A Lemonade Stand's Guide to Inflation, Tariffs, and Rational Choices

From lemons to layoffs, see how rational market decisions can spiral into economic challenges when tariffs and inflation hit hard. 

Another day, another inflation warning. If you sell lemonade and the price of lemons go up, you are in a quandary. You can either risk upsetting your favorite customers by raising prices to cover your cost increase, or you can keep prices constant and accept lower profits. It really shouldn’t be a dilemma… if you run a for-profit organization. Yes, for profit. Why else would you bother waking up at the crack of dawn to squeeze lemons each morning just to lose money. That is where the academic, economic concept of the rational firm comes in. As economists, we like to say things, like “rational firms will raise their prices to consumers to cover any increases in their costs in order to maintain profitability.” Seems rational right.

On a little sidenote, the cost of lemons can go up for many reasons. Of course, you need lots of sun to get good crop yields. Natural disasters and poor growing seasons can limit supply and cause prices to go higher. There are also—let’s call them—unnatural disasters that can impact costs. One such unnatural disaster may be tariffs. Let’s say you buy your lemons from Mexico and there is suddenly a 40% tariff on lemons from Mexico. Well, plainly and simply, your cost of lemons will go up by 40%. Your costs will increase. Mexico doesn't care, but you do, because your costs just went up and your profits will be diminished. You would surely not like that… if you were rational; you would surely raise your prices to cover the tariff THAT YOU PAY to the Government. That is why everyone is so concerned about tariffs and their impact on inflation.

Let’s extend our definition of rational firms. Rational firms might decide to avoid the Mexican tariffs by seeking out domestic growers which are tariff free. The challenge is that domestic lemons cost more money than the Mexican ones because labor costs are higher in the US. And, you know that lemon farmers are rational too, which is why they charge more per bushel… to cover their higher costs. You are back to your two choices, raise prices or not.

Let’s now change the camera angle to the consumer. While we don’t refer to consumers as “rational” in a strict sense, we recognize that they are somewhat… rational. Consumers are price sensitive! At some price point, a consumer will simply forego the glass of lemonade. Why? Because there are choices, substitutes. There is orange juice, cranberry juice, grapefruit juice… WATER. Those are substitutes at some level. But wait, what if oranges and grapefruits are also produced in Mexico and subject to tariffs. Well, then, I hope you like cranberry juice. Hang on, let’s take a step back. Cranberry juice costs more than lemonade. As a consumer—a rational consumer—you are fed up. You simply stop buying juice altogether.

Back to your lemonade firm. You are selling less lemonade now that you raised your prices. In order to remain in business, you have to find other ways to remain profitable. You have no choice but to lay off workers. Surely, you only resort to that if you have to, but alas, you have to do the rational thing. Those now laid-off workers, without income, can no longer afford to pay for bottled water, and they realize that tap water is a pretty good substitute. Now bottled water companies make less sales and are faced with tough decisions; but they are rational, and they too lay off workers. Because they are selling less water, they purchase less glass bottles, and that glass bottle manufacturer struggles as well. Guess what? They too, are rational.

Now we are faced with an untenable situation. People are out of work and the prices of everything have gone up. This can become a social crisis. As a lemonade producer, you may be at a point where you are unable to cut any more costs, and your revenues have fallen significantly. You must make a decision. Faced with no alternatives, you choose to lower your prices to lure customers back, because, rationally, at some point, even lower margins are better than no margins. It happens slowly, but your old customers, now sick of cranberry juice, start lining up for your tangy, ever slightly sweetened, lemonade.

Why did I take you through this odd circle of circumstances? To illustrate very simply how complicated inflation and the economy work. There is supply and demand which is complicated enough. If you throw exogenous factors such as tariffs into the model, it becomes even more complicated. One final word on inflation and substitutes. One of my distant ancestors once decided to offer advice to out-of-work people who were struggling to afford highly priced bread. She thought “surely cake is a reasonable substitute for bread, perhaps even better.” She was wrong and found herself missing an important part of her anatomy as a result of her irrational assumption.

Can we all just step back and keep our heads by being rational? Yesterday’s Producer Price Index / PPI posted another monthly gain. In this case, it was not lemons that was the culprit. No, it was energy costs, you know, like gasoline. Gasoline has very few, if any, real substitutes, and if you are in the trucking business, you kind of need it to do what you do. You may find yourself in a tough situation with your costs going up. The choices you make, rational or otherwise, will find their way into the Consumer Price Index / CPI at some point. We will get a read of that number this morning. The headline number is expected to have increased slightly, and it has been inching up in recent months. Now, it is still lower than it was back in 2022, but it is also above the Fed’s 2% target. Investors will be watching this very closely, perhaps even more than in most months. A hot employment number from last Friday sent yields higher and stocks lower. A hot inflation figure this morning has the possibility of doing the same. Tariffs, at some level, are just around the corner and with natural disasters plentiful, specifically the horrific wildfires in California, we would be irrational not to expect an impact on housing prices and insurance, which were already part of the sticky inflation culprits. Stay focused, stay rational.

YESTERDAY’S MARKETS

Stocks had another mixed close yesterday as Tech shares weighed on the indexes under assault by regulators. The Producer Price Index came in cooler than expected, which should provide a bit of comfort for rate-cut junkies, though today’s consumer inflation number will be the real tell-tail for Fed strategy.

NEXT UP

• Consumer Price Index / CPI (December) may have ticked up to 2.9% from 2.7%.
• Federal Reserve Beige Book will be released 2:00 PM Wall Street Time. Look for anecdotal information on economic health throughout the Fed regions.
• Fed speakers today: Barkin, Kashkari, Williams, and Goolsbee.
• Earnings season kicks off this morning with Bank of NY, Wells Fargo, JPMorgan Chase, Goldman Sachs, and Citigroup. All beat on EPS and Revenues except for Wells Fargo.

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