How will Consumers Respond to Tariffs – Testing Economic Theory

 

 

Written by: Martin Shields, CFP®, AIF®

 

Throughout my Economics Master program in Virginia Tech one of my favorite areas of study was consumer theory.  The discussion was centered around how consumers reacted when the price or quality of a good and service changed.  In some cases, they could control the variables and in other situations they were out of their control.  One of the primary variables was price increases or decreases.  The tariffs being implemented will bring these theoretical discussions into real-time analysis across a wide range of goods and it will be interesting to see how consumers respond.

There are a few factors that are important to consider when trying to determine how they will respond.

 

Large versus small price transactions – If the cost of the good you are purchasing is substantial then adding a 15% increase to the costs may have the consumer reassess their purchase decisions and see what other options exist.  If the purchase cost is small, a 15% increase most likely will not impact on their decision as to whether they will move forward with the purchase.

 

Few versus many substitutes - If there are many substitutes for the goods impacted by the tariff then the product is considered to have high price demand elasticity and consumers will move from that good to other goods very quickly.   If there aren’t many substitutes, then it’s considered to have low price demand elasticity and consumers will bear the burden of the higher price.

Goods that are commodities are very elastic as they are all very similar in quality and there are usually many options to choose from.  Luxury goods tend to be more inelastic as each good is more unique and there are fewer options to choose from when prices increase.

 

Want versus need – When a good is truly needed, like medicine, then consumers are more likely to accept the higher price because it is indispensable for their life.  For goods that are true wants, such as third pair of skis, the consumer may hold off on purchasing if the price increases.

 

Consumer Financial Health – Consumers that have high incomes, strong balance sheets and low debt levels will most likely continue their purchases the same as they did before the tariffs were implemented.   The only variation to this would be on large purchases where the dollar increase could be significant.  Although, it is likely in the big purchase category that if the buyer does not know that amount of the price going towards the tariff their purchase decision may not be impacted by the tariff. In this category, they tend not to be very price sensitive, but they would rather not cover the cost of the tariff, which is really a tax.

Consumers who are struggling financially are much more price-conscious on all purchases and will likely change their purchasing decisions in almost all categories very quickly as prices rise.

 

Delay Because of Uncertainty - The other big fact at play is that the tariffs can change very quickly, either up or down or get removed completely.  This level of uncertainty can cause consumers to hold off on purchases to see what happens.  No one wants to make a large purchase, pay a tariff and then find out a month from now that the tariff has been removed.

As an economist, it will be interesting to see how the theories we discussed in the classroom will actually play out in the markets.  Because of the uncertainty of human behavior and emotions, the reality can be very different than what consumer theory would tell us to expect.