Goldwing Tom dot com

Understanding Supply-Side Economics

What is Supply-Side Economics?

The term "supply-side economics" was coined sometime in the 1970s. The theory, however, has been in use far longer than that.

I imagine that long before money was coined, some sharp trader likely figured out that he could trade three fire stones for two hunting clubs. This not only would get him twice the amount from a person wanting a fire stone, it likely also enticed traders to seek him out rather than his competition who had not conceived the notion, and wanted one hunting club for each fire stone.

However, I do not actually know the relative values of fire stones and hunting clubs. Also, three for the price of two is only one way in which supply-side economics can be applied. For the sake of keeping things even, and to apply single item price to something, we shall rely upon that great commodity known as widgets.

If one retailer sells widgets for $1 apiece, and a second retailer sells his for 10% less, then the result if each sells the same number of widgets is the second retailer will recieve 10% less revenue. If, however, consumers purchase 12% more widgets at the lower price, the second retailer's revenue will be greater than the revenue realized by the first retailer. Why would it require 12%, and not 10%, more sales? Good question; let's look at it.

If the first retailer sells 100 widgets, he will have $100 in revenue. If the second retailer sells 10% more (110 at $.90), his revenue will be $99. If he sells one more (11%), his revenue will be $99.90. It will take the 12th transaction for his revenue to exceed the revenue realized by the first retailer.

We now have sufficient information to create a formula wherein we can determine if supply-side economics increases or decreases revenue: lower prices will increase revenues PROVIDED there are sufficient transactions to result in increased revenues; otherwise, lower prices decrease revenues.

Those amazing M&Ms!

Imagine devising a business plan including building a factory, hiring employees to run expensive equipment, and purchasing quality materials, for the purpose of mass-producing quality products to sell to middlemen, to sell to retailers, to sell to consumers your quality product for about a penny or two per unit - AND EVERYONE ALONG THE WAY RECEIVES ADEQUATE REWARD!

Consider, though, how significantly the true overall result may change if we alter only the supply-side aspect in the marketing plan as such: instead of selling "a supply of twenty-five for fifty cents," these delightful lozenges were sold for "three, four, or five cents each, but only in single units."

Though the per-unit transaction amount is inarguably greater when sold individually, the number of units transacted at the lower per-unit price is so much greater that they do not even sell individual units.

In fact, if you are not willing to pay fifty cents for twenty-five, they will sell you six times as many for four times the price. However, they will not sell you one, for the cost to sell individual units for a profit would make it unaffordable to consumers.

It is logical, then, overall revenue is increased because the company accepts lower per-unit revenue, and transacts many, many more as a result. Paradoxically, it is also logical, M&Ms would not be available if not for supply-side economics. Fortunately, the provision has been met, and we enjoy the wealth of fine morsels melting in our mouths, and not in our hands!

Reaganomics, Trickle-Down, and Supply-Side

If you are old enough, the first time you likely heard the term used in relation to taxation was when Ronald Reagan ran against Jimmy Carter in 1980. It was part of an economic strategy that became known as "Reaganomics."

Reagan proposed, as part of his economic recovery plan, that reducing tax rates on the wealthy would result in them using the tax savings to hire people. Those newly employed people would shift from being drains on tax revenues as beneficiaries to becoming productive tax payers, and the result would be a combination of greater revenues and reduced expenditures.

To those inclined to believe that the country’s problems dissolved the day he was inaugurated, they point to his logic. It makes sense on a very simple level of understanding.

To those more inclined to look at facts and figures, unemployment continued to grow from 7.5% on the day he was inaugurated, to a high of almost 12% two years later, and he is still the only President under whom the national debt doubled - and it almost tripled.

To be fair to supply-side economics with regard to taxation, however, much of the failure of Reaganomics to produce the promised results had to do with conflicting principles, such as hiring government employees to shrink the government and reducing spending while growing the military.

Hence, it was more the ideals that did not reconcile that led to high deficits, than the premise that a greater number of taxation transactions at a lower rate might have offset the loss of revenue at a higher rate. It also served more to show us that the trickle-down theory that lower tax rates for the rich would result in them spending that money hiring employees is not true.

Simply put, the conflicting principles of "Reaganomics" makes the results of the supply-side principles incalculable.

Hey Maynard, Is There a Solution?

One of the primal arguments in economics is whether supply creates demand, or demand creates supply. I believe the latter is true, and so did an economic philosopher from the early twentieth century named John Maynard Keynes.

During the Great Depression, the lassiez-faire economists contended the market would correct itself. The economy sat idle for years. Keynes noted that the economy was in perfect balance: there was no demand, and there was no supply to meet the lack of demand. His suggestion was for the federal government to create a small amount of artificial demand through works projects. That artificial demand would create a small amount of real supply, which, in turn, would create additional real demand. Further, that the increased revenue realized through increased activity would be sufficient to repay the cost of creating the artificial demand.

It worked! However, the recovery, albeit steady, was slow. The government concluded foolishly, as most fools do, that if a small amount were good, then more would be better. Keynes spent the rest of his life trying to convince those in charge that the small amount was sufficient, and more is excessive. He urged them to use the increased tax revenues resulting from increased economic activity to pay off the debt incurred that prompted the increased activity.

Getting back to the point, though, unemployment dropped from somewhere between 20% and 25% in 1933 to somewhere between 9% to 15% in 1941. (The range in estimates is because unemployment was not measured in those days the way it is measured today.)

The increased deficits were not the result of supply-side economics, but rather were the result of increased spending by the federal government. Increased employment resulted in greater tax revenues because the provision for sufficient additional transactions had been met, but continual increased spending was favored over using the revenues to pay off the initial investment.

In Summation: Maybe

Because the answer to whether reduced prices or rates will result in increased revenues is provisional, the answer to the question is "maybe." The definitive answer of "yes" or "no" can only be determined after we know whether or not transactions were sufficiently increased to result in greater revenue.

We wandered a bit around the topic. The M&Ms example shows definitively how and why at times supply-side economics is hugely successful. The Reaganomics example shows how it can be tied to another theory that did not work as planned, but why supply-side economics did not fail; the provision simply was not met. The Keynes example shows that supply-side economics can be implemented through something other than reduced prices or rates, in that case, through creation of artificial demand.

The purpose of the article is not to advocate higher or lower prices or tax rates, but, rather, to give the reader a better understanding of what supply-side economics is and how it works. If you now can seperate it from "trickle-down" and "increased spending," and attribute it more to the provision for sufficient increased transactions, then my time writing and your time reading was well spent.

If not, I urge you to re-read it. Even if you still don’t understand it, your reading of it again will result in one more transaction for me!

Some other things I've written about: