President Donald Trump’s pledge to double tariffs on steel and aluminum imports to 50% took effect Wednesday – the latest twist in the trade saga that has defined the stock market this year. We don’t own the stocks of any steel or aluminum producers — Nucor is in our Bullpen — but we stay on top of the moves in commodity prices because they often represent material input costs for companies across sectors of economy. Therefore, it’s the perfect opportunity to delve into how a tariff works, who may benefit, and determine the actual costs. We broke it all down in five charts. 1. Domestic free market supply and demand As with most things in the economy, it all starts with supply and demand. This chart represents a domestic market with the intersection of the supply and demand lines representing the equilibrium point. Think about the equilibrium point like this: If a producer makes one fewer product, they will be leaving a financially beneficial sale on the table. If they make one more of a product, they won’t be able to sell it because the demand isn’t there at that price point. Additionally, take note of the areas that represent consumer and producer surplus because they will be important to compare to later charts. In economics, consumer surplus represents the difference between what consumers are willing to pay and what they actually pay. It doesn’t mean they have too much of something in their closet or pantry. It’s a “consumer benefit,” as measured by a lower price. The larger the consumer surplus area is on our chart, the more the consumer is benefiting. Producer surplus is the difference between what a producer actually receives for a good and the lowest price they would be willing to accept. It is not the same thing as a producer’s profits because profit is the difference between the revenue generated by selling the good and the costs to make it. Consider: You, the reader, are willing to pay $2,000 for a smartphone – that’s the value you place on that good. However, in reality that smartphone sells at a $1,500 thanks to the competition among domestic producers in a free market economy, which means the surplus to you is $500. For the producers, consider that there’s a company willing to sell a smartphone for $750. However, because demand for phones is so strong, the company has an average selling price of $1,500. That $750 average differential is the producer surplus. When it comes to understanding tariffs, we need to differentiate domestic demand from global supply. So, we’ll update the chart to reflect global supply and pricing dynamics alongside domestic demand. 2. Domestic demand with free market global supply This chart indicates a tariff-free world, where the world price is lower than that of the domestic producer’s price. In this scenario, the consumer benefits from the ability to import more goods at lower prices and therefore fulfill more demand. Note the change in consumer and domestic producer surplus when an economy is allowed to trade freely and import from lower-cost producing countries. Domestic producer surplus is reduced because it’s not financially beneficial to produce beyond the intersection of the world price and domestic supply lines. But the size of the consumer surplus is much, much larger than on our previous chart. Translation: The benefits to the consumer – a larger differential between what they would pay and would they actually do – are much, much larger. Sticking with smartphone example, we now have an economy with global imports and no trade barriers (no tariffs), which means more competition among producers across the world. As a result of this added competition, the average price of a smartphone being sold is $1,000. This takes the producer surplus down to $250, since remember they would be willing to sell it for $750. The consumer — still valuing the phone at $2,000 — now experiences a surplus of $1,000, which is up from $500 before. The ability to import freely has increased the net surplus in the local economy by $250: a $500 increase for the consumer against a $250 decrease for the producer. This is an important takeaway in making the argument for the globalization. So, cleaning that chart up a bit for clarity, in a free market economy with no trade barriers, the global supply/domestic demand chart looks like the following. 3. Consumer surplus in global free market Keep in mind: This is the same chart as in the previous section, just simplified to emphasize the consumer surplus component and to clearly show the amount of goods imported. Compared to the very first chart in our exercise, consumer surplus is way up thanks to the benefit of being able to import cheaper goods. Domestic producer surplus is lower because companies are at the mercy of the world price and won’t produce beyond a level at which they can make money. That means if the average price of the smartphone has fallen to $1,000, from the $1,500 that it was in a domestic-only market, it may not make financial sense for the domestic producer to build a new factory. Or, it may not make financial sense for a new domestic producer to try entering the local market, given there is no extra surplus for it to capture. The difference between the amount produced by the domestic suppliers and the amount demanded in the domestic market based on the lower world price determines the number of imported smartphones. That’s highlighted in red in the chart above. Up to now, we have charted out the benefits for consumers in scenarios when goods are imported freely, without government intervention. To be sure, the ability to buy cheaper goods abroad comes at a cost to domestic producers. But as we explained in the smartphone example, the gain in consumer surplus more than offsets the loss in producer surplus, which is the argument for free market globalization. However, in some cases that cost to the domestic producers is significant — and that full cost is likely not fully reflected in these textbook charts. For example: The domestic availability of personal protective equipment during the Covid-19 pandemic. There was a very real cost to the U.S. for its inability to manufacture the needed number of masks early on in the pandemic, though that cost wouldn’t have been reflected on a chart like this (we’ll revisit this example shortly). And in cases like that, a government might deem it necessary to reduce that harm. Indeed, that is the key reason to implement a tariff in the first place: to protect domestic businesses, especially when foreign players operate under conditions that the domestic producers simply cannot compete with, such as more lenient safety standards and no minimum wages. In addition, many governments subsidize their domestic industries, especially steel and aluminum, which makes it harder for American producers to compete or cuts them out of the market completely. This is why the question of whether tariffs are good or bad is not exactly black and white. As a consumer, I want lower prices. I want cheap gas, cheap eggs, cheap lumber, cheap steel, cheap everything. I want to spend less and save more. Who doesn’t? At the same time, we need to maintain low unemployment levels, and we need to consider the risks of exporting our manufacturing capabilities to other countries, especially those that may not be as friendly as we like in the future. That’s especially true for goods related to national security, like steel or personal protective equipment. With that in mind, let’s consider the impact on domestic consumer and producer surplus when a tariff is enacted. 4. Domestic surplus with tariffs In this chart, we see the higher world price resulting from the tariff: consumer surplus is reduced because consumers have to pay more for goods, and therefore will demand less goods. The domestic producer surplus increases due to businesses’ ability to sell at a higher price. The amount imported is still the difference between the domestic supply and domestic demand; however, as we can see, we are importing less due to more being sold domestically and lower demand overall as a result of the higher prices. With a 25% tariff average on smartphones, the cost of buying a new model just went up in price to $1,250. For some consumers, like those who were more than willing to pay $2,000 initially, this is not a problem at all. While their surplus did go down, they still can afford the new phone. But for other consumers who could only afford a phone when it was $1,000, the tariff becomes a problem. They might decide to put off buying the new phone until next year, giving them time to save up money for the newest phone at $1,250. That means less overall demand for smartphones in the local economy, so fewer phones are imported and sold. But it’s good news for the domestic producers because they can now sell phones at the average market price of $1,250, up from the $1,000 price tag when they had tariff-free foreign competition. Now we’re going to relabel this chart to better focus on several key areas. 5. Loss of economic surplus with tariffs The first thing to note: consumer surplus has been reduced by the total area represented by A+B+C+D. Producer surplus increased by the amount of area A. As noted previously, the amount imported is the difference between the domestic supply with tariff and the domestic demand with tariff. Given that this amount of a good is still imported even with the tariff, area C represents the amount of revenue raised by those tariffs. So, area A went from a consumer surplus to a producer surplus, while area C was subtracted from the consumer surplus and now goes toward paying for the tariff, which is revenue to the government revenue. Areas B and D are the real areas of concern when it comes to tariffs. These were previously adding to the consumer surplus, but now they are eliminated from the equation entirely. So, while the producers and government are getting more than they did previously, the amount they gain is less than the amount of surplus lost by consumers. We refer to the area of B+D as “deadweight loss,” as it represents the loss of economic surplus overall resulting from the tariffs. There is no denying that tariffs come with a net negative cost to the consumer and economic surplus overall. Again, the amount of increase we see in producer surplus and government revenue will never equal to the amount of consumer surplus lost due to a less efficient, less free market. So, if the goal is to create an economy that is as efficient as possible, trade barriers are clearly not the answer. Of course, it’s not that simple, which is why we see so much debate over the tariffs. Again, as a consumer, I want lower prices everywhere. I don’t want to pay more for an iPhone because Apple is forced to pay American wages to produce it. However, when thinking on a longer-term horizon, we must also acknowledge that there are costs associated with the outsourcing of manufacturing that are not represented in these charts. In 2018, for example, had we mocked up these charts for the N95 mask market, we would have most likely concluded that the clear economic move for maximum surplus would be to allow manufacturing of masks and other personal protective equipment, or PPE, to be outsourced. Forcing domestic production via a tariff would have resulted in deadweight loss. However, that chart in 2018 would have been lacking whatever the cost was that we ultimately paid during Covid-19 pandemic for not being able to source or manufacture the number of N95 masks to meet U.S. demand. In other words, there is also a cost to relying on others to meet domestic demand. In some cases, that cost is worthwhile as the risk of supply disruptions isn’t that great. Americans will survive without Champagne from France. However, not getting N95 masks in 2020, or not being able to source semiconductors in the future can certainly result in a national security crisis. Our inability to manufacture missiles or warships at scale could well prove a major issue should we, heaven forbid, find ourselves in another broad-scale conflict. So, in certain industries, the risk of outsourcing may well outweigh the deadweight loss resulting from tariffs or any other form of free trade barriers. From an employment perspective, one might argue the need for tariffs. After all, what good are cheap goods and services if U.S. unemployment surges and Americans can’t afford food, let alone cheap discretionary goods? Don’t forget the U.S. is a consumption-based economy. If unemployment gets out of hand, there won’t be much consumption of anything, which accounts for roughly two-thirds of U.S. economic activity. Another question is, are today’s Americans even going to want some of those low-paying and low-skill jobs that we already outsourced to nations like China? Probably not, and with artificial intelligence advancing rapidly, who is to say you need a human in those positions at all by the end of the decade? Rather than demonize tariffs, we have to acknowledge that they are a tool that can be used to realize an objective. They may well be a great tool if targeted with precision and implemented with a great deal of thought. However, when implemented hastily, in a broad-based fashion that has us all wondering what the actual objective even is, that’s when things get problematic. That’s what Wall Street is contending with now. It’s not so much that investors can’t understand the need for some tariffs or that companies, the economy more broadly, or our national security status can’t benefit from tariffs. It is, however, the way these policies are hitting the newswires every day. The barrage of headlines every other day about new, higher tariff rates being imposed on entire countries, rather than specific goods or industries, makes it impossible for businesses to plan. What country is safe? What will the actual price be by the time it hits U.S. shores? How is an economist supposed to even begin to understand the loss of consumer surplus, increase to producer surplus, potential tax revenue, and dead weight loss associated with a tariff if it can jump from 25% to 50% over a weekend, seemingly on a whim? That was the heart of Jim Cramer’s weekly column on Sunday. Bottom line As we continue to navigate these headlines and do our best to understand what it all means for the companies in which we are invested — and, of course, refresh our thinking with every update out of Washington — what we all really need is more clarity. We aren’t saying no tariffs, ever. 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