Laffer Curve Explained

While I was still a student, I had the pleasure to attend a lecture by Art Laffer at my university. He is a great economist in his own regard and has also a career tangled in Republican politics. Basically, he is one of the default go to advisors for supply side anti-keynesian economic policy. His theoretical model, the Laffer Curve, has served as a justification for tax decreases. But what exactly is going on here? The reasoning relies on looking at the government as a non-competitive corporation trying to maximize their long term profits. If you think this is boring, consider these profits are the tax revenue which funds the whole operation. 

So you learn in basic economics that price is where supply meets demand. This essentially means that you look at the price people are willing to pay you; If you can produce it for less than they are willing to pay you, then you sell it and make a profit. When this can no longer be done supply meets demand. If we had a market for books. Demand is how much people are willing to pay for one more book; Supply is the amount of cost it creates to supply that additional book. 

Now the issue here is that this  assumes that someone can just come along and produce more. There are costs that don’t show up in supply, fixed costs. Fixed costs are when you pay some upfront cost to enter the market. The cost to make a pizza is factored in supply, but the cost to rent the building of your pizza shop is not. The reasoning here is simple. If you already paid the rent, but hardly sell pizza. This doesn’t mean you should raise your prices to try to compensate. You should make as much money as possible, even if it is at a loss factoring in the rent. This seems simple enough, but it tricks a lot of people. It has even been named the sunken cost fallacy. We will talk more about this later. 

Now we don’t want to make a loss, right? People will only make an investment in the market if they can expect to make a sufficient return. This is intuitive and you can even imagine people trying to find the best overall investments. So let us look at an example.

Let us say that you need to choose which industry to invest $100 in. Now shoes will give you a $10 profit over the next year. This factors in the costs to get started and the revenue on each shoe when you enter the market. When a producer enters the market, they are competing with people and pushing the price down. Consumers get more shoes at a cheaper price, but producers don’t make as much money. 

Suppose that an investment in cookies will earn you a $20 profit over the next year. Then instead of investing in shoes, you might choose to go with the higher profits in cookies. As more people enter cookie production the rate of profit will fall. This is because higher outputs lead to having to lower prices and more competition over necessary ingredients to make cookies increases costs. Less people invest in Shoes and the opposite happens. You might even imagine that profits will tend to equalize overtime across industries.

Okay so let us get started in the cookie industry. Let us make Oreos… wait that is already a brand… uhhh we can call our cookies, Cremeos. Yes, these are not Oreos. 

Now, let us get more specific about our fixed costs. There is a special fixed cost you will need to pay that Oreos does not in order to sell Oreos. This actually means that your expected return will be less than Oreos. These are called your barriers to entry. Oreos already has relationships with food distributors and has paid for the licenses and inspections from regulators. Just like Oreos, you need to continue paying fixed costs, such as replacing old equipment and building new factories. So in terms of profit, Oreos has this advantage. 

When you finally bring Cremeos to the market, you will realize that people might still prefer Oreos much more. Maybe they have become accustomed to the specific taste or maybe they just are biased by the branding. There are a variety of psychological effects that come to play. Regardless here, Oreos are able to charge a higher price, because people are willing to pay more. This is true even if the cost to make an Oreo is the same as a Cremeo. 

I am going to present this new graph, don’t be intimidated it is based on the supply and demand graph. I will make a connection to the production of Creameos. You have the revenue earned from a particular quantity of Creameos produced. The price people are willing to pay for something goes down the more Creameos you want to sell to people. This is represented in our Average Revenue curve, this is just a fancy way of saying demand. The other curve we have is our Total Revenue curve. If you produce very few Creameos, then people will be willing to buy them at a higher price and thus you will have a lot of revenue per Creameo. If you produce a lot of Creameos, you will have to sell them at a lower price, thus making less revenue per Creameo. There exists a sweet spot where you charge enough to maximize total revenue. The Marginal Revenue curve here just shows the change in Total Revenue if you want to expand production. You want this to be greater than zero, otherwise you are losing revenue. 

This is all an elaborate way of graphing out a simple principle. You don’t care about how many Creameos you make or how much you charge per Creameos. You just care about making the most revenue. 

This reasoning matters much less when you think about competitive prices, such as a basket of apples sold at a farmers market. If you don’t charge prices others are charging, the buyer can just go buy the same thing from other sellers at the market. This doesn’t exactly work when you have something like Oreos. People love Oreos and are willing to buy them at higher prices compared to competitors. 

We can recall that we were interested in understanding the Laffer Curve. If you look carefully at the previous graph, the Laffer Curve and total revenue curve both have a similar shape. This is because the Laffer Curve is just the total revenue earned from taxes given a quantity of taxation. It is simple the higher you price Oreos, the less Oreos people will want to consume. Just as the more you tax, the less people will want to do the thing you tax. So just like Oreo, the government can find a revenue maximizing point. This means that both groups get the most amount of money. 

This is usually where people stop at explaining the Laffer Curve, but there is another point, the growth maximizing point. What is going on with this point? This point is very rarely understood by people and is a crucial aspect to understanding a lot of economic phenomena. 

So we are going to return to Oreos as a company and try to make decisions for the company. We have an established brand and want to focus on making money over a long period of time. For simplicity, I will give you two choices which give different profits over a two year period. These will not be reinvested, they are just your profits.

Year 1Year 2
Plan A$1000$1505
Plan B$1100$1400

Now Plan A looks good if you are thinking about total profits earned from Oreos over a two year period. There is a problem with this assumption, you can do stuff with the money earned in Year 1 during Year 2. We have ideas such as an interest rate which is a numerical representation of how much we value money over time. So you can simply take the profits from Year 1 and invest them in an alternative investment. This might be a good idea to do instead of reinvest, because other investments might give a better return.

For simplicity, let us just say we open a savings account and get a ludicrously good deal of 20%. What would be the total profits at the end of Year 2 if we deposit the profits at the end of Year 1?

Total Profit (20% Interest)
Plan A$1000 + $200(Interest) + $1505 = $2705
Plan B$1100 + $220(Interest) + $1400 = $2710

In the case of 20% Interest, we would prefer more money now. This is because we have better uses for that money, during Year 2. Often reinvesting in the current company is not worth it. We can try this with a different interest rate of say 10% and get different results.

Total Profit (10% Interest)
Plan A$1000 + $100(Interest) + $1505 = $2605
Plan B$1100 + $110(Interest) + $1400 = $2600

This means that the amount of return on other investments can determine your long term plans for how to deal with Oreo as a brand. When we talk about the long term, we need to think about how pricing, quality, and brand change over time. Oreos might make a lot of money now by pricing high, but it could kill their long run profits. This is not necessarily a bad idea, especially if there are much better alternatives. 

How does this fit into pricing? What we have shown is that simply maximizing profits based on what you are earning now is short sighted. Now you could raise your prices to get the most money now. This might work best if large profits or high prices don’t ruin the future market. 

How can large profits be bad for business? Normally if you are making a lot of money, then people will try to compete with you. What ultimately stops this is barriers to entry. It is easier to be Oreos than Creameos, because one is established and the other isn’t. This leads to Creameos paying more money and thus lower profits. The government has a lot more power than Oreos to crush their competition. If you want to compete with the government, you will need to worry about getting arrested for black market activities. 

This is a very narrow view of the situation though. Black markets can be a large competitor to the government, but also other governments. People and investment move around the world. There are multiple countries and if it is too costly to operate in one country it might lead to future investment and migration going to another country. This is where high prices can be a problem. While a lot of people are loyal to their government, it will drive some people to abandon the market and degrade the demand over time. If Oreos are sufficiently expensive, it may lead to people thinking that Oreos are ripping them off. The name of the brand may be tarnished.

These arguments have very constrained limits. They only apply if you consider the goal of taxation to be maximum revenue generation. The significance of this argument is important to a lot of people. This is more money to spend on social programs, military, public recreation, etc. I mean if you think the goal of the government is to protect its interests, then this is a good start. If you don’t have a large and powerful economy, then you will be less likely to be able to fend off other people trying to loot you. You can also see it as a means to maximize money spent on a variety of social programs that help people. I think it would be useful to look at a variety of objections though. 

You might be an anti-government activist, such as an anarchist. An anarchist would look at the desire to maximize revenue, just a more efficient plunder of the people. The government is essentially farming human livestock. The Laffer Curve just argues that you are worth more to them in the future if the government takes less from you now. 

You might not actually think the size of the economy is actually important. You might instead want to focus on something like human happiness. You can appeal to the fact that people could feel better with more equality. A very basic argument could be as follows: Even if the economy is worse off, rich people are hardly happier than poor people. Deaton and Kahneman have found that happiness is capped at an annual income of about $75,000 per year. There is a famous supposed and disputed Easterlin paradox showing that national levels of income have no correlation with happiness. Stevenson and Wolfers have proposed that happiness is logarithmic. To understand what logarithmic here means. Consider your happiness at $10,000 per year. Now, in order to double your happiness you would need to make about $100,000,000 dollars. Hence, if we redistribute a lot of the money of the rich, even if it is bad for the economy, poorer people get a lot more happiness. This doesn’t mean you can tax at 100%, but it could mean you might argue for taxes higher than the Laffer Curve would imply is good. This is only one argument. I think this argument is theoretically interesting, but it has a lot of baggage. This might be better discussed in a future piece.

The Laffer Curve is a way of thinking about government services as a company that is operating in an uncompetitive market. They are trying to find a price which will maximize their long run profits. If they tax you too much, they will start to actually make less money. Making the most amount of money this year is short sighted when it can restrict future growth opportunities by charging less now. They want to limit potential competition and maintain the good name of your brand. If they do so the corporation… I mean the government will make lots of money going into the future. 

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