As the saga with the US tariffs on Chinese goods is playing out in the public arena, there is a lot of speculation about who the ultimate losers and winners in this game will be.
There is Plenty of Shallow Analysis
Most journalists do not have time to think it through deeply, and most serious commentators are economists, who take a game theoretical approach.
I want to add one more, a real-world analytical perspective to the debate – the supply chain perspective – something that most economists and game theory exponents lack.
The Results of Deep Analysis are Startling
If President Trump knew this, probably he would not impose the tariffs, and perhaps even remove the existing ones.
So, what is the conventional wisdom about tariffs in general? Economists believe that all tariffs come out of the pockets of the end consumers – but that is because economists lack a deep supply chain perspective.
Let’s Go Deeper – Smile Curve
If you deeply explore the supply chain margins for a typical Chinese import into the USA – you will eventually come to the smile curve as shown below:
A typical smile curve lays out the entire supply chain on the horizontal axis and the margins of each activity on the vertical axis. It allows companies to decide where, in the entire supply chain, is the highest margin.
Intuitively, or explicitly, almost every company is doing this analysis to determine where to play, and what to outsource. There is a lot more to be said about this body of work, that is relevant to strategic supply chain decision making, which I am not going into at the present moment. I will keep that discussion to another blog post.
For most items imported into the USA, only one activity – manufacturing (that is shown in a box) – is carried out in China. This activity also happens to have the lowest margins in the entire supply chain.
Every company configures its own business network of internal and external teams to carry out all the activities on the smile curve. Almost all other teams have a much higher margin than the manufacturing team. That is the reason why manufacturing was outsourced in the first place. That is also the reason why global supply chains are currently configured the way they are.
So, when it comes to bearing the cost of tariffs, manufacturing is not in the position to bear it. This is because manufacturing is a very small part of the overall value chain. For example, for a sneaker that is sold for $100 in the shopping mall, the manufacturer will be lucky to get around $15.
International Supply Contracts Are Very Clear
Imagine a sub-contractor in China – manufacturing shoes, or shirts, or bathroom scales, or anything out of the countless numbers of items being imported from China on a daily basis.
Almost all of their contracts with the US buyers are signed on FOB (with the occasional exception of CIF) basis. In both cases, the duty (tariffs) are paid by the US importer. In fact, in all but one case (DDP – Delivery Duty Paid), the tariff is paid by the US importer.
To get the details of these terms, and what they entail, look at the figure below. Each row below shows a different type of international sale contract and who is responsible for what activities in that type of contract:
The last row of the table shows DDP – an import contract that is almost never used in practice. That is the only type of contract where the Chinese exporters would be compelled to pay the tariffs.
This practice is so deeply entrenched that out of all the possibilities shown above only in a handful of cases have I seen DDU in while examining tens of thousands of import contracts in over 30 years of experience.
I do not expect President Trump to know this because he has barely any experience in the international sale of goods. However, his negotiation team and strategy planning team would have clearly known this because the table above is derived from the International Chamber of Commerce (ICC – 2018), and is common knowledge.
Why Importers Pay the Tariffs
In our work we never recommend DDP type of contracts, precisely for this reason – the seller cannot control unexpected imposition of tariffs any time after signing the contract, and before delivery of goods.
Additionally, there is no margin in this activity, so why take responsibility for extra work with no reward in return, and the additional risk of monetary loss?
The Key Question – Who Will Bear the Burden of the New Tariffs?
So if the US importers are going to pay the tariffs, would they be able to pass these on to the end consumers, or will they bear it themselves? That depends entirely on the price elasticity of demand and pricing power enjoyed by the importer, or end retailers.
To answer that question let us look at the latest news (April 2019) here. The most relevant quote is below:
America has too many stores.This year, US retailers have announced that 5,994 stores will close. That number already exceeds last year’s total of 5,864 closure announcements.
I do not want to belabour the point because it is amply clear that store chains have almost no pricing power left. Unfortunately, neither do their suppliers – the US importers. That eco-system is already drying up – otherwise, why would those stores be closing left, right and centre?
Who Has The Pricing Power?
Only one company has the margin, and pricing power in this entire supply network as is clear from the info-graphic below (click to see larger scale version):
It will take an entire blog post to go into the reasons for the pricing power differential between Amazon and its competitors. So I will not get into that discussion here. Let’s move to the impact of this differential.
Tariffs Would Lead to Closure of More Stores and Shopping Malls
In the short run, tariffs will accelerate the migration of market share to Amazon and its marketplace. This will be a surprising development given the other history between President Trump, and Mr Bezos – the owner of Amazon.
Amazon Would be The Biggest Beneficiary of These Tariffs
In the medium run – given Amazon’s growing pricing power, as the store chains close down – it is likely that some of the tariffs might even be passed down to the end consumers.
I would not like to speculate, how the tariffs will pan out in the long term because of much wider implications for the two economies that so closely intertwined.
Effect of The Trade Wars
“The benefits and costs of these tariffs are not falling where expected. In fact, their impact will be the opposite of what was intended.
If China retaliates, the effect may be even worse because the export commodities supply chain smile curve looks very different.”
— Vivek Sood