Political Economy Critique of Neoclassical Economics Wrong answers

Political Economy: Critique of Neoclassical Economics Wrong answers to the wrong questions: Markets Steve Keen

Last lecture, Demand • Can’t derive downward-sloping market demand curve from theory of individual behavior unless assume all consumers & commodities identical • Utility maximisation theory fails to explain individual behaviour in controlled experiment • This lecture: neoclassical theory of the firm bollocks – All markets are “monopoly-monopsony tradeoffs” even if “well behaved” market demand functions exist – Assumptions of theory (nature of competition, diminishing marginal productivity, etc. ) counterfactual: not merely “simplifications of reality” but “the opposite of reality” ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 2

Supply & Demand • Often-overlooked pre-requisite of supply and demand analysis is perfect competition or equivalent – Without “P=MC”, supply curve does not exist • Different “point of supply” for every demand curve P • Demand supply interdependent unless market competitive—hence importance of “perfect competition” to neoclassical economics ©Steve Keen 2006 MC Supply P 1 P 2 “S u D 1 pply MR 1 Q 1 Q 2 D 2 cu rve ”? MR 2 Q Advanced Political Economy, Economics & Finance, University of Western Sydney 3

Supply & Demand • Textbooks argue profit maximisation means price equals marginal cost in competitive industries because – Firms equate MC and MR to maximise profits • But for them, MR=P because they are: … – “Price takers”; – “Too small to influence market price”… – Mathematically, whereas d. P/d. Q<0, d. P/dq=0… • Graphically: whereas market demand curve slopes downwards (forgetting last lecture!…), demand curve for individual firm is horizontal • E. g. , from Mankiw Ch. 14… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 4

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Profit Maximization for the Competitive Firm. . . Costs and Revenue MC 2 The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC ATC P=MR 1 P = AR = MR AVC MC 1 Known to be mathematically false since 1957! 0 ©Steve Keen 2006 Q 1 QMAX Q 2 Advanced Political Economy, Economics & Finance, University of Western Sydney Quantity 5

“Horizontal” Firm Demand Curve • Leading neoclassical academic in leading neoclassical journal (despite name!): slope of individual firm’s demand curve same as market demand curve! ©Steve Keen 2006 • What’s this mean? Advanced Political Economy, Economics & Finance, University of Western Sydney 6

“Horizontal” Firm Demand Curve • Using the Chain Rule, slope of individual firm’s demand curve d. P/dqi can be broken down into – Slope of Market demand curve (d. P/d. Q) – Times how much market output changes for a change in output by one firm (d. Q/dqi) • For textbook argument that d. P/dqi=0, d. Q/dqi would have to equal zero • But Stigler says it equals 1… • Which is correct? – Stigler! d. Q/dqi=1 simply statement that competitive firms are independent: change in output by one firm does not directly cause change in output by any other: dqj/dqi=0 ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 7

“Horizontal” Firm Demand Curve • Expanding out d. P/dqi: • Apply Chain Rule • Q sum of output of n firms • Expanding out summation • Expanding out differentials • All are zero except dqi/dqi • Therefore d. P/dqi=d. P/d. Q: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 8

Horizontal demand curves: the 1 st Fallacy Price • The graphical intuition: – If the market demand curve slopes down, then any tiny part of it slopes down with the same slope: • “Zoom in” & both axes compress: still same slope: P P P- P “S” D – Only if it “doesn’t matter” to assume that zero equals minus one!: q Q ©Steve Keen 2006 q Q+ Q • “Can’t we just assume d. P/dqi=0? After all, ‘assumptions don’t matter’…” Quantity Advanced Political Economy, Economics & Finance, University of Western Sydney 9

What if we “assume” price-taking? • Start with and assume • Split industry into ith firm and the rest QR – Independent firms so d. QR/dqi=0 • Only possible if : a logical contradiction • What if we just assume that d. QR/dqi=-1? ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 10

What if we “assume” price-taking? • Expanding d. QR/dqi=-1: (not including qi) • The dqx/dqi’s are not independent • we’ll discuss game theory later • With Marshallian “atomism”, can’t get away from d. P/dq i=d. P/d. Q. • So the individual firm’s demand curve slopