression. The similarities
between current proposals and the historical
record in these and other areas strongly sug­
gest that an industrial policy for the 1980s
would not escape from the implementation
problems experienced in the first half of
this century.
Initiatives frequently proposed by indus­
trial policy advocates would involve the fed­
eral government in a wide variety of private
decisions normally handled by individual
companies, that is, the most “promising” pro­
duction technologies to pursue in research
and development ventures; the most profit­
able technologies for production; the optimal
location of plants; the most effective methods
for withdrawing from declining industries;
and the proper degree of corporate diversifica­
tion. Today’s federal government is larger
and employs more expert civil servants than
it did four decades ago. Yet, it may not be any
better prepared to make such traditionally
private decisions, especially in times of peace.

The technical and administrative skills nec­
essary for informed decisionmaking would
force the federal government, acting as prin­
cipal, to seek qualified agents from the pri­
vate sector.
The agents would, in all likelihood, have
policy preferences that differ from other inter­
ested parties, including elected representa­
tives, alternative agents within federal, state,
and local governments, and other industry
and labor spokespersons. The primary agents
of industrial policy in our three historical
cases represented a relatively narrow subset
of private businesses in each regulated indus­
try, although efforts were made to include the
voices of organized labor, government, and
the public. Organized labor would play a
more influential role in the design and imple­
mentation of an industrial policy for the
1980s. Some proponents believe that labor
representation will serve as a counterweight
to private business executives. Yet, business
and labor sentiments often converge, as evi­
dent in protectionist trade policies. Such poli­
cies are certainly detrimental to U.S. consum­
ers and exporters (see Bryan and Humpage,
this Economic Review), but these groups are
not likely to be well represented among the
agents selected to implement industrial policy.
Supportive coalitions for the WIB, NRA,
and WPB were forged in times of menacing
national crisis. Industrial policy enthusiasts
must agree that the U.S. economy is not now
facing a similar external threat. The likeli­
hood of developing a broad coalition in a non­
threatening peacetime environment must
be considered remote. Nevertheless, policy­
makers have more time to select objectives and
design programs that represent a consensus
and are potentially effective. Currently, the
industrial policy debate remains confused,
with no single approach or goal seemingly
acceptable to most advocates. Thus, legisla­
tive action at this point would be premature,
leading to unclear instructions for agents.

Federal Reserve Bank of Cleveland




Contemporary industrial policy proposals
seek to increase U.S. productivity and enhance
the competitive position of U.S. products in
the international marketplace. Like the objec­
tives of the WIB, NRA, and WPB, the value of
policy-induced marginal improvements to
society would be indeterminate. Government
and its industrial policy agents would face
great difficulties in attempts to measure the
final physical output of policy. Principals and
agents alike would have to settle for crude
and intermediate measures of performance
that might not have any quantifiable or pre­
dictable relation to the ultimate goals of policy.
The absence of effective performance mea­
sures will cause difficulties in the design and
maintenance of an incentive system for the
agents of industrial policy. The application of
rewards and penalties might be limited to
observable agent behavior (for example, the
ability to get along in large bureaucracies)
and not related to effective performance in
carrying out policy directives. Imperfect
information, divided agent loyalties, and
asymmetrical agent representation may also
make it difficult to gain the trust and com­
pliance of secondary agents, whatever the
formal incentive structure.
Good intentions are not sufficient to pro­
duce effective public policy. If enacted, a
coordinated and interventionist U.S. indus­
trial policy would have to negotiate an arduous
obstacle course on the way to delivery. The
barriers to effective implementation are not
insurmountable: both the WIB and WPB
achieved a measure of success. In peacetime,
however, the implementation difficulties
are likely to be more severe. The arguments
and evidence developed in this paper should
convince industrial policy advocates and critics
that questions of policy implementation are
just as important as the content of the pol­
icies themselves.

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Federal Reserve Bank of Cleveland




Both authors are
economists with the
Federal Reserve
Bank of Cleveland.
The authors would
like to thank Wil­
liam Gavin, Roger
Hinderliter, Ed­
ward Weber, Paul
Gary Wyckoff,
and especially
K.J. Kowalewski
for their valuable
comments through­
out the prepara­
tion of this article.
Diane Mogren pro­
vided highly com­
petent research assis­
tance. Any errors
that remain, of
course, are the
responsibility of
the authors.

17

Voluntary Export
Restraints:
The Cost of
Building Walls
by Michael E Bryan
and Owen E Humpage
Before I built a wall I ’d ask to know
What I was walling in or walling out,
And to whom I was like to give offence.
R obert F ro st

Economic Review • Summer 1984




Concerned over the impact of foreign com­
petition, U.S. industries have increasingly
turned to elected representatives to seek pro­
tective barriers against the flow of imports.
Calls for protectionist legislation are inten­
sifying as elections draw near. Proponents
of such legislation argue that trade restric­
tions are necessary to protect U.S. jobs, but
protectionist devices usually secure jobs at a
substantial cost to consumers and economic
efficiency. When building protectionist walls,
policymakers should consider the individu­
als to whom such barriers would likely give
offense. The Japanese Voluntary Export
Restraint (VER) program, which restricts
exports of Japanese cars to the U.S. market,
provides a recent example of such a barrier.
This article develops a supply and demand
equation for new Japanese cars to estimate
the price and quantity impacts of the Japa­
nese VER program. In theory, the impact of a
quota, whether voluntary or mandatory, is
to raise the price of a good in a given market
while reducing sales. Because retail prices
for new Japanese cars are not publicly avail­
able, we must estimate them. The retail
price model consists of dealers’ markups over
options-adjusted wholesale prices of Japanese
cars. The markups vary as dealers adjust
their inventory positions to market condi­
tions. This is an important avenue by which
pressures from the VER program influence
market prices and consequently market sales.
Combined with a demand equation, the whole­
sale price model is simulated under a set of
non-VER assumptions, yielding estimates of
the price and quantity impacts of the VER
program. These estimates enable us to approx­
imate measures of income transfers and effi­
ciency losses associated with the VER program.
The results of our study show that the
VER program initially had little impact on
the new-car market. By 1983, however, the
program added over $1,114 to the optionsadjusted price of a new Japanese car, trans­
ferred roughly $2.0 billion from consumers of
new Japanese cars to producers and dealers,
and generated $166.4 million in efficiency

1. For a summary
of studies on the
Japanese cost advan­
tage in automobile
production, see
Loos (1984).
2. The quota fig­
ures cited do not
include certain car­
like vehicles (that
is, some four-wheel
drive vehicles) that,
when included, raise
the limitations to
1.76 million units
per year in the
1981-83 period and
1.95 million units
per year currently.

costs. These results are based on a partial
equilibrium model that does not consider
secondary price effects, that is, the price of
substitute cars. While not explicitly considered
in this analysis, such effects also could add
to the efficiency costs of the program. Sepa­
rately, we estimate that the VER program
“protected” at most 1,500 new jobs for domes­
tic autoworkers.

and quantity restrictions against car imports.
Ford Motor Company filed a similar petition
in August 1980. The ITC, however, rejected
the petitions, finding that imported cars were
not an overriding cause of injury to the U.S.
car market. Instead, the ITC determined that
the U.S. recession and a shift in consumer
preferences toward small, fuel-efficient cars
were more detrimental to the domestic auto­
mobile industry than were imported cars.
Following the ITC’s decision, the pressures
I. The Framework for Analysis
to limit car imports were aimed more directly
The Setting for Restraint
toward the Japanese government. Both the
Carter and the Reagan administrations,
Until the mid-1970s, sales of intermediatefavoring
neither legislated quotas nor tariffs,
and full-sized cars dominated the U.S. auto
encouraged
Japanese voluntarily to limit
market. Confronted with rapidly rising gaso­ their new-cartheexports
to the United States.
line prices and economic recessions, Ameri­
Neither
administration,
however, could rule
can consumers dramatically altered their
out
U.S.
legislation,
and
both the U.S. House
automobile preferences in favor of more
of Representatives and the Senate introduced
economical, fuel-efficient models. By 1980,
quota
legislation in an effort to pressure the
subcompact cars represented the largest com­ Japanese
impose their own limitations. In
ponent of the U.S. new-car market, account­ May 1981,tothe
Japanese government agreed
ing for 42 percent (compared with 20 per­
“voluntarily”
to
cent in 1975 and 12 percent in 1965). Foreign the United States.limit their car shipments to
producers, especially the Japanese, had an
Japan initially agreed to limit car exports to
apparent advantage in the production of
the
United States over the three-year period
small, fuel-efficient cars and gained a sub­
from
April 1981 through March 1984; in
stantial share of the U.S. new-car market dur­ November
1983, the Japanese extended the
ing the 1970s.1The Japanese market share
agreement
through March 1985. In the first
rose from 6 percent in 1972 to 12 percent in
year,
the
agreement
limited Japanese car
1978. As the decade closed, the U.S. market
exports
to
the
United
to 1.68 million
contracted: domestic new-car sales fell 29 per­ units, contrasting withStates
sales
of 1.75 million
cent between 1978 and 1980. Japanese sales,
units
in
1979
and
1.91
million
units in 1980.2
however, continued to expand, with the
In
subsequent
years
of
the
program,
the VER
Japanese market share increasing sharply
limitations
were
to
rise
by
16.5
percent
of
to 21 percent by 1980.
the
growth
experienced
in
U.S.
new-car
sales
As declining domestic new-car sales idled
during
the
previous
year.
The
recession
in
labor and capacity, the United Auto Workers the United States, however, continued to
(UAW) and some of the large domestic car
hamper domestic sales: U.S. new-car sales
producers began seeking protection from
declined from 8.9 million units in the
their foreign competitors, especially the Jap­ actually
year
preceding
the VERs to 8.1 million units
anese automakers. In June 1980, the UAW
in
both
1981
and
1982. Because the U.S.
petitioned the International Trade Commis­
market
failed
to
grow
over the first two years
sion (ITC), alleging that imports were a sub­ of the VER period, Japanese
limitations
stantial cause of serious injury to the domes­ remained at 1.68 million unitscarthroughout
the
tic industry and seeking both higher tariffs
first three years of the program. Under the
current, fourth-year extension of the pro­
gram, the VER limitations have risen to
1.85 million units.
Federal Reserve Bank of Cleveland




