Under Japanese taxation, licensing and inspection systems there are 3 broad classes of cars (and light commercial vehicles): full-sized, compact and "kei" minicars. The latter have to have a small engine, a narrow width and a short length (the BMW "Mini" is too big, even the Smart is too wide!). They get a different (yellow) license plate, face lower taxes and inspection fees (annual taxes of ¥10,800 – in contrast a friend pays about ¥70,000 a year for his C-class Mercedes). They also face less stringent safety regulations (basically, don't get in an accident in one). The leaders in this segment – Suzuki, Daihatsu [a subsidiary of Toyota], and Honda – spend significant resources developing new models. But as with Japanese cell phones – if you haven't seen one, there's a reason why! – is this a niche peculiar to Japan. Are they – like Japanese cell-phones – a dead-end strategy, a niche that due to the peculiar development of domestic cell phones have no market in the rest of the world? If so, it's a commercial disaster that will drag down these players, as over the next decade the level of sales confronts an aging and domestic population.
Despite the claim of a widely cited New York Times story, Japan Seeks to Squelch Its Tiny Cars (June 8, 2014), this segment has steadily increased in importance over the past 15 years. The gist of the article is that the key tax was going to be hiked 25%. Yes, but that meant from (approx) US$80 to US$100. Of course industry officials complained, but no one expected it to be a big deal, and it wasn't. (I assume that an editor rewrote the article, because the reporter whose byline is on the story is generally careful.) That in itself is bad news for Japanese domestic carmakers, because a "kei" goes for about half the price of a comparable full-sized car: at ¥113 the base Toyota Prius – if you can actually find a base one! – goes for $22,000 while the base Daihatsu Tanto will set you back on $11,000. The good news is that, as per the graph, sales of full-sized cars have likewise increased, and they carry full-sized margins.
Are these Galapagos products? Diesels aren't unique to Europe, but their market share is far higher there than anywhere else in the world. To my knowledge, they are uniform sellers across all segments, so neither directly hurt nor enhance products. Furthermore, virtually all European models come with a variety of drivetrains, so the same core vehicle can be marketed globally. Similarly, in the US we have our own odd category of light trucks. As with Japan's "kei" cars, there's little market elsewhere, and few exports other than crossovers and SUVs. But unlike "kei" cars, light trucks carry the biggest margins outside of the luxury segment; the money they generate keeps the entire North American industry operating in the black, in many years making it the US the most profitable market in the industry.
Unfortunately "kei" cars have not done well in any market of size other than India (they're a small slice of China's market, but since it's a big market the aggregate numbers may be larger than I realize). Furthermore, several firms have exited the segment, including Mitsubishi [I'll fact-check the latter three later], Nissan, Subaru and Mazda.
Can countries encourage local R&D by creating niches unique to their market? China may attempt that by pushing the adoption of vehicles with electric & hybrid drivetrains. As long as energy prices remain low, that's a risky strategy. Doing so may require continued subsidies, and despite its size leave Chinese carmakers with "galapagos" products.