Business Cycle

Posted by PITHOCRATES - February 13th, 2012

Economics 101

When you have a Captive Audience you can Charge whatever Prices you Want

Go to a football game lately?  Hockey?  Basketball?  Baseball?  It’s a pretty expensive day out.  Especially if you eat while in the stadium.  Those concession prices are pretty steep.  In fact, people say that stadium food is some of the most expensive food anywhere.  I don’t.  I say it is some of the highest quality and some the most fairly priced food you’ll find anywhere…in the stadium.

Stadium food is convenient food.  And that’s what you’re paying for.  Convenience.  Because it’s too great of an inconvenience to leave the stadium to buy a more reasonably priced hotdog someplace else.  And despite what the critics say of concession pricing, those concessions have long lines.  Because people may say the prices are too high.  But deep down they know what a bargain they are.  Delicious food cooked and sold only steps away from their seat.  It’s better than at home.  And there’s no cleanup.

When you have a captive audience you can pretty much charge what you want.  Because the market is fixed.  Stadiums charge a fortune for those concession spaces.  Because running a big stadium is expensive.  And it’s not really used all that often.  I mean, there are only 8 home games in the regular season in football.  Doesn’t give the stadiums much time to earn revenue to pay for these expensive things.  So they charge high fees wherever they can.  So the concessioners have to pass that cost on to the customer.  As all businesses do.  And when you have a captive audience it’s a whole lot easier to do this.  Because, where else are the people going to go?

Competition Increases Quality and Lowers Prices for Consumers

Let’s look at this in another way.  Say you have a friend who works for a catering company.  He drives a ‘roach coach’.  He stops at the factories and local construction site to sell food to hungry workers.  He sees the money these trucks make.  Considers his paycheck.  And thinks he’s tired of making his boss rich.  So he buys a truck for himself.  And looks for his own territory.

Now let’s say you go on an evening bike ride on weekends.  And you come across your friend.  He’s found some prime real estate to park his roach coach on.  In the median of a boulevard across from an automobile assembly plant gate.  Where he has a captive audience.  Hungry workers working the midnight shift with no place else to buy delicious food.  Business is good.  You stop by on your bike ride and buy a snack and chat.  Then one night you noticed a beat up Ford Pinto pull up in the median not far from your friend’s truck.  He pops the hatch.  And you start smelling something.  Something good.  Fresh pizzas.  And hot fresh subs.  This guy owns a pizzeria.  And just closed for the night.  After filling his car with fresh pizzas, hot fresh subs and soda.  And just like that business wasn’t so good for your friend anymore.  For fresh pizza and hot fresh subs are more delicious than the sandwiches and cans of stew your friend was selling.  But one thing the Pinto didn’t have that your friend did.  Ice.  He was selling warm soda.  Or trying to.  Your friend had cold soda.  And that was just what the doctor ordered on a hot, humid, summer night.  Your friend was now sharing his captive audience.  Selling less than he was.  And at lower prices because of this new competition.  But he was still able to turn a profit and make his truck payment.

Then the Pinto guy took it up a notch.  One night, as the workers headed out into the median on break, he pulled out a tub filled with ice.  And soda.  “Cold soda,” he barked.  “Ice cold soda.”  This squeezed your friend’s sales even more.  He had nothing left to compete with but price.  So he lowered his prices even further.  Barely breaking even.  Then one night someone else pulled up on the median.  A beat up AMC Gremlin.  Some kid just out of high school got out.  Popped the hatch.  And started barking, “Fresh McDonald Big Macs.  French fries.”  And, of course, ice cold soda.  The kid didn’t have a lot.  But what he had he was selling at a nice markup.  Which was enough for him.  Because he had no overhead.  And made enough to by some beer later that night.  A very modest sales goal.  But it split that captive audience three ways.  Soon your friend was losing money.  Then the economy went into recession.  And they discontinued the midnight shift.  Your friend lost his truck.  And went back to driving a truck for his former boss.  The Pinto guy increased his pizzeria’s delivery radius to make up for the loss business.  And hired the Gremlin kid to help with those deliveries.

The Business Cycle is a Natural and Necessary Part of the Economy and is the Only Way Supply adjusts to Demand 

From the perspective of the workers increasing competition made things better.  Competition gave them more variety.  Higher quality.  And lower prices.  Over time that competition gave them more value for their money.  This microcosm of the economy was booming for awhile.  Others jumped in.  Making investments.  Increasing their inventories.  But eventually they expanded too much.  Supply exceeded demand.  Some inventory went unsold.  Prepared food not being something you can return these people had no choice but to cut their prices.  To reduce those burgeoning inventories.  The guy with the highest overhead, your friend with the catering truck, was the first to fail.  Then the market collapsed completely with the elimination of the midnight shift.  So the other two had to shutter their operations there.

We call this the business cycle.  It’s the boom-bust cycle of the economy.  From good economic times (boom) to recessions (bust).  It’s the natural ebb and flow of economic exchange.  When the market presents a demand to be met supply flows into it.  At first prices and profits are high.  Like at a stadium with a captive audience.  Then competition moves in.  Unlike at a stadium.  That demand is now split between the competition.  Each sells less.  And profits less.  To try and increase sales they try to offer better value for the money.  Tastier food.  Colder soda.  Etc.  When that doesn’t work any longer they start lowering prices.  But because supply built up so much as eager competitors joined in get a piece of that action supply grew so much it exceeded demand.  And no amount of price cutting can fix that.  Only a recession.  To reset prices and supply to meet market demand.  Which means some businesses fail.  Those who don’t lay off employees.  To reset their prices and production to levels that meets demand.

Monetary and fiscal policy tries to massage this business cycle.  By softening the recession part of it.  By lowering interest rates.  To encourage businesses to invest and expand production.  And hire more employees.  Or by increasing government spending.  Creating jobs by building roads and bridges.  Or by simply giving more money to consumers (via tax cuts or stimulus checks) to encourage them to buy more.  Thus encouraging businesses to hire more workers.  To meet this ‘higher’ demand.  Of course, in our example, this wouldn’t have helped our three businesses.  None of them would have borrowed cheap money to increase supply.  Not when supply already exceeded demand.  In fact no amount of monetary or fiscal policy action would have helped.  It certainly wouldn’t have added back that midnight shift.  Unless the government started buying cars for people.  Which might have put people back to work on that midnight shift.  But such an expansion of government spending would have increased taxes.  So high that it would have reduced economic activity elsewhere.  As it transferred this money out of the private sector and into the public sector.  Saving a few jobs at the cost of consumers everywhere paying higher taxes.

The business cycle is a natural and necessary part of the economy.  It’s how supply adjusts to demand.  And the only way supply adjusts to demand.  Thanks to prices.  That automatic mechanism that tells businesses exactly where supply should be.  And by interfering with this you make markets operate blindly.  Unable to know when supply exceeds demand.  So supply keeps increasing even after it already exceeds demand.  Creating bubbles.  And when the bubble bursts prices plummet.  To unload those burgeoning inventories.  Making recessions longer and more painful than they need be.

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Ronald Reagan’s Reaganomics Increased GDP and Tax Revenue, Decreased Unemployment and Tamed Inflation

Posted by PITHOCRATES - August 8th, 2011

Ronald Reagan’s Supply-Side Reaganomics caused an Economic Boom

Politics is a struggle.  Between those on the Left.  And those on the Right.  And nowhere is it more partisan than when it is about one subject.  ReaganomicsRonald Reagan‘s supply-side economics.  Of the Austrian School.  That the Left belittles as trickle-down economics. 

His tax cuts during the Eighties sparked an economic boom.  No one denies this.  In fact, life was very good during the Eighties.  So good that the Left denounce those years as the Decade of Greed.  “Yes, a lot of people got rich,” the Left says.  “But at what cost?”  And then they point to those ‘soaring’ Reagan deficits.  Peaking at about $221.2 billion in 1986.  Or about $358.3 billion adjusted for inflation.  (Pretty tame by today’s standards.  Barack Obama has one in the $1.6 trillion neighborhood.)  But did Reagan cause them with his tax cuts?

To answer this question we look at historical GDP (gross domestic product).  And tax receipts.  From the Seventies and the Eighties.  From the heyday of Keynesian economics.  After the Nixon Shock in 1971. That ended the ‘gold standard‘.  When Nixon said, “I am now a Keynesian in economics.”  And through Reaganomics.  All dollar amounts are constant 2005 dollars (shown in billions).  These are graphed along with the top marginal tax rate, inflation and the unemployment rate.

(Sources: GDP, tax revenue, top marginal tax rate, inflation, unemployment)

Inflation Eroded GDP and Raised Unemployment in the Seventies

There are two relatively flat plateaus on the GDP graph.  Flat or falling GDP growth indicates a recession.  One starting sometime after 1972.  The other one around 1979. 

Both of these correspond to a spike in the inflation rate.  This happens because inflation erodes GDP.  By raising prices.  Higher prices mean we buy less.  Which means less GDP.  And higher prices tend to inflate business profits.  Where profit gains are from inflation.  Not from selling more stuff.  Which means less GDP.

Inflation is one half of the business cycle.  Which is a boom-bust cycle.  A booming economy.  And a busting recession.  Inflation.  And deflation.  Growth.  And recession. 

During growth there’s inflation.  Prices go up as more people want to buy the same things.  Bidding up prices.  The unemployment rate falls.  Because businesses are hiring more people.  To expand.  To meet this demand. 

When they expand too much there’s too much stuff on the market.  People can’t buy it all.  So prices go down.  To encourage people to buy.  And businesses cut back.  Lay people off.  With fewer people working there’s fewer people to buy that excess supply.  So prices fall more.  And businesses lay more people off.  To reflect the falling demand.  Which increases the unemployment rate.

The business cycle, then, corrects prices.  And readjusts supply to demand.  Keynesian economics was going to change this, though.  By removing the recession part.   Through permanent inflation.  At least, that was the plan.  The two plateaus in the GDP graph shows that the business cycle is still here despite their best efforts.   

And the Keynesians only made things worse.  By causing double-digit inflation.  By creating more demand than existed in the market.  People used that easy money.  To buy things they wouldn’t have otherwise bought.  Creating ‘bubbles’ of inflated prices.  Which are corrected by recessions.  And the greater the bubble, the greater the recession.

Easy Monetary Policy (i.e., Printing Money) made Inflation Worse in the Seventies

Government spent a lot during the Seventies.  A lot of that was Keynesian spending paid for with easy monetary policy (i.e., printing money).  Something governments can only do.  They are the only ones that can say, “Use these paper bills as legal tender.  We guarantee it.”

Making fiat money is easy.  But there is a cost.  The more you make the more you devalue your currency.  That’s the cost of inflation.  Money loses some of its purchasing power.  The greater the inflation the greater loss of purchasing power. 

They printed a lot of money during the late Seventies.  So much that the dollar lost a lot of its purchasing power.  Hence the double-digit inflation.

Paul Volcker was a Federal Reserve chairman.  He started in the last year of Jimmy Carter‘s presidency.  And remained chairman for about 8 years.  He raised interest rates severely.  To constrict the money supply.  To pull a lot of those excess dollars out of circulation.  This caused a bad recession for Reagan.  But it killed the double-digit inflation beast.  This sound money policy was a tenet of Reaganomics.  Which was an integral part of the Eighties boom.

Reagan’s Tax Cuts Increased both GDP and Tax Revenue

The hallmark of Reaganomics, of course, is low taxes.  Reagan cut the top marginal tax rate.  He dropped it from 70% to 28% in four cuts.  After the first cut GDP took off.   Because rich people reentered the economy. 

They weren’t parking their money in investments that helped them avoid paying the top marginal tax rate.  They were starting up businesses.  Or buying business.  Creating jobs.  Because the lower tax rates provided an incentive to earn business profits.  And not settle for lower interest income.  Or capital gains. 

For business profits can be far greater than interest earned on ‘income tax avoiding’ investments.  Such as government bonds.  And if we don’t penalize rich people for risk-taking they will take risks.  Create another Microsoft.  Or Apple.  But they are less likely to do that if they know we will penalize them for it.  And that’s what a high marginal tax rate is.  A penalty.  Remove this penalty and they will choose risky profits over safe interest every time.  And make a lot of jobs along the way.

And this is what they did during the Eighties.  Their ‘greed’ created a boom in employment.  A rising GDP.  Accompanied with a falling unemployment rate.  Rich people were pulling their money out of tax shelters.  And putting it into businesses.  Where they could make fat profits.  And making fat profits in business requires employees.  Jobs.  Unlike making money with safe tax-sheltered investments. 

Tax revenue increased.  There were more business profits.  And more business income taxes on those profits.  There were more jobs.  More employees in the workforce.  Paying more payroll taxes.  And more personal income taxes

Successful businesses made more rich people.  And more rich people pay more income taxes than fewer rich people.  A lot more.  The top marginal tax rate was lower.  But there were more businesses and people paying taxes.   Because the lower rates created more taxpayers.  And richer taxpayers to tax.  Which increased overall tax revenue.

Tax Revenue Increased under Reaganomics but Government Spending simply Increased More

So to summarize the data during Reaganomics, GDP grew, tax revenue grew, unemployment fell and inflation was tame.  All the things you want in a healthy economy.  And this all happened when the top marginal tax rate was cut from 70% to 28%. 

So, no, the Reagan deficits were NOT caused by the Reagan tax cuts.  That’s a myth created by the Left to revise history.  To recast the successful policies of Ronald Reagan as failures.  So they can continue in their tax and spend ways.

Those deficits were a spending problem.  Not a revenue problem.  For tax revenue increased after the tax cuts.  So why the deficits?  Because government spending simply increased more.

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