Theoretical Effects of Trade Restraints
Trade restraints limit the flow of foreign goods
into domestic markets and raise the prices of
imports, the protected goods, and their sub­
stitutes. In doing so, trade restraints transfer
real income away from consumers toward
domestic producers of the protected good and
foreign producers of the restricted good, and
create production and consumption inefficien­
cies. Figure 1 presents a simple, comparative
static model of the U.S. market for Japanese
cars and helps to illustrate some of the effects
of the VER program. The downward sloping
line DjD° in panel A is the U.S. demand curve
for imported Japanese cars. Assuming that
domestic and foreign cars are close substi­
tutes, the import-demand curve is constructed
as the horizontal difference between the total
U.S. demand curve for all cars D jD f and the
domestic supply curve SdSfi (see panel B).
The import-demand curve DjD° shows the

number of Japanese cars that U.S. consum­
ers would purchase at various prices or, con­
versely, the maximum per-unit price that
U.S. consumers would pay for a given quan­
tity of imported Japanese cars. The upward
sloping line S jS f in panel A is the supply
schedule for Japanese cars exported to the
United States. It depicts the number of cars
that profit-maximizing Japanese producers
are willing to export at any given price, or the
minimum per-unit price the Japanese produc­
ers must receive to export a specific quantity
of new cars. The intersection of the importdemand curve and the export-supply curve
determines the price/quantity combination of
new Japanese cars imported into the United
States. In the absence of VERs, Q° Japanese
cars are sold in the United States at price P°.
To illustrate the effects of the VERs, we
rely on the concepts of consumers’ surplus and
producers’ surplus. For quantities of new Jap­
anese cars less than Q°, U.S. consumers are

Fig. 1 The U.S. New-Car Market

Q j ~ Qd + Qj

Economic Review • Summer 1984



3. We measure the
welfare effects of the
VERs following a
competitive model.
By organizing the
Japanese export
market, the VER
program could
confer on Japanese
producers increased
oligopoly power. This
implies a greater
welfare loss than
measured in our
competitive model.
4. The more inelas­
tic the import de­
mand curve, the
greater the reduc­
tion in consumers’
surplus resulting
from the VER
program.
5. The manner in
which the Japanese
administer the VER
program determines
how the income
transferred from
U. S. consumers is
divided between
Japanese producers
and the Japanese
government. If, for
example, the Jap­
anese government
simply allocates
market shares
among its pro­
ducers, all of the
income transfer
accrues to the Japa­
nese producers. If,
however, the Jap­
anese government
elects to sell the
rights to export cars
to the U. S. market,
the government then
will capture some
of the additional
revenue.

20

willing to pay a price greater than P f as indi­
cated by the demand curve DjDf. The trian­
gular area below the demand curve and above
the price line, Pfac, represents a benefit that
consumers receive called consumers’ surplus.
Similarly, Japanese producers are willing
to supply quantities of cars smaller than Qf
at prices below P f as described by the supply
curve SjSf. The triangular area P fcf below
the price line but above the supply curve mea­
sures the producers’ surplus, which accrues
to producers as economic rents.
The empirical measures developed in this
article are related to consumers’ surplus
only.3 The use of consumers’ surplus (and
producers’ surplus) to measure the costs
and benefits of trade policies has generated
a great deal of discussion among economists
(see Currie, Murphy, and Schmitz 1971).
One major aspect of the debate centers on
the partial equilibrium nature of the model.
Our model considers only the Japanese newcar market, but the VER program could
have price effects (upward and downward)
on many other goods and services. The prices
of new cars, domestic and imported from
other foreign countries, for example, probably
will rise following the VER program. Usedcar prices also could rise. Any increase or
decrease in consumers’ surplus associated
with such secondary price effects is relevant
to the calculations of the costs and benefits
associated with trade restraints. By consider­
ing only the Japanese new-car market and
assuming that the price impacts in other
car markets are small, we have understated
the income transfers and efficiency losses
associated with the VER program. Many
economists also argue that consumers’ sur­
plus should be measured under demand
curves that are compensated for the income
effects of price changes. We have not done
so under the assumption that the income
effects associated with the VER-induced price
increases are small (see Willig 1976). Despite
these and other concerns about the use of
partial equilibrium models and the concept
of consumers’ surplus for measuring the
Federal Reserve Bank of Cleveland




effects of trade restraints, the approach has
been widely used (see Morkre and Tarr 1980).
Our study views the VER program basi­
cally as a quota organized by the Japanese
government (see Bergsten 1975). If the Japa­
nese government imposes a quota equal to Qj
in figure 1, panel A, the U.S. price of Japanese
cars will rise to Pj, since this is the price U.S.
consumers are willing to pay for Qj Japanese
cars. The quota effectively shifts the Japa­
nese supply schedule from the diagonal SjSf
to feS'j, which becomes vertical at point e.
As the price of new Japanese cars rises, some
U.S. consumers will switch to new domestic
cars. The price of domestic cars will rise and
production will increase Q j- Q§, as shown
in figure 1, panel B. As the prices of new Jap­
anese and American cars rise, fewer cars
in total will be produced and purchased.
By raising the price of imported Japanese
cars to Pj, the VER program reduces the con­
sumers’ surplus in panel A by an amount
given by area PfPjbc.4 Part of this reduction
in consumers’ surplus represents an income
transfer to Japanese producers from U.S. con­
sumers who continue to buy Qj imported Jap­
anese cars at PJ - P f more per car than before
the VERs. This income transfer, shown by
area PfPjbd, does not represent a loss to the
world economy, but it does represent a loss to
the U.S. economy, especially in the short run.5
Although most of the income transferred
from U.S. consumers to Japanese producers
eventually returns to the United States as
foreigners buy U.S. exports and invest in the
United States, such transactions could take
many years to complete. Even in the long
run, the United States could incur a loss if
the price of U.S. imports rises relative to the
price of U.S. exports because of the VERs.
The second part of the overall reduction
in consumers’ surplus represents a net loss
to both the U.S. and world economies and
is given by area bed in figure 1, panel A.
Because we constructed the import-demand
curve in panel A as the horizontal differ­
ence between the total-demand curve and the

6. The more inelas­
tic the Japanese sup­
ply curve, the
greater the loss in
producers ’ surplus
resulting from the
VER program.

domestic-supply curve in panel B, the loss
depicted by area bed in panel A under the
import-demand curve represents the combined
losses given by areas abc and def in panel B.
The first of these losses results from greater
inefficiency in car production. An increase
in domestic production of Qd - in panel B
replaces part of the reduction in Japanese
new:car imports. Before the VERs, the Japa­
nese provided these additional units at a total
cost of cbQdQd, but domestic producers can
provide these units only at an additional cost
given by area abc. This area measures pro­
duction inefficiencies resulting from the VER
program. The second net loss area, def, is a
loss in consumers’ surplus. Because of the
VER program, total car purchases have fallen
from Q f to Q j , and consumers incur a loss
represented by the area def. This area repre­
sents the consumers’ surplus that would
have been received from buying these units
at a price below their demand schedule
(except at the margin).
From an international perspective, area dee
(figure 1, panel A) also represents a net loss
measured in terms of foregone producers’ sur­
plus.6 Japanese producers intially bear this
loss. Because this article focuses on the costs
of the VER program to the United States, and
because we lack sufficient information about
Japanese production costs, we do not measure
this loss. Nor can we estimate the change in
Japanese producers’ profits resulting from the
VER program. However, we can approximate
the change in Japanese producers’ net reve­
nues via panel A. Area PfPjbd represents addi­
tional revenues from higher prices on the Qj
units sold after the VERs are imposed. Area
dcQJQ'j measures the revenue lost because
of a reduction in total units sold. The differ­
ence between these two areas is the net effect
on revenues, and it can be positive or nega­
tive, depending on the price elasticity of the
import-demand curve. If the demand curve

Economic Review • Summer 1984




is elastic, Japanese producers will lose reve­
nue as a result of the VER-induced price
increases. This revenue estimate provides a
link between our model of Japanese new cars
and domestic new cars.
In section II of this article, we develop an
econometric model to estimate the effects of
the VER program on prices of new Japanese
cars and on the number of new Japanese cars
sold in the United States. Following the theo­
retical analysis in figure 1, panel A, we can
then obtain estimates of the income transfers
and efficiency losses associated with the rise
in Japanese new-car prices and borne by U.S.
consumers. These measures are as follows:
(1) transfers from U.S. consumers of Japanese
cars to Japanese producers =
(Pj-Pf)Q j;

(2) net efficiency losses =
1/2 ( P j - P f ) ( Q J -

Qj).

Similarly, we can measure the loss to Japanese
new-car manufacturers as
(3) change in Japanese producers’
revenue =
[ ( P j - P f ) Q j ] - [P°(Q°- Qj)].

The empirical model departs from the
theoretical model presented in figure 1, as
it introduces into the analysis the role of
U.S. dealers of Japanese cars. (A theoretical
discussion of dealers appears in section II.)
The measures of the consumers’ surplus
loss described in figure 1 remain basically
the same except that we calculate the income
transfers to Japanese producers using the
change in wholesale prices; we estimate the
income transfer to U.S. dealers of Japanese
cars using the change in the dollar value
of dealers’ margins, and we calculate the effi­
ciency loss borne by U.S. consumers using
the change in the transactions price of new
Japanese cars. With the introduction of U.S.
automobile dealers into the analysis, we
also broaden the measure of revenue lost
to include both Japanese producers and
U.S. dealers.

7. See Santoni and
Van Cott (1980),
Falvey (1979), and
Feenstra (1982) for
references and
examples.
8. When the re­
straint is based on
value, such as an
ad valorum tariff,
the incentive to
upgrade quality does
not exist. Quality
increases raise the
value of the product
and would raise
the import duty by
a proportional
amount under an
ad valorum tariff.
There is no advan­
tage in this case
to improving quality.
9. In contrast, a
restriction based on
the value of imports
such as an ad valo­
rum tariff would
raise the price of
each car by the
tariff rate, 6,
Pi= Pi (1 + 0),

and
Pi = P2( 1 + 0).
Relative prices would
not change:
Pi = P2(l + e)
P{
PxiX + e) '

22

The Quality Adjustm ent Phenomenon

quality of imported Japanese cars should
increase in response to the VERs.8
Before turning to the empirical section, we
second explanation of quality upgrad­
should consider the possibility that the VER ingThe
involves
a shift to a better grade of mer­
program could alter the quality composition
chandise
within
a broad product category,
of Japanese cars. If quality improvements
largely
reflecting
to restraints
occur, measures of the income transfers and from the demand adjustments
side
of
the
market
(see Fal­
efficiency losses associated with the VERs
vey
1979).
Consider
a
Japanese
car
market
will be overstated since price changes will
of two models that are close, but
reflect greater product services in addition to consisting
not
perfect,
substitutes. The models differ in
economic rents. This section considers theo­ terms of quality
and options, and their prices
retical arguments for believing that quality
reflect
these
differences.
Following Feenstra
upgrading occurs as a result of the VERs.
(1982),
the
basic
and
higher-quality
Japa­
When faced with trade restraints on im­
nese
cars
will
have
unit
production
of
port quantities, foreign manufacturers often Ci and C2 , respectively, such that C\costs
is
less
upgrade the quality of their products in an
C2 . In the long-run competitive equilib­
attempt to maintain profits in the restricted than
rium
with no restraints, the following
market. The effect has been observed in
condition
holds:
the markets for imported textiles, footwear,
dairy products, steel, and, recently, Japanese (a) P\ = Ci < P2 - C2 ,
cars.7 Quotas, specific tariffs, and VERs are
where Pi and P2 are the respective car prices.
examples of such quality-altering trade re­
a VER program, the prices of both cars
straints. Trade restraints based on the value Under
will
rise
to P{ and Pi, respectively. At the
of imports do not promote quality upgrad­
margin
the
manufacturer
ing. The theoretical literature offers two expla­ will produceprofit-maximizing
the
car
yielding
the
nations for the quality-upgrading phenome­ return, ensuring that at the new highest
equilibrium
non (see Feenstra 1982).
(b) P{ - Ci = Pi - C2.
One explanation of quality upgrading
involves changes in the specifications of a
single, narrowly defined commodity that pri­ Substituting from equation 1 yields
(c) P{ - P, = Pi - P2.
marily reflects the response of foreign pro­
ducers to trade restraints (see Rodriguez 1979 The profit-maximizing producer will raise the
and Santoni and Van Cott 1980). According
prices of both cars by the same dollar amount,
to this view, an imported good consists of a
but this implies a reduction in the price of
bundle of characteristics appealing to con­
the more expensive car compared with the
sumers. A car, for example, provides trans­
price of the less expensive car:9
portation, comfort, and aesthetic appeal.
A VER limits the physical quantity of an
A
imported good, not the composition and
Pi < Pi
amounts of other characteristics embodied in Under some rather restrictive assumptions
the product. Foreign suppliers, facing quan­
about the own-price and cross-price elas­
tity restraints, have a strong incentive to
upgrade and increase the unrestrained attri­ ticities for the car models, a larger proportion
of the expensive cars will be sold (see Falvey
butes of their product. In the car example,
VERs limit the amount of transportation that 1979, pp. 1106-8). Even though the VERs
Japanese producers can sell in the U.S. mar­ reduce the overall quantity of new Japanese
ket, but not the amounts of comfort and
aesthetic appeal that they provide. The
Federal Reserve Bank of Cleveland




10. This figure is a
rough estimate. In
any given year, the
number of vehicles
actually arriving
in the United States
need not equal the
number of vehicles
exported from fapan
because of a ship­
ping time lag. A
small number of
vehicles not covered
by the 1.68-million
unit limit (for ex­
ample, some fourwheel drive vehicles,
which have a sep­
arate quota) are
included in sales
data. The VERs do
not include Japa­
nese cars shipped to
the United States
via another country,
which may also
cause a slight data
discrepancy.

cars, the proportion of more luxurious car
imports will rise.
The income transfers and efficiency losses
associated with VERs when quality upgrad­
ing occurs are less than those associated with
VERs when quality remains unchanged (see
Feenstra 1982, p. 14). When quality upgrad­
ing occurs following the imposition of trade
restraints, the observed price increases in­
clude both the rents resulting from artificial
restraints in the marketplace and the costs
of the improved quality. In measuring the
welfare effects of VERs, price increases
attributable solely to quality improvements
in the restricted goods can be excluded, as
these do not reduce consumers’ economic
well-being.

II. The Model

We estimated a supply and demand model for
the Japanese new-car market in the United
States. Unfortunately, data on retail (transac­
tions) prices of new Japanese cars, necessary
to estimate the two equations, are not avail­
able. As did earlier researchers, we found our­
selves in the unenviable position of having
to construct a measure of transactions prices
from available wholesale price data.
In this section, we envision a price-setting
process whereby new-car transactions prices
consist of three components: wholesale cost,
constant markup (reflecting overhead costs),
and variable markup (reflecting temporary
shortage or surplus in the marketplace).
In addition to the wholesale price, we assume
that the variable markup is a major chan­
nel of transmitting VER influence into the
marketplace. The signal by which U.S. deal­
ers recognize changing market conditions,
and consequently adjust variable margins, is
provided by dealers’ inventory pressures.
In our analysis we first built an inventory
model of new Japanese cars from which we
derived a ratio of desired to actual Japanese
new-car inventories. This ratio is the crucial
(and admittedly tenuous) link to the variable

Economic Review • Summer 1984




margin component. Next, we formulated a
wholesale cost equation, where the dealer
cost of cars is a function of unit sales, the
bundle of car options, and the dollar/yen ex­
change rate. Using a two-stage least squares
regression technique, we estimated models
of wholesale prices and Japanese new-car
demand with quarterly data over an eightyear period (1976:IQ to 1984:IQ).

The Basic Framework with Inventories
The quotas on new cars from Japan restrict
imports rather than sales. Given the existence
of inventories, sales of Japanese cars need
not directly equal imports.
(1) Japanese sales = imports from Japan
- change in inven­
tory stocks.
As a result, the degree to which quotas bind
the marketplace and generate consumer price
increases depends on the state of inventories
over the period. In 1981, sales of new Japa­
nese autos (and utility vehicles) exceeded the
quota by 21,000 units.10 Over the same period,
inventories of new Japanese cars fell 34,000
units. Did the first year of the quotas influ­
ence Japanese new-car prices? Only insofar as
the quotas forced dealers’ inventories below
desired levels, which respond to overall eco­
nomic conditions. Just prior to the VER
program, for example, U.S. interest rates
reached unusually high levels and the auto
market was in a state of cyclical contrac­
tion. U.S. dealers of Japanese cars could have
intentionally liquidated inventory stocks in
response to the declining market environ­
ment. If the inventory corrections that oc­
curred in 1981 were adjustments to desired
levels and not quota-induced, the VER pro­
gram would be nonbinding, having no price,
quantity, or related effects. The initial task,
therefore, is to measure actual Japanese newcar inventories relative to a desired inven­
tory position.
Virtually all new-car inventories are held
by independently owned dealerships that

