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Protectionist policies in the form of tariffs and quotas are coming from a Trump Administration. It seems appropriate then that we examine tariffs and quotas from a macroeconomics perspective.
The two most common ways of restricting trade are with tariffs and quotas. From a political point of view and to prevent a trade war, a Trump Administration should consider the use of quotas over tariffs in some cases.
This figure illustrates the domestic market for food in Europe.
The equilibrium between supply and demand occurs at point A at a price of $8, and quantity of two hundred. Now, suppose that food is available in an unlimited amount from the rest of the world, at a price of $4 per unit and Europe doesn’t like this because it hurts their farmers.
The world supply curve is represented by the red horizontal line. In the absence of any transportation costs, the food price in Europe must be equal to the world price of $4. At the $4 price, you can see that European domestic production is measured by the line segment B, C and will be one hundred units, considerably less than before free trade.
American imports are measured by the line segment C, D and are equal to two hundred units, and revenues from the sale of these imports are equal to the shaded area C, D, E, F.
Now let’s say that European trade ministers impose a tariff of $2 per unit on food imports, where a tariff is a tax levied on imports. What happens now to domestic production and imports?
Clearly, domestic producers win because their production not only rises by fifty units, but their profits rise by the shaded area B, C, H, G.
European food consumers lose, not only because the price of food rises from $4 to $6, but also because they consume fifty fewer units of food. In fact, the total loss to consumers is measured by the area B, D, I, G.
The other big loser is the American food industry, which now exports one hundred fewer units and loses revenues equal to the shaded areas C, J, L, E and K, D, M, F.
The winner is the European governments that imposed the tariff. They collect tariff revenues, equal to the area H, I, J, K.
The Politics of Tariffs
From a political perspective, a relatively small handful of people in one domestic industry, farming, have gained a considerable profit at the expense of a much larger, but politically less powerful group, food consumers.
This protectionist tariff has also considerably harmed food producers in America, and this group is unlikely to remain silent on the tariff.
Why Quotas Trump Tariffs Politically
One likely result is that pressure will build politically in America to retaliate against European food tariffs with protectionist tariffs of its own, perhaps on European clothing imports. There is a way for Europe to avert this trade war and it’s with a quota which is an exact quantity limit on imports.
An equivalent quota, in this case, would be a one hundred unit limit on American food since that is the level of imports after the $2 per unit tariff.
Under a tariff, the shaded area H, I, K, J goes to the European governments in the form of tariff revenues. However, under a quota foreign exporters (American food producers) will be able to capture these revenues which will mostly offset their losses from selling fewer exports. The result in America will be far less political pressure from food producers for retaliatory tariffs.
Whenever a government interferes in a free market, there is usually deadweight loss. There is deadweight loss associated with the imposition of a tariff or quota. In fact, the loss is the same regardless of whether a tariff or quota is used.
The shaded area C, H, J, represents the loss in producer surplus. In this case, too many European resources are being diverted into the inefficient production of food, at the expense of production in other sectors. At the same time the shaded area K, I, D represents the loss in consumer surplus and the loss in consumer satisfaction, from consuming fewer units of food. Together the two shaded triangles measure the total deadweight loss from tariffs or quotas.
Source: This lesson was made possible by the University of California Irvine and my favorite professor Dr. Peter Navarro, now economic advisor to the Trump Administration.
Increases in government regulation, taxes, environmental regulations, and ObamaCare on businesses, shifted the aggregate supply (AS) curve inward and thus reduced aggregate demand (AD).
With the explosion higher in the cost of doing business, businesses hired fewer workers. In fact, many small businesses reduced the size of their workforce in response to ObamaCare. Less hiring means a weaker consumer with less discretionary income.
Typically, in stage three of an economic recovery, the supply curve (AS) shifts out to AS2, as firms hire more workers, and expand output. Together, these price and wage adjustments drive the economy back to full employment at Q1 and close the recessionary gap, but at a new and lower price of P2.
Increases in government regulation, taxes, environmental regulations, and ObamaCare on businesses, shifted the aggregate supply (AS) curve inward and thus prevented the outward shift of the AS curve that was needed to get the US economy firing on all cylinders.
You will soon be reading about policy decisions from the Trump administration that are aiming at shifting the supply curve outward. An attempt to shift the AS curve outward means that Donald Trump’s economic team will end things like Dodd-Frank and Federal fracking regulations. The media will correctly call this supply-side economics.
Higher taxes also negatively impact the number of people willing to work as illustrated by the Laffer Curve.
