The Bridge between Policy and Stock Prices: Understanding the economic factor

April 9th, 2018 by Tanner Wrisley

Since the last election, the Trump Administration’s actions have moved the stock market up and down many times. This is a result common amongst any major governmental policy. But what are the economics behind these moves? I believe many individuals, investors, and media outlets look right past the bridge between policy and the stock prices. Economics drive the markets that our investments are actually operating in. So I would like to give some insight into the economics of governmental policies and how they affect markets and, in turn, your stock portfolio.

In a free market, the supply and demand for any good are free to meet at the maximum profit level. Markets operate efficiently and prices are regulated through competition.  This means that if producers decided to lower supply and raise the price of their good their action would take buyers out of the market and decrease profits. Alternatively, if they increased supply and lowered the price of their good it would not entice enough buyers to make up for the lowered price. The result is again, decreased profits. There is a certain point where maximum profit can be reached and in a free market, producers will continue to adjust prices and supply quantity until they reach this maximum market efficiency. However, governmental policies disrupt this process by introducing new costs to the consumer or the producer that create market inefficiencies.

Tariffs are an example of a disruptive government action.  Take soybeans for example. Let’s say a farmer exports his soybeans to China and has found that he can maximize his profit by selling 100 bushels at $5 per bushel for a revenue of $500. At that supply, it costs him $4 per bushel to produce and export the product leaving him with a $100 profit ($500-$400). If China puts a 20% tariff on soybean imports, the farmer will have to give $100 per bushel to the Chinese government. If he tries to maintain the same price and pay the tariff his profit will be zero. And because we know the farmer was already at maximum efficiency, if he tries raising the price to $6 per bushel, less people will be willing to buy soybeans and his revenue will fall. The end result is this farmer not turning a profit and eventually leaving the market. The loss of profit and exiting of suppliers is called the deadweight loss.

Minimum wage is another governmental policy that has a huge effect on markets that many people do not realize. The labor market is just like the market for any good. The employee is the supplier, the good is the employee’s service or the work that they do, the price of that labor is their wage, and the buyer is the employer.

Say the only place to get food in a town are 3 different restaurants that employ waiters and waitresses at $8 per hour. A new minimum wage law is enacted making the minimum wage to $10 per hour. The first restaurant tries to pay all of their servers the $10 per hour but their profit margin was too slim. They are unable to keep up with the increased costs and so they go out of business. The second restaurant tries laying off some of their servers so that they can pay the higher wages to the servers they keep. But this then leads to them not being able to serve enough tables to keep up with their original costs and so they go out of business as well. The third restaurant is so well liked by the citizens of the town, they were able to raise their menu prices to stay in business and absorb the new higher wage costs. But now, the town only has one choice for a restaurant and more unemployed workers. In addition to those adverse effects, minimum wage only has a nominal effect on people because of an increased cost of living. This means that even though the servers are getting paid more dollars per hour, the restaurant had to raise their prices and so now the workers have to pay more to eat.

These examples come with a big caveat. These scenarios are created in a vacuum. This is purely the academic explanation of the functions of economics.  In the real world, there are numerous factors affecting every transaction, every policy, and every market, which is why it is hard to pull out the true cause and effect of economic happenings- it’s not an exact science. It helps to look at examples to understand the concepts and what might happen at a very basic level, but the real U.S. economy is very complex and different policies and occurrences overlap. And that is not to mention the social benefits of policies. There are times when a policy may be enacted for its social benefits even though there may be economic consequences.

Economics show that policies affecting price, quantity, supply, or demand take that market away from its natural disposition. Implementing taxes or price floors introduces a manipulated factor that may cause markets to operate away from maximum efficiency. This is why the stock market and our investments change so much with every new direction from the executive branch of government. These policies affect the markets that companies work in, changing their outlook for growth and the investors respond accordingly. If a company’s growth is expected to slow because a new tariff is affecting their market, investors may take action by selling shares of that company. This widespread selling then creates a drop in stock price. Right now we are seeing the market dropping on worries of tariffs and possibly an all-out trade war with China. For more on tariffs and trade wars, check out our ***STOCK MARKET UPDATE 3/22/18***.   Hopefully this article provides insight into the economic factors driving the market and next time you are watching the news and see the stock market moving on the announcement of a new governmental policy, you will understand the economic link behind these moves.