compete in a highly competitive marketplace
where inventory stocks and retail prices
adjust rapidly to market conditions. If an
overstock of inventories exists, new-car deal­
ers will lower prices, thus stimulating sales;
if inventories fall below desired levels, dealers
increase retail prices. Such a market-clearing
process has important implications to our
analysis, implying that the transactions
prices of new cars are tied to dealers’ inven­
tory positions and that transactions price
patterns can deviate from wholesale newcar price patterns.
Inventories and variable dealers’ margins
in the market-clearing process allow the deal­
ers’ supply curve, S^(the effective short-run
market supply curve), to deviate from the
manufacturers’ supply curve, Sm, over short
periods of time (see figure 2). To illustrate,
imagine that foreign manufacturers are in a
state of equilibrium in that they import an
amount equal to consumer demand into the
domestic market. Such a state could be rep­
resented by point A in figure 2. The dealer is
in a state of equilibrium in that inventory
stocks are at desired levels. In such a case,
the retail price of the product, P \ , is equal to
the wholesale price plus a constant dealers’
margin. Suppose that demand in the market­
place suddenly surges from D\ to D 2 . Inasmuch
as increased foreign imports require a sub­
stantial lead time for delivery from a foreign
manufacturer, sales in part will be main­
tained by an “undesired” inventory liqui­
dation at the dealers’ level: the dealers expe­
rience inventory shortages. Dealers are
induced into the shortage condition because
of higher margins (or dealers’ rents) as con­
sumers bid up the existing price of the
product in short supply (represented as the
difference between P\ and P 2). A short-term
equilibrium is achieved at point B in figure 2,
where the dealers’ supply curve intersects
the market demand curve. However, this is
only a temporary equilibrium, since compe­
tition and manufacturers’ pressure will tend
to increase dealers’ supplies. Shipments are
made by the foreign manufacturer, and
Federal Reserve Bank of Cleveland




dealers restock inventories to desired levels.
Consequently, the dealers’ supply curve trav­
els along the manufacturers’ supply curve
(S^to Sd) as the level of imports is increased,
and a more lasting equilibrium is reached at
point C. Here, dealers are again earning no
economic rents, while manufacturers are
selling more of the foreign product at higher
wholesale prices. Retail prices in the final
equilibrium, P3, are higher than the initial
retail price, P\, but lower than the retail price
immediately following the demand shift, P2 .
The existence of inventories can dramati­
cally change the standard supply-constraint
analysis shown in figure 1 to an environment
more accurately resembling that in figure 3.
Notice that, in situations where the existence
of inventories is significant, the supply curve
of the restricted product does not become
vertical until inventories are zero. That is,
the point at which the market supply curve
becomes fully binding, Si, is lengthened
by the amount of the inventory stock, Si to
S 2 . Indeed, the temptation is to argue—
erroneously—that import restrictions need
never be binding as long as inventories exist.
Imagine that in the current period we are at
equilibrium with respect to inventory stocks,
or the dealers’ supply curve intersects the
manufacturers’ supply curve at current unit
sales levels, represented by point A in fig­
ure 4. Notice that this equilibrium sales
quantity is also equal to the level of imports
from the manufacturer, since only if unit
sales match imports will actual inventories
equal desired inventories. Next we institute a
limit on imports such that they cannot exceed
the level designated by the current unit sales
level. If demand increases such that unit
sales exceed the quota, undesired inventory
liquidations occur, and dealers earn rents (fig­
ure 4, point B). Inasmuch as the quota pre­
vents further shipments from a foreign coun­
try, the dealers’ supply schedule is essentially

fixed to th e in tersectio n of th e m a n u fa c tu r­
converges on th e im p o rt q u o ta c o n stra in t, the
e rs ’ su pp ly cu rv e at point A . O ver tim e, as
d e a le rs’ su pp ly cu rv e becom es m ore vertical,
inv en to ries are depleted and app ro ach zero,
and, in th e lim it, th e d e a le rs’ su pp ly cu rv e
th e v ertical su pp ly c o n stra in t, S 2 , collapses
becom es v ertical at th e q u o ta level. E v e n tu ­
leftw ard to w ard th e im p o rt q u ota, S\ (figure 5). ally, th e m ark et w ill settle in a quota-induced
eq u ilib riu m at point D.
L ikew ise, as th e v ertical su pp ly c o n stra in t

Fig. 2 Inventories and Supply

Fig. 3 Inventories and VERs

Prices

Prices

Units

Fig. 4 Short-run Equilibrium
Prices

Quota plus
inventories

1

1

Units

Prices

Si

Economic Review • Summer 1984

Im port
quota

Fig. 5 Long-run Equilibrium

Units




S,

Units

11. See appendix fo r
a detailed descrip­
tion of the variables
used in this article.
12. Although many
alternative fu n c ­
tions were esti­
mated, all yielded
strikingly sim ilar
results.

26

The Inventory Model
Irvine (1979) has demonstrated that monthly
models of dealers’ new-car inventory behav­
ior outperform similarly specified quarterly
models. Inventory adjustments at the deal­
ers’ level proceed rapidly, and, consequently,
adjustments between desired and actual deal­
ers’ inventory holdings often occur within
a matter of months. That is, inventory dis­
equilibrium in the absence of constraints
does not persist over long time horizons. For
this reason, we have chosen to specify a Feldstein/Auerbach target-adjustment inventory
model that allows rapid inventory adjust­
ment to a relatively slowly changing, desired
inventory target (Feldstein 1976). This inven­
tory model hypothesizes that dealers’ inven­
tories are equal to a desired inventory posi­
tion plus a fraction of the unanticipated
dealers’ sales forecast error and a random
error (see Feldstein 1976, p. 369).
(2) It = I f + d(Set - St) +
where
It = actual unit inventories
in period t,
I f = desired unit inventories
in period t,
St = actual sales in period t,
Set = dealers’ sales expectations
in period t.u
Dealers hold inventories for many differ­
ent reasons. Primarily, dealers hold a desired
level of inventories to provide an immediate
supply to the retail market and to meet a con­
tinuous demand for sales between periodic
deliveries from a foreign manufacturer. These
inventories must further allow for a suffi­
cient variety of models to satisfy alternative
consumer preferences. As sales increase,
dealers’ inventory holdings should increase.
Inventories also involve costs to the dealers
in terms of wholesale price and borrowing
expenses. These costs tend to offset the sales
influence on the dealers’ desired inventory

Federal Reserve Bank of Cleveland




positions. Therefore, following Irvine (1979,
p. 3), we specify a dealer’s desired inventory
position as a linear function of sales and
the real cost of holding inventories, or
(3) I f = aiSf + a2StCt,
where
Ct = real marginal inventory holding
cost during the current quarter.
Substituting equation 3 into equation 2 and
dividing through by sales, we can estimate
new-car inventory behavior in quarters-supply
form. A nonseasonal, quarterly model was
specified to isolate the influence of seasonal
fluctuations in new-car inventories that
eventually translate into seasonally sensitive
transactions prices.12 The equation was esti­
mated over the non-VER period, 1975:IQ to
1981:IQ, using second-order serial correla­
tion correction. The /-statistics are in paren­
theses. The estimation horizon does not
include the VER period, since we expect that
the quotas may have artificially prevented
actual new-car inventories from maintaining
a “desired” level and consequently precipi­
tated a long-term inventory shortage. Since
we do not have an accurate measure of the
VER influence on inventories, estimating
a Feldstein-Auerbach inventory specification
over the full time horizon runs the risk of
biasing the regression results. The estimated
inventory equation was
It/St = 1.51 - 0.055Q + 0.132(Sf - St)/St
(3.27)
(0.72)
- 0.23DQ2 - 0.31DQ3 + 0.08DQA
(3.63)
(3.80)
(1.32)
+ 1.217RH01 - 0.753RH02,
(9.75)
(3.50)
(D W = 1.90, R2 = 0.72,
SEE = 0.162, F = 9.78).

13. After adjusting
for the first-quarter
seasonal dummy,
the constant value
is 1.39.
14. The presence
of a strong seasonal
pattern can also
account for some of
the serial correla­
tion detected in this
equation, inasmuch
as these dummies
are only a crude
approximation of
what may be a much
more complex sea­
sonal influence.

The results of this model were encouraging
in coefficient values and fit, but discourag­
ing because of the presence of second-order
serial correlation. Many factors can generate
serial correlation. Our primary concern is
that we may have omitted a determinant of
new-car inventory behavior. One possible
omission, found in Irvine (1979), is a price
expectation variable that enters into the
inventory cost component. Dealers can hold
inventories in anticipation of future price
increases that would yield capital gains on
new-car stocks. Attempts to capture such a
“speculative” auto inventory behavior using
various expected inflation measures were all
unsuccessful. However, the existence of serial
correlation may simply be a consequence of a
desired inventory level that displays a ten­
dency toward inertia. Indeed, the significant,
but small, value on the cost variable sug­
gests that target inventory levels adjust quite
slowly to changes in inventory-holding costs.
The constant term is significantly larger
than 1, which implies that dealers maintain
an inventory buffer against random fluc­
tuations in sales.13 The high coefficient also

Fig. 6 Desired Dealer Inventories
Relative to Actual

Ratio

27

1

Economic Review • Summer 1984




Years
2

3

could reflect holdings of a mix of model types.
The presence of large and highly significant
dummy coefficients (DQ2 , DQ3, DQ4) indi­
cates a strong seasonal pattern in the auto­
mobile market. Relative to sales, auto inven­
tories are most plentiful during the first half
of the model year (IVQ and IQ), while inven­
tories relative to sales dramatically decline
during the third quarter as manufacturers
make the transition to new models.14 Al­
though further research may result in supe­
rior inventory specifications, the econometric
model presented here is consistent with pre­
vious auto inventory analysis.
From these estimates, we calculated the
dealers’ desired inventory-to-sales position.
The desired dealers’ inventory-sales ratio can
be expressed as a ratio of total inventories to
sales, yielding a quarterly measure of newcar inventory pressure called SHORT (that
is, SHORT = /*//). As the ratio increases (or
decreases) from 1, a shortage (or surplus)
of inventories develops at the retail level. Fig­
ure 6 shows the estimated quarterly fluctua­
tions of desired Japanese dealers’ inventories
relative to actual inventories over the 1975:IQ
to 1984:IQ period.
In the pre-VER period, the series accurately
illustrates quarters that experienced sub­
stantial inventory shortages or surpluses. For
example, between the second and third quar­
ters of 1975, a shortage of domestic subcom­
pacts, combined with surging gasoline prices,
fueled a mini-sales boom in the Japanese
new-car market. Consequently, actual deal­
ers’ inventory positions temporarily strayed
from desired levels. After showing equilib­
rium in inventories for the earlier quarter,
the shortage variable rose to a value of 1.74
in 1975:IIIQ, or desired dealers’ invento­
ries of Japanese cars were approximately
74 percent above actual levels. The index fell
to 1.23 in the following quarter. In mid-1977,
an unexpected, record-producing surge in Jap­
anese new-car sales created another inven­
tory shortage: the shortage variable rose from
1.01 in 1977:IQ to 1.70 in 1977:IIQ to 2.06 in
1977:IIIQ. By 1977:IVQ, the shortage virtually

15. The equilib­
rium, or trend,
markup was calcu­
lated using annual
data found in Con­
sumer Reports
(April issues, 1977
through 1983). The
markup represents
the percentage dif­
ference between
dealers ’ costs and
list prices of a salesweighted composite
of Japanese models.

28

disappeared, and the ratio of desired inven­
tories relative to actual inventories remained
at 1.17.
Using the non-VER inventory model, we
calculated inventory shortages over the VER
period, attributing any inventory shortage to
the effects of the VER program. These esti­
mates suggest that a meaningful shortage of
Japanese cars at the retail level did not exist
during the VERs’ first year, as the begin­
ning of the program coincided with a cyclical
decline in Japanese new-car sales and rela­
tively high U.S. interest rates that induced
dealers to liquidate their desired inventories.
According to our estimates, an overstock
of Japanese new-car inventories existed at
the dealers’ level, on average, throughout
the first year of the VER program. Although
more binding during their second year, the
VERs were weakened as the market for new
Japanese cars continued to deteriorate during
1982. Inventories deviated substantially from
desired levels by year-end 1982, however,
and during the third year of the VERs the
Japanese new-car market experienced unprec­
edented shortages.

atile and wholesale prices are not), a constant
margin model may fail to reflect the underly­
ing price mechanism. We have augmented the
constant margin model to allow for two deal­
ers’ margin components: (1) a long-run mar­
gin (or marginal costs at the dealers’ level),
and (2) a short-run margin (or the dealers’
rents), as shown in equation 4.
(4) Pj= V- M - R,
where
Pj = transactions price of new Japa­
nese cars,
V = wholesale value of new Japanese
cars (in dollars),
M = 1 + marginal cost margin,
R = 1 + dealers’ rents.
The long-run equilibrium margin, M, was con­
structed by using 1 plus the average annual
markup of Japanese cars (dealers’ cost vs. list
price); over the 1977 to 1984 period, this mark­
up averaged 16.8 percent.15 The short-run
margin, R, was assumed to be a function of
short-run market conditions, or the relative
shortage of dealers’ inventories, as speci­
fied in equation 5:
The Price Model
(5) R = (SHORT,.!)1*,
Data on the dealers’ (wholesale) costs of
where
new Japanese cars are readily available, but
k = price adjustment parameter that
there are no publicly available data on Japa­
determines degree to which inven­
nese new-car transactions prices. We have
tory disequilibrium generates
attempted to specify the relationship that
transactions price changes.
ties these two price series together. The link
between the wholesale cost to dealers and the
This specification is appealing because
market price ultimately paid by consumers
it allows undesired fluctuations in invento­
depends on dealers’ margins. As a transac­
ries to translate into the price variable, as
tions price proxy, earlier analyses have used
described in figure 2. We maintain the
wholesale price data (dealers’ cost of new
competitive property of no long-run deal­
cars) adjusted by a constant dealers’ margin
ers’ rents, since desired dealers’ inventories
(see Feenstra 1982; Carlson 1978; and Carl­
tend toward actual inventories over time
son and Umble 1983). However, in an environ­ (in the absence of supply constraints). As a
ment where dealers play an important role in matter of empirical convenience, this specifi­
the market-clearing process (that is, under
cation allows us to substitute the inventory
conditions where inventories are highly vol­ shortage variable into the demand equation
as a proxy for fluctuations in dealers’ mar­
gins—the missing link in the transactions
price specification.
Federal Reserve Bank of Cleveland




This is not to say that dealers are assigned
all of the market-clearing responsibility. In­
deed, there exists a manufacturers’ supply
function, which makes it necessary to esti­
mate a wholesale price equation that is
responsive to market conditions. As a result,
our wholesale price model includes a sales
variable in an effort to capture the influence
of market demand on Japanese new-car prices.
Also embedded in the wholesale price data
are changes in product quality. As discussed
in section I, if product quality changes are
significant, studies that fail to adjust for
the influence of these changes on the price var­
iable will necessarily bias the estimated price
elasticity. As a proxy for such quality shifts,
we constructed an index of five Japanese newcar options (automatic transmissions, power
steering, air conditioning, sunroof, and audio
systems), using data from Ward’s Automo­
tive Reports (see appendix). The historical pat­
tern of the Japanese options index is shown
in figure 7.
The Japanese options index has risen con­
siderably since its 1975 base year, with a
strong underlying trend. It is likely that the
trend increase in the quality index simply
reflects a maturing product life cycle. The

Fig. 7 Japanese Options Index
Index 1975:IVQ = 100

Japanese entered the new-car market as a
low-margin, high-volume competitor. Having
succeeded in this market, the Japanese sub­
sequently expanded the boundaries of their
market influence. After 1982, the second year
of the VER program, the options index rose
noticeably above its historic trend rate of
increase, suggesting further that the VER
program had little impact in the market­
place during its initial years. Beyond 1982,
as inventories of new Japanese cars sharply
tightened, the options index rose substan­
tially faster than trend.
Our wholesale price model also accounts
for fluctuations in the dollar/yen exchange
rate, which influences the wholesale price of
Japanese cars to U.S. dealers. That is, as the
dollar/yen exchange rate rises, the dollar
wholesale price of new Japanese cars will
rise, other things being equal. The resulting
wholesale price model is shown in equation 6:
(6) VJ72t = f(SALESt, OPTIONt, YENt),
where
VJ72t = real wholesale cost of
new Japanese cars,
SALESt = per capita Japanese newcar sales, in units,
OPTIONt - Japanese options index,
YENt = dollar/yen exchange rate.

The Demand Model

The final step in our modeling process in­
volves the specification of the demand equa­
tion. Since Chow’s seminal work in 1957,
auto demand models have been cast in a stockadjustment framework, where sales are a
function of the difference between desired and
actual auto stocks (called new demand) and
auto stocks of the last period (called replace­

240

1976

1978

1980

1982

Economic Review • Summer 1984




1984

16. The two-stage
estimation proce­
dure used in this
analysis is the Fair
estimator with
serially correlated
errors. The compu­
ter program we
used was PEC 9.1
(Jon K. Peck, PEC
(Program for Econ­
ometric Computa­
tion), Version 9.1,
Yale University,
March 1982). Care
should be used when
interpreting the
t-statistics, as the
standard errors
are not exactly cor­
rect. For a thorough
discussion of the
procedure, see
Fair (1970).
17. An alternative
procedure would
have been to esti­
mate the equation
over the non-VER
period and fore­
cast out of sample
through 1984: IQ.
Because of the small
sample problems
that already exist,
this alternative did
not appear feasible.

ment demand). Desired stocks are determined
generally by relative prices, real income,
and demographics.
(7) St = f(K *~ K t_i) + d(Kt.i),
where
f and d - functional forms,
s t = sales of new cars in cur­
rent period,
Kt. i = stock of cars in previ­
ous period,
K f = desired stock of new cars
in current period.
and
(8) K t = f(P t, G^4S72/, Y72t,HHt),
where
Pt - price of new cars relative
to rate of inflation,
GAS72t = weighted operating costs
of cars relative to rate
of inflation,
Y72t = real per capita perma­
nent income,
HHt - U.S. civilian, noninstitutional population.
Unfortunately, the stock-adjustment
approach does not lend itself easily to this
analysis, as data on auto stocks are available
on an annual basis and therefore limit our
ability to estimate the impacts of an importrestraint program that has been in effect
since April 1981. As in many auto-demand
studies, we instead chose to estimate directly
per capita new-auto sales as a function of
desired stock explanatory variables: real price
(specified in equation 4), real operating cost,
and real income.
(9) SALESt = f(P]t, GAS72,, Y72t),
where
SALESt = St/HHt,

Pjt = relative price of new

Japanese cars.

30

Federal Reserve Bank of Cleveland




Estimation
Given the wholesale price model of equa­
tion 6, and having specified the transactions
price mechanism in equation 4, we can esti­
mate the supply and demand equations for
the Japanese new-car market. The equations
were estimated using two-stage least squares
with first- and second-order serial correla­
tion correction.16 The estimation period was
1976:IQ to 1984:IQ.17
(10) LVJ721 = 4.63 + O.IOLSAL^S,
(2.24)
+ 019LOPTIONt + 0.27LYE Nt
(4.46)
(2.42)
+ 0.96RH01 - 0.32RH02,
(5.82)
(1.96)
( DW= 2.21, R 2 = 0.98,
SEE = 0.027, F = 590.0).
(11)

LSALES, =

+
+

-4.84 - 1.31LF/72,
(1.17)
0.\7LSHORTt_x

(2.07)

0.60LGAS72t

(1.26)

+ 7.54LF72,
(2.15)

0.53RHOI - 0.32RH02,

(3.21)

(1.95)

( DW= 1.92, R 2 = 0.65,
SEE = 0.132, F = 13.2).

where
L -

SHORTt_!

log form,

= iU / It-i.
The coefficient on the log-adjusted wholesaleprice variable (LVJ72) is a direct estimate of
the own-price elasticity of new Japanese cars,
-1.31; the coefficient on the log markup var­
iable (LSHORT) represents this price elastic­

18. Remembering
that the price
specification is
Pj = V- M - R, the
estimated price elas­
ticity is the coeffi­
cient on the log of
Pj, or, in this
instance, /30lnPj
= p 0(\nV + In M
+ k\nSHORT). Our
estimate of k, the
sensitivity of Japa­
nese inventory
shortages on trans­
actions prices, is
0.133. (An estimate
of 0 suggests that
inventory shortages
play no role in the
price-setting process,
while an estimate of
1 suggests that per­
centage changes in
shortages generate
equal percentage
changes in transac­
tions prices.)

ity times the dealers’ rents adjustment, k.m
Our price elasticity estimate is slightly
larger than that found by Carlson (1978) for
subcompact and compact cars and slightly
smaller than that found by Carlson and
Umble (1983) for compact cars.19
The other components of the Japanese newcar demand model conform to our expecta­
tions and to the results of other auto-demand
studies. As nearly all auto-demand studies
find, real permanent income is the primary
determinant of new-auto sales. The Japanese
market is no exception. In addition, the cost
of operating cars has a positive influence
on Japanese new-car purchases. Carlson (1978),
Carlson and Umble (1983), and Tishler (1982)
had similar findings for the subcompact
and compact new-car markets.

III. The Results

Model Simulations

Our final task is to simulate the wholesale
price and demand equations under a set of
non-VER assumptions to speculate on the

Fig. 8 Japanese New-Car Prices

quantity and price combinations that would
have resulted in the absence of the program.
These simulations are highly dependent on
our assumptions concerning non-VER market
conditions and thus should be viewed with a
measure of caution. However, each assump­
tion was made to allow for the maximum
price and quantity impacts on the system. In
the price equation, we assume that, in the
absence of the VERs, the options index would
have maintained its 1981:IVQ value through­
out the 12-quarter VER period.20 In the demand
equation, we assume that dealers’ inventory
positions would have maintained an equilib­
rium ratio of 1 over each of the VER years.21
The results of these simulations are shown in
table 1. According to our simulations, in its
first year the VER program had virtually no
effect on the U.S. automobile market. The
options-adjusted transactions prices of new
Japanese cars increased by only $11 per unit
because of the restrictions, primarily reflect­
ing a rise in wholesale prices. Dealers did not
significantly raise their markups following
the VER program; they experienced an over­
stocked inventory position prior to the VER
program that lasted halfway through the pro­
gram’s first year. The VERs consequently

Thousands of dollars

10

1976

31

1978
1980
Variable
m arkup

1982
Constant
m arkup

Economic Review • Summer 1984




1984

Although we use real, options-adjusted prices through­
out the estim ations, nominal unadjusted price esti­
mates have been included in figure 8 to show the be­
havior of actual consumer prices over the VER period
and to compare these w ith the price estim ates found
in a constant m arkup model. The variable margin
specification yields an average price that seasonally
fluctuates around the constant m arkup price vari­
able throughout the non-VER period. As VER-related
shortages develop in the marketplace though, the
constant m arkup price m easure fails to register
meaningful increases compared w ith the dram atic
acceleration in prices estim ated by our approach. For
example, our estimates suggest that the average price
of a new Japanese car during 1983 was approximately
$8,315, while a constant markup approach would yield
an average price of $7,385.

19. Carlson (1978)
found a price elas­
ticity of 0.82 for the
subcompact newcar market and 1.21
for the compact mar­
ket. Carlson and
Umble (1983) found
the price variable
to be insignificant
in the subcompact
market, with a
compact new-car
price elasticity
of 1.47.
20. In fact, it is
quite likely that the
Japanese would
have continued
some options up­
grading in light of
such a strong trend
component. This
result would tend to
decrease the influ­
ence of the VERs in
the simulations.
21. Because the
“glu t” experienced
in the Japanese newcar market in 1981
conceivably could
have been more se­
vere without the
VERs, these simula­
tions may under­
state the VERs ’
influence. However,
observation suggests
that such severe
surpluses are rare;
the possibility of a
more dramatic sur­
plus in 1981 is
remote. It is possible
that the glut was in
part VER-induced,
if manufacturers
attempted to build
inventories in antic­
ipation of a shortage
that never fully
materialized.

32

lowered sales by only 4,000 units during the
first year, a negligible amount for a market in
which sales averaged approximately 1.8 mil­
lion units in the previous two years.
During the second year of the VER pro­
gram, transactions prices increased $273 as
dealers experienced more sizable inventory
shortages. Most of this increase reflected
dealers’ markups, as wholesale prices of new
Japanese cars increased $51. Unit sales fell
78.000 during the second year of the VER
program. With the U.S. economic recovery
under way in 1983, the VER impact on prices
intensified; transactions prices rose $1,114.
Again, most of the options-adjusted price in­
creases reflect dealers’ markups ($956), com­
pared with an options-adjusted wholesale price
increase of $158. As a result, unit sales fell
299.000 units between 1983:IIQ and 1984:IQ.
The total, three-year loss in consumers’
surplus resulting from the VER-induced
increase in Japanese new-car prices was
approximately $2.7 billion (see table 2). Most
of the loss was experienced in 1983, when
the program was most binding on the U.S.
market. Of this total amount, $2.6 billion
represents a transfer of purchasing power to
producers and dealers of Japanese cars from
U.S. consumers who continue to buy Japa­
nese cars at artificially high prices. Approx­
imately 80 percent of this income transferred
to U.S. dealers of Japanese cars and does
not represent a net loss to the United States.
Japanese producers received the remaining
$401 million. Although most funds eventually
will return to the United States via world
trade, such a return would be a long-term phe­
nomenon. Because of the VERs, the prices
of U.S. imports could rise relative to the
prices of U.S. exports, producing a loss to
the United States. Of the total reduction in
consumers’ surplus, we attribute $177 million
to increased inefficiencies in production and
foregone consumption opportunities, also
representing a loss to the United States.
We also measured the net change in rev­
enues accruing to the Japanese automobile
Federal Reserve Bank of Cleveland




producers and U.S. dealers because of the
VERs. Over the three-year period, Japanese
producers and U.S. dealers lost $125 million
in revenues because of the VER program;
higher prices on the units sold did not gen­
erate enough revenue to offset a reduction in
volume, because the import demand curve
is elastic. Without knowledge of Japanese
cost curves, however, we do not know how
these revenue reductions translate into
profit performance.

Impact on the U.S. Market
Using the estimates obtained from the Japa­
nese auto demand model, we can speculate
about the largest possible effects of the VER
program on the number of U.S. cars produced
and the number of U.S. workers hired. A
fairly standard assumption in the literature
on automobile demand is that the overall
price elasticity of demand for new cars equals
1. This implies that the total amount of rev­
enue spent on new cars does not change over­
all. As an extreme case, we assume that any
revenue not spent on new Japanese cars is
spent on other new cars. We further assume
that revenue not spent on new Japanese cars
is spent entirely on new U.S. subcompact
cars. This is an overestimate, as consumers
would spend some of this revenue on new
non-Japanese foreign cars and on compact or
full-sized American cars. Dividing this reve­
nue transfer by the average price of a new
subcompact American car, we obtain a rough
estimate of the additional units of new U.S.
cars produced. Following this procedure, we
determined that the VER program increased
U.S. car production by 399 units in 1981,
3,444 units in 1982, and 16,768 units in 1983
(see table 3).
Having estimated the units produced, we
can determine the associated employment
effects using assumptions about labor pro­
ductivity and average hours worked. Table 3
shows the total hours necessary to produce
the additional units, adopting a U.S. Con­
gress (1982) estimate that it takes 200 man-