The marginal tax rate is measured on the vertical axis, and total tax revenues are measured on the horizontal axis. Note that the Laffer Curve is backward-bending, reflecting the behavioral notion that at some point, people will work less the more they are taxed. This backward bend means that above a certain tax rate, “m” in the figure, an increase in the tax rate will cause overall tax revenues to fall.
Now here is the important point that Dr. Peter Navarro will likely be advising Trump on, for a supply-side tax cut to increase tax revenues, the existing tax rate before the tax cut must be above “m,” perhaps at a rate associated with point “n” on the curve. The tax rate being above “m” is an important point because, in the early 1980s, the Reagan Administration’s economists believed that the economy was on the backward-bending portion of the Laffer curve (above “m”) and that a tax cut would increase total tax revenues. Based on this assumption, it moved forward with one of the largest tax cuts in American history.
Policies which can successfully shift the economy’s supply curve out, do so with the twin advantages of both lower unemployment and lower inflation.
Pharmaceutical drug pricing is all over the mainstream financial media right now. Let’s examine the macroeconomics of what is happening.
The demand for pharmaceutical drugs is inelastic. People that need a pharmaceutical drug prescribed by their doctor will demand that drug regardless of price. As the price of the drug goes up, demand mostly stays the same.
Notice how steep the demand curve is. This steep drop-off represents the inelastic demand for pharmaceutical drugs. The increase in supply from S to S1 leads to a relatively large decline in the price, but not much of an increase in quantity demanded.
Companies like Valeant Pharmaceuticals and former CEO Michael Pearson abused the inelasticity of demand for pharmaceutical drugs for maximum profit. If demand for pharmaceutical drugs is hardly influenced at all by price changes, then raise the price of the drug to a level that maximizes shareholder profits. Sure the supply curve may shift up a little from a drop in demand from people on the margin, but most of the public with their large health insurance providers will pay the higher price.
The horizontal brown line on the supply and demand graph below represents a drug price ceiling.
The lower price of the drug shifts the demand curve up a little to point b. However, suppliers will rapidly stop supplying the drug when they are forced to sell it below market price at point a. The difference between the quantity of the drug demanded and the quantity of the drug supplied is a drug shortage as represented by the red shaded area. People will die from a drug shortage when there are no readily available substitutes, and so the government should not attempt to use price ceilings.
Make Pharmaceutical Drug Demand More Elastic
The way to control runaway drug prices is to make the demand for pharmaceutical drugs more elastic. If people have choices and substitute drugs they can use, the steepness of the demand curve will be flattened and represent a more healthy free market as illustrated below.
Notice that the demand curve is flatter and not so steep.
The prospect of a Federal Reserve rate hike is driving up the US dollar. The rising US dollar has a significant impact on the US economy and thus stock market. It’s important that traders understand the implications of a rising US dollar from a macroeconomic perspective.
Rising US interest rates mean that a lot of people around the world will want to take advantage of higher interest rates inside the US. For simplicity sake, we will use just one country, Brazil, to illustrate what happens.
On the supply and demand graph S equals the supply of the Brazilian real and D equals demand for the real. If the exchange rate were one dollar for two reals, then the price of one real would be 50 cents.
When the Federal Reserve raises US interest rates, Brazilians will want to take advantage of higher interest rates on their savings, and so they will want to put more money in the US. To get the relatively higher interest rates in the US, Brazilians need to exchange Brazilian reals for US dollars. Thus, the supply of reals increases which shifts the supply curve outward.
The increased supply of reals is now used to buy US dollars, so the demand for dollars goes up which shifts the demand curve for dollars outward. This increase in demand for US dollars pushes the value of the dollar up. The supply and demand graph is S equals the supply of US dollars and D equals the demand for US dollars.
The dollar will now buy more reals, and it would take more reals to buy a dollar. The dollar has appreciated, and the real has depreciated.
The rising value of the dollar is good for US consumers as it makes imports cheaper and so demand for imports goes up. That’s bad for the domestic US economy because cheaper imports are purchased over more expensive domestically produced goods.
Another reason why a rising US dollar is not good for the US economy has to do with exports. A strong US dollar is bad for the US economy as it makes US exports more expensive and thus decreases US export sales.
A rising US dollar increases imports and decreases exports. If the value of the imports is greater than the exports, the country is said to have a trade deficit. The rising US dollar makes the trade deficit worse.
A trade deficit (Exports – Imports) subtracts from the GDP. In the GDP formula:
GDP = C + I + G + (Exports – Imports)
Having more imports than exports means US dollars are flowing out of the country and not going into the “I” (business investment) component of the GDP formula. All the business investment is going into manufacturing plants overseas instead of into the domestic economy.
The US dollar is exploding higher right now.
The rising US dollar is why the durable goods orders and shipments activity in the US continue to languish.
New manufacturing orders just can’t get going in a rising US dollar environment.
California, New Jersey, and New York have the most cities with rent control. Sanctuary cities in California like San Francisco and Los Angeles have some of the toughest rent controls. Rent controls hurt the local economy and make rental unit availability worse. Aggregate deadweight loss from rent controls across the country negatively impacts the US economy and hence stock market. Let’s examine what happens with rent control from a macroeconomics perspective.
In a free, non-rent controlled market, the price of rent is established by the market where the supply and demand curves cross.
Look at what happens when rent control is introduced into a free market.
The red horizontal line represents rent control, or the maximum price landlords can charge for rent. The lower price of rent increases demand to “B.” However, since suppliers (owners) cannot charge the same rent that a free market would support, they choose to supply less rental units to the market at point “A.”
The gap between market demand and market supply is a shortage shown as a red shaded area. This shortage of rental units means that the competition for rental units becomes increasingly stiff and even well-qualified prospective tenants will find it difficult to find adequate housing in rent controlled cities. Worse, setting a price ceiling in cities like San Franciso and New York that have high property taxes and high maintenance costs means landlords would make hardly any profit and perhaps even lose money on rental properties. In other words, through rent control, the government has provided a strong disincentive for landlords to provide sufficient supply to meet a growing cities’ demand.
Rent control hurts local tax revenues as well because owners are bringing in less taxable income from their properties. Look at where the blue line intersects the demand curve at “D.” Point “D” represents the price renters would be willing to pay at the lower supply landlords provide under rent control. In other words, there are fewer rental units to tax (as supply contracts) and lower income tax paid by owners (because owners are making less). That’s a contraction in a local real estate market of both supply and lower tax revenues brought on by rent control. The local government must raise some other tax to offset what was lost from rent control, thereby increasing deadweight loss from taxation.
The blue shaded area represents a deadweight loss to a local economy from rent control. Deadweight loss is a loss of economic efficiency caused by rent control because more landlords could be leasing and thus more renters who could be renting (because of greater supply) if it were not for the price ceiling.
Finally, rent control shifts the aggregate supply curve inward or to the left which is not good for the economy as supply contracts.
As rental unit supply contracts, prices eventually rise. As William Tucker of the Cato Institute writes…
A look at the classified ads in rent-controlled cities reveals that very few moderately priced rental units are actually available. Most advertised units are priced well above the actual median rent. Yet in cities without controls, moderately priced units are universally available.
Inflationary expectations are the expectations that consumers have concerning future inflation. If buyers expect higher prices in the future, they increase their demand in the present. This shifts the aggregate demand curve outward (to the right) which is good for the economy. For example, if the price of a house is expected to be higher next year, consumers decide not to wait, but to buy now. The increase in inflationary expectations causes an increase in consumption expenditures and subsequently an increase in aggregate demand.
Inflation expectations are on the rise in the U.S. which increase the possibility of a Federal Reserve rate hike soon.
Institutional traders and money managers are increasingly moving to hedge inflation risk in their portfolios by buying the iShares TIPS Bond ETF.
Are Inflation Expectations Really That Important?
A common question I get is if inflation expectations are that important. The answer is yes, and we can look back at history to see why. During the 1970s the importance of inflationary expectations as an aggregate demand determinant was revealed to economists. During the 1970s, inflation rates kept rising. The government deployed contractionary fiscal policies, but inflation continued to rise. The reason inflation kept rising is that the public “expected” it to. Once economists determined what was going on, manipulation of inflationary expectations was used during the 1980s to reduce inflation and to keep it low throughout the 1990s.
Most government revenue comes from the taxation of transactions and labor. Taxes impact both the supply and demand curves. Taxes cause a buyer to pay more for something and suppliers to receive less. The loss of value for both buyers and sellers is called the deadweight loss of taxation. Taxation has an enormous impact on the economy and thus stock market. Traders and investors need to understand the effects that taxation has on the economy and thus stock market. We will examine deadweight loss from a microeconomics perspective, ending with a macroeconomics viewpoint.
In a market without taxation, we will say that a package of socks will sell at a fair market price of $14. This $14 equilibrium price is set where the supply and demand curves cross.
When taxes hit the package of socks, the buyer pays a higher price of $15.40, and the seller receives a lower price of $11. Taxation lowers demand to d1 because buyers have to pay a higher price for socks. The seller is also taxed, and so he receives less profit for his package of socks. If there’s less profit, the supplier will supply fewer socks at a level of s1.
The amount that the government receives in taxes is equal to the buyer’s price minus the seller’s price, multiplied by the quantity of the transaction, whether for goods or services. The area of the light red rectangle is the tax revenue collected by the government. The area of the dark red triangle is equal to the economic value that is lost to taxation.
This loss of economic value consists of buyers who will either buy less or not at all because the price is higher than what they can afford so they decide to do without. Likewise, some suppliers will not produce the product because they are not receiving a high enough price to cover their costs. The benefit that these buyers and sellers would have added to the economy if it were not for taxation is called the deadweight loss of taxation. Because these buyers and sellers do not participate in the market, they do not contribute to the tax. Instead, the taxes are paid by the buyers and sellers who continue to participate in the market. The tax burden falls on the fewer buyers and sellers who continue to participate in the market. A vicious taxation loop can start where a government raises taxes more to offset lower tax revenues caused by rising deadweight loss.
Demand and Supply Elasticity
Demand elasticity is the change in quantity demanded at a particular price. If a large change in price results in little change in the quantity demanded, then demand is considered inelastic. If a small change in price results in large changes in the quantity demanded, then demand is considered elastic.
Products that have good substitutes have a high elasticity of demand, since if the price of one substitute increases, buyers can switch to another substitute. For example, if the price of beef increases, then people will buy more chicken, ham, pork, or some other meat. Beef is considered an elastic product.
Products that have fewer or no substitutes have a high inelasticity of demand since if the price increases, there are no substitute products buyers can switch to. For example, if gasoline and oil prices increase, buyers have to pay the higher price because there are no close substitutes.
Supply elasticity is the change in supply costs at a particular price. If the supply changes little with a change in price, then supplies are considered inelastic. Supply is elastic if there are large changes in supply for a small change in price.
For example, the supply of land is inelastic because no one is making any more of it. By contrast, the supply of software is fairly elastic since it costs very little to make and distribute copies of software over the internet.
Deadweight Loss Varies with Elasticity
The amount of the deadweight loss varies with both demand elasticity and supply elasticity. When either demand or supply is inelastic, then the deadweight loss of taxation is small, because the quantity bought or sold does not vary much with the price.
Demand Inelasticity and Deadweight Loss
Buyers need to have the product and so changing the price through taxation is not going to change that. For example, buyers need gasoline to operate their automobile. Gasoline is inelastic as there are no substitutes. Raising taxes on gasoline will result in a lower deadweight loss.
Supply Inelasticity and Deadweight Loss
Sellers want to sell land, and so the tax rate is not going to heavily influence the supply of land for sale. The supply of land is inelastic because, as Will Rogers once said, they’re not making any more of the stuff. Raising taxes on land sales will result in a lower deadweight loss.
Deadweight loss increases proportionately to the elasticity of either supply or demand.
Higher Taxes and Deadweight Loss
Balancing the tax rate which gives the most tax revenue with the least amount of deadweight loss is impossible. The tax rate that worked during the Bill Clinton Administration did not work during the Obama Administration. An endless amount of factors come into play when determining a moderate tax rate with the most yield versus minimal deadweight loss. What we do know is that when the tax rate is small, there is less deadweight loss and conversely, when the tax rate is high, there is more deadweight loss as illustrated in the two graphs below.
As can be seen from the graph below, as taxes are increased, the deadweight loss of the tax also increases, gradually at first, then steeply as the size of the tax approaches the market price of the product without the tax. Likewise, tax revenue increases at first but then starts to decline as a decrease in quantity more than offsets the increase in the tax rate.
Macroeconomics and Taxes
The Federal Reserve has been unable to get the meaningful shift from aggregate demand outward that they wanted to increase GDP. It’s no coincidence that under the Obama Administration, the US has the third highest corporate income tax rate in the world, at 38.92 percent. The U.S. rate is exceeded only by the United Arab Emirates and Puerto Rico. Higher taxes shift the aggregate demand curve inward from AD1 to AD2.
Conversely, lower taxes shift the aggregate demand curve outward.
Higher taxes also negatively impact the number of people willing to work as illustrated by the Laffer Curve.
The marginal tax rate is measured on the vertical axis, and total tax revenues are measured on the horizontal axis. Note that the Laffer Curve is backward-bending, reflecting the behavioral notion that at some point, people will work less the more they are taxed. This backward bend means that above a certain tax rate, “m” in the figure, an increase in the tax rate will cause overall tax revenues to fall. Note also, for a supply-side tax cut to increase tax revenues, the existing tax rate before the tax cut must be above “m,” perhaps at a rate associated with point “n” on the curve. The tax rate being above “m” is an important point because, in the early 1980s, the Reagan Administration’s economists believed that the economy was on the backward-bending portion of the Laffer curve (above “m”) and that a tax cut would increase total tax revenues. Based on this assumption, it moved forward with one of the largest tax cuts in American history.
The Reagan Administration also took actions to shift the supply curve outward such as cutting back sharply on the regulation of everything from monopoly and oligopoly to pollution and product safety, critical elements that shift the aggregate supply curve outward.
Policies which can successfully shift the economy’s supply curve out, do so with the twin advantages of both lower unemployment and lower inflation.
Looking at the aggregate supply (AS), aggregate demand (AD) model, we can see where the US economy is currently at in the economic cycle. It is critical that traders and investors understand where we are at in the business cycle so as to be in on the right side of the trade. Timing Bull/Bear cycles and sector rotation is a critical skill for traders.
Stage 1: The economy is at full employment, Q1 where AS1 (aggregate supply) intersects AD1 (aggregate demand) at a price of P1.
Stage 2: The Great Recession hit causing a demand shock, shifting the aggregate demand back to AD2. Consumers reduce their spending and businesses reduce their investment. The new equilibrium is a recessionary output of Q2 at a price of P1. And the result is a recessionary gap equal to Q1 minus Q2.
The Great Recession had a wicked negative feedback loop or multiplier effect.
In the graph above, phase one is an aggregate demand shock, which leads to $100 billion in unsold goods from a reduction in aggregate demand. In phase two, this leads to a cutback in employment and wages. While in phase three, this leads to a reduction in income. Now assuming a marginal propensity to consume of 0.75, we see a reduction in consumption of $75 billion in phase four. This triggers a cutback in sales and further cutbacks in employment, and the process continues to go around in a negative feedback loop.
Stage 3: Wages, prices, and interest rates fall, as a result of the recession. This causes aggregate demand (AD) to move downward, along the aggregate demand (AD) curve.
At the same time, the supply curve (AS) shifts out to AS2, as firms hire more workers, and expand output. Together, these price and wage adjustments drive the economy back to full employment at Q1 and close the recessionary gap, but at a new and lower price of P2.
We are currently at Stage 3 where the trouble is that aggregate demand (AD) is not increasing at a fast enough pace.
Increases in government regulation, taxes, and ObamaCare on businesses, shifts the AS curve inward and thus reduces AD.
The Federal Reserve’s goal of QE was to increase AD.
The figure above shows how an expansion of the supply of money causes a rightward shift of the aggregate demand curve from AD to AD prime. Note that in the range of this shift; the aggregate supply curve is relatively flat. This Keynesian range reflects the presence of unemployed resources and recessionary forces. In this region, we get a very small increase in the price level from the Federal Reserve’s expansionary monetary policy and a large increase in real GDP as equilibrium moves from E to E prime. This is exactly what we saw with the larger increases in GDP in 2010 through 2012.
The Fed decided to expand the economy even further and tried to push the aggregate demand out even more to E double prime. This is well past the economies level of potential output or potential GDP. Here, the slope of the aggregate supply curve turns steeply upward. In this fully employed economy, the higher money stock would be chasing the same amount of output so that the major impact of the Fed’s expansionary policy would be to significantly raise the price level, with little increase in real GDP and this is where we are currently at in the economy.
The next stage is that the Federal Reserve wants to see the price level (CPI, PPI) rise which would indicate the time to raise interest rates. We are starting to see the CPI and PPI move higher. I think this is largely from the recent rise in the price of oil. The move higher in the CPI and PPI would have happened a year ago if it were not for the crash in the price of oil which caused disinflation. The process of the Fed raising interest rates is as follows.
The Fed reduces reserves R, through open market operations which causes the money supply M to contract, and interest rates I, to rise. In the GDP formula (GDP = C + I + G + (Exports – Imports), this interest rate rise, not only reduces investment I, but it also reduces consumption expenditure C and net exports. The cumulative effects of a fall in I, C and exports are to push aggregate expenditures or aggregate demand down in doing so real GDP and inflation likewise go down, thereby achieving the desired policy goal.
Source: A special thanks to Dr. Peter Navarro, Professor, Paul Merage School of Business, University of California for which this article would not be possible. Go here to find out more about my favorite economics professor.