22. The man-hours
estimate refers to
autoworkers and
workers in directly
related industries
(see U.S. Congress
1982).

hours to produce one subcompact car in the
are based on our model’s results, they too
United States.22 We estimate that the VER
are small relative to the findings of the other
program stimulated an additional 79,800
studies cited.
production man-hours during its first year,
These employment gains do not represent
688,800 hours in 1982, and 3.4 million hours
net benefits to the United States because of
in 1983. The link between our hours esti­
the VER program, especially in the long run.
mates and actual employment gains is uncer­ As discussed earlier, the U.S. revenue gains
tain, as additional hours may be distributed
represent a transfer from consumers to domes­
among the existing workforce. As a conser­
tic producers and workers. These funds now
vative estimate, we can assume that the
remain in the United States and increase
average hours worked per U.S. autoworker
jobs in the automobile industry, but this does
remain unchanged as a result of the export
not necessarily imply a net increase in U.S.
restraints, in which case additional U.S.
employment in the long run. Most funds sent
employment can be determined using the
abroad to pay for Japanese imports eventually
average hours worked per U.S. autoworker.
return to the United States as foreigners buy
We estimate that VERs increased U.S. auto­ U.S. exports. In the long run, any gains in
mobile employment by 38 workers in 1981,
auto industry employment because of the
328 in 1982, and 1,492 in 1983. This compares VERs must be compared with possible losses
with indefinite layoffs of 250,000 U.S. auto­
in U.S. employment among export-oriented
workers at the industry’s 1982 employment
industries. The net result depends on the
trough. Because these employment estimates decline in exports and the relative intensity
of labor in the production functions of these
two industries. Such comparisons are beyond
the scope of this article, but gains in auto­
Table 1 Impacts of VERs on Prices
worker employment should not be labeled
and Quantities of New Japanese Cars
as net benefits in the absence of such
1981
1982
1983
comparisons.
Dealer cost,
in dollars
With VERs
W ithout VERs
Difference
Percent change
Transactions price,
in dollars
With VERs
W ithout VERs
Difference
Percent change
Unit sales
estim ates,
in thousands
With VERs
W ithout VERs
Difference
Percent change

5,479
5,469
10
0.2

5,759
5,709
51
1.1

6,294
6,137
158
2.6

6,284
6,273
0.2

6,941
6,668
273
4.1

8,282
7,168
1,114
15.5

1,962
1,966
-4
-0.2

1,829
1,908
-78
-4.1

1,831
2,130
-299
-14.0

11

NOTE: Annual data are derived from quarterly estimates and may not
sum exactly because of rounding errors. Years correspond to VER years,
beginning in the second quarter of the current year and running through
the first quarter of the subsequent year.

33

Economic Review • Summer 1984




Results in Perspective
To the best of our knowledge, ours is the
only study that considers the effects of the
VER program over its first three years. More­
over, it is difficult to compare our results
with those of other studies, because of meth­
odological differences (see Crandall 1984;
Feenstra 1982; Gomez-Ibanez, Leone, and
O’Connell 1983; Stuchlak, Shickman, and
Pochiluk, Jr. 1983; and Wharton 1983). Our
results show substantially weaker first-year
effects than other studies but a large impact
by 1983. Two factors seem to distinguish
our results from those of earlier studies. Un­
like other researchers (except Feenstra), we
adjusted wholesale prices for options. As dis­
cussed earlier, studies that fail to adjust for
options will overstate the impact of the VER
program on prices and measures derived from
prices. We also introduced the role of inven­
tories into the analysis. This should dampen

the estimated impacts of VERs, especially
Feenstra and Gomez-Ibanez, Leone, and
in 1981 and 1982, relative to the results of
O’Connell provide sufficient description
studies that implicitly assume no inventories. to make some useful comparisons with our
results. After adjusting for inflation, Feen­
stra observes that the average import price of
new Japanese cars rose 8.4 percent in 1981.
Table 2 Income Transfers and
He provides a detailed explanation of quality
Efficiency Losses Associated with VERs
upgrading and concludes that 5.3 percent
In millions of dollars
of
the observed price increase reflects VER1982
1983
Total
1981
induced quality adjustments. The remaining
Total consum ers’ 21.6 510.8 2,206.4 2,738.8
3.1 percent increase is the VER-induced rents
surplus loss
component of the price rise. Assuming ownIncome transfers
price elasticities for Japanese automobile ser­
19.4
92.6 288.8 400.8
To Japanese
vices
of 2 and 3, Feenstra estimates that 1981
m anufacturers
sales of Japanese cars fell 220,000 units and
2.2 407.5 1,751.2 2,160.9
To U.S. dealers
277,000
units, respectively. The resulting
500.1
2,561.7
21.6
2,040.0
Total
gains in U.S. autoworker employment were
10.7 166.4 177.1
0.0
Efficiency loss
5,600 and 11,100 workers, respectively. After
21.3
101.7 125.3
2.3
M arket revenue
adjusting for the influence of quality, Feen­
loss
stra calculates that the consumers’ surplus
NOTE: Annual data are derived from quarterly estimates and may not
loss was between $322 million and $327 mil­
sum exactly because of rounding errors. Years correspond to VER years,
lion in 1981 under his respective elasticity
beginning in the second quarter of the current year and running through
assumptions. Feenstra also examines the
the first quarter of the subsequent year.
effects of VERs under the assumption of an
inelastic own-price demand for Japanese
automobile services (0.9). In this case, sales
Table 3 Impacts of VERs on
of
Japanese cars would have fallen (123,000
U.S. Autoworker Employment
units); total revenues spent on Japanese cars
Output, hours, or
would have risen. Consequently, U.S. new1983
employment
1981
1982
car sales would have declined 5,300 units and
Revenues lost by 2,300,000 21,300,000 101,700,000
U.S. autoworker employment would have
Japan, dollars
fallen by 600 workers. The total loss in con­
6,065
U.S. average
5,768
6,184
sumers’ surplus for the inelastic scenario
subcompact
equaled
$314 million.
price, dollars
Gomez-Ibanez,
Leone, and O’Connell con­
3,444
16,768
Additional U.S.
399
structed
a
model
of
the U.S. market to mea­
supcompact
production, units
sure the effects of the VER program that did
not include a quality-adjustment allowance or
688,800 3,353,600
Additional U.S.
79,800
an
inventory influence. Instead, they divided
production hours
the
U.S. market into basic small cars (Japa­
2,247.7
2,103.8
Average annual
2,125.9
nese
and all others), luxury small cars (Japa­
man-hours per
worker
nese and all others), and traditional cars.
The researchers simulated their model,
1,492
Additional U.S.
328
38
auto employment
which is not specific to a particular year,
under alternative assumptions about the over­
NOTE: Annual data are derived from quarterly estimates and may not
sum exactly because of rounding errors. Years correspond to VER years,
all
strength of the U.S. new-car market and
beginning in the second quarter of the current year and running through
different
price/quantity reactions to the VER
the first quarter of the subsequent year.
program from domestic car producers. The
case of a weak U.S. market (total new-car
sales of 8.8 million units) and both price and
quantity
responses from U.S. manufacturers
Federal Reserve Bank of Cleveland




23. Actual new-car
sales were 8.1 m il­
lion units in 1981,
8.0 million units in
1982, and 9.2 mil­
lion units in 1983.

seems the most representative of the actual
market environment.23 In this case, the VERs
raised Japanese new-car prices 2.6 percent
per year and reduced Japanese new-car sales in
the United States 6.7 percent per year. U.S.
car production rose 0.5 percent, and U.S. auto­
worker employment increased 6,500 workers.
Gomez-Ibanez, Leone, and O’Connell esti­
mated that the loss to consumers in all seg­
ments of the market was $566 million per year.

IV. Conclusion

International trade theory demonstrates that
artificial barriers against imports raise prices
of traded goods, transfer income from con­
sumers to producers, and create production and
consumption inefficiencies. This article has
illustrated these effects for the case of the Jap­
anese VERs on new-car imports to the United
States. The results of our empirical analysis
are tentative approximations because of the
small size of our sample and the unavoidable
difficulties of estimating structural models.
Given the partial equilibrium nature of our
analysis, the costs of the VER program could
be greater than we have estimated.
Our results suggest that in its initial year
the VER program had little effect on the
U.S. market for Japanese cars and did not
appreciably create new auto-industry employ­
ment in the United States. At the time, inven­
tories of new Japanese cars were overstocked
because of weakening new-car demand and
high-inventory carrying costs. With the U.S.
economic recovery under way in 1983, inven­
tory shortages at the dealers’ level became
extreme. According to our partial equilibrium
estimates, the VER program so far has cost
the United States approximately $2.7 billion
in lost consumers’ surplus. The VER program
is an expensive way to increase U.S. auto
industry employment. Such expensive walls
for the U.S. auto industry surely must give
offense to U.S. consumers.

Economic Review • Summer 1984




Appendix

5=
Japanese new-car sales are measured nonseasonally adjusted in thousands of units (data
from Ward’s Automotive Reports). The sales
data include captives (Japanese new cars sold
by U.S. manufacturers), since the captive
market is included in the VERs. Regardless,
the captive share of the Japanese new-car mar­
ket historically has been quite small (less
than 5 percent). Per capita auto sales, SALES,
were found by dividing unit sales by the total
U.S. civilian, noninstitutional population.
sales forecast variable, Sf, is derived from a
specification similar to that found in
Irvine (1979):
Set = SM + Sm (Sm ~ S,-s)/Sm>.
/=
inventories are nonseasonally adjusted,
measured in thousands of units, from
Ward’s Automotive Reports (quarterly data,
1974 to 1984).
VJ72 =

nonseasonally adjusted wholesale price index
of Japanese cars was obtained from the Bureau
of the Census, U.S. General Imports: Sched­
ule A, commodity by country (FT135). The
price was determined by dividing the total
customs value (c.i.f.) of new Japanese cars
and utility vehicles, including shipping costs
to the port of entry (c.i.f.) by the volume of
Japanese new-car imports. The average, nom­
inal wholesale price was deflated, using the
implicit price deflator for personal consump­
tion expenditures.
Y 72 =

the income variable used in this analysis was
real permanent income, calculated as the fit­
ted quarterly values of real disposable income
regressed against four years of lagged values.
The income variable was generated in per
capita form, using the total U.S. noninstitu­
tional civilian population.

C 72 =
real marginal costs of new Japanese car
inventories was calculated as the product of
real dealer new-car costs (VJ72) and the nonseasonally adjusted 90-day commercial paper
rate, i, or
VJ72 • i.
OPTION =
the options index was calculated with
the following equation:
5

Index = ^

i=1

Wi ■ Oi,

and domestic subcompacts would be useful.
Data that would allow such comparisons are
not readily available. Indeed, it is unclear
that significant operating cost differences
between the two markets exist.

YEN =

the dollar/yen exchange rate is nonseasonally adjusted.

References

Bergsten, C. Fred.

On the Non-Equivalence of
Import Quotas and “ Voluntary” Export
Restraints. Technical Series Reprint T-009.

Washington: Brookings Institution, 1975.
where the weights, Wiywere determined according
to each options 1980 list price relative to the Carlson, Rodney L. “Seemingly Unrelated
total options package costs:
Regression and the Demand for Automo­
biles of Different Sizes, 1965-75: A Disag­
w,
gregate
Approach,” Journal of Business,
Automatic transmission 0.174
vol.
51,
no.
2 (April 1978), pp. 243-62.
Power steering
0.087
Carlson, Rodney L., and M. Michael Umble.
Air conditioning
0.283
“Forecasting the Demand for Automobiles,
Sunroof
0.348
1983-1985: A Disaggregate Approach,”
Audio system
0.108
Akron
Business and Economic Review,
1.000
vol. 14, no. 4 (Winter 1983), pp. 35-41.
The options data, O,, represent the percen­
tage of each option installed in Japan relative Chow, G.C. Demand for Automobiles in the
United States: A Study in Consumer
to total Japanese imports. Data on options
Durables.
Amsterdam: North Holland
installations are available semiannually over
Publishing
Company, 1957.
the 1975 to 1983 period. The index was then
linearly interpolated to create a quarterly
Crandall, Robert W. “Import Quotas and the
time series.
Automobile Industry: The Costs of Pro­
tectionism.” Unpublished manuscript, to
GAS7 2 =
be published in Brookings Review, Brook­
for an approximate measure of Japanese car
ings Institution (Summer 1984).
operating costs, we generated an index of aver­
age car operating expenses relative to the
Currie, John Martin, John A. Murphy, and
total consumer price index (CPI). The compo­
Andrew Schmitz. “The Concept of Eco­
nents of the CPI include gasoline (weight
nomic Surplus and Its Use in Economic
= 0.66), auto insurance (weight = 0.18), and
Analysis,” Economic Journal, vol. 81,
auto repairs (weight = 0.16). Each weight
no. 324 (December 1971), pp. 741-91.
was determined by the component’s relative
importance in the CPI (December 1982).
Ideally, a variable that also captures oper­
ating efficiency differences between Japanese

Federal Reserve Bank of Cleveland




Fair, Ray C. “The Estimation of Simultane­
ous Equation Models with Lagged Endog­
enous Variables and First-Order Serially
Correlated Errors,” Econometrica, vol. 38,
no. 3 (May 1970), pp. 507-16.
Falvey, Rodney E. “The Composition of Trade
within Import-Restricted Product Cate­
gories” Journal of Political Economy,
vol. 87, no. 5 (October 1979), pp. 1105-14.
Feenstra, Robert C. “Voluntary Export Re­
straints in U.S. Autos, 1980-1981: Quality,
Employment and Welfare Effects.” Inter­
national Economics Research Center
Paper 17, 1982.
Feldstein, Martin, and Alan Auerbach.
“Inventory Behavior in Durable-Goods
Manufacturing: The Target-Adjustment
Model,” Brookings Papers on Economic
Activity, 2:1976.
Gomez-Ibanez, Jose A., Robert A. Leone,
Stephen A. O’Connell, “Restraining Auto
Imports: Does Anyone Win?” Journal of
Policy Analysis and Management, vol. 2,
no. 2 (Winter 1983), pp. 196-219.
Griliches, Zvi, Ed. “Hedonic Price Indexes for
Automobiles: An Econometric Analysis
of Quality Change,” in Price Indexes and
Quality Change. Cambridge: Harvard
University Press, 1971.
Irvine, F. Owen, Jr. A Study of Automobile
Inventory Investment. Working Paper No. 6.
Washington: Board of Governors of the
Federal Reserve System, December 1979.
Loos, Susan A. “The Japanese Cost Advantage
in Automobile Production,” Economic
Commentary, Federal Reserve Bank of
Cleveland, July 2, 1984.

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Morkre, Morris E., and David G. Tarr.

The
Effects of Restrictions on United States
Imports: Five Case Studies and Theory.

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to the Federal Trade Commission. Wash­
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June 1980.
Rodriguez, Carlos Alfredo. “The Quality of
Imports and the Differential Welfare
Effects of Tariffs, Quotas, and Quality
Controls as Protective Devices,” Cana­
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(August 1979), pp. 439-49.
Santoni, Gary J., and T. Norman Van Cott.
“Import Quotas: The Quality Adjustment
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Smith, R.P Consumer Demand for Cars in the
USA. Cambridge: Cambridge University
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Stuchlak, Wesley J., Daniel E. Shickman, and
William R. Pochiluk, Jr., “The Impact of
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Owen F. Humpage
is an economist with
the Federal Reserve
Bank of Cleveland.

Working Paper
Review
Owen F. Humpage
Dollar Intervention and
the Deutschemark-Dollar
Exchange Rate: A Daily
Time Series Model
Working Paper 8404.
September 1984. 28 pp. Bibliography.
In March 1973, the major industrialized
nations abandoned the Bretton Woods fixedexchange-rate system. Observers have charac­
terized the subsequent exchange-rate regime
as a dirty float. While the major industrialized
countries generally have allowed fundamen­
tal market forces to determine their exchange
rate, they periodically have bought and sold
foreign exchange to influence the market out­
come. The volume and frequency of exchangemarket intervention have varied greatly among
the developed countries.
Economists have questioned the efficacy of
foreign-exchange-market intervention, espe­
cially if intervention is divorced from monetary
policy (sterilized) and especially if exchange
markets are highly efficient. An emerging
consensus holds that sterilized intervention
has no lasting impact in foreign-exchange
markets and cannot be used to supplant the
impact of such market fundamentals as rel­
ative money-stock-growth rates, inflation rates,
or interest rates. Researchers, however, have
not rejected the possibility that sterilized inter­
vention has a short-run or temporary impact
on exchange rates.
In this working paper we develop a simul­
taneous time-series model to investigate the
daily interactions between U.S. exchangemarket intervention and the deutschemarkdollar exchange rate. Such an investigation
involves answering two questions. How does
the Federal Reserve System react to exchangerate movements? How does the exchange

38

Federal Reserve Bank of Cleveland




rate respond to intervention? By incorporat­
ing both a morning-opening and an after­
noon-closing deutschemark-dollar quote, and
by assuming that U.S. intervention occurs
only during the interim, this study attempts
to interpret the direction of causality be­
tween contemporary exchange-rate move­
ments and intervention. The model divides
U.S. intervention into dollar purchases or
sales of deutschemark and dollar purchases
or sales of all other currencies to capture both
the direct and cross-rate effects of interven­
tion. The model also includes an aggregate
measure for the intervention of the other
large developed countries. Using autoregres­
sive integrated moving average (ARIMA) tech­
niques, we estimate the model from Novem­
ber 2, 1978, to October 31, 1979, a period of
frequent, often heavy intervention.
The model indicates that, on average over
the period investigated, U.S. intervention re­
acted without a lag to unanticipated changes
in the morning-opening exchange rate in
a manner consistent with a leaning-againstthe-wind strategy. Such a strategy would
tend to dampen exchange-rate fluctuations
if it were capable of altering the exchange
rate in the appropriate direction. The results,
however, do not indicate that intervention,
on average over this period, was effective in
changing the exchange rate in the desired
direction. The coefficients on the intervention
terms suggest that U.S. and foreign interven­
tion accentuated movements in the afternoonclosing exchange rate. The size of the effect,
however, was very small.
The seemingly perverse exchange-rate
response could be rational from the perspec­
tive of private exchange-market participants.
Foreign-exchange speculators could view
central-bank support for a currency as under­
scoring that currency’s fundamental weak­
ness, and they could react by selling that cur­
rency. Moreover, the experiment’s failure to
find the expected exchange-rate response to
intervention could result because the volume
of intervention was too small relative to the
volume of daily exchange-market transactions
or because the influence of daily intervention
deteriorates too quickly to be detected by
the closing quote.

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8/27/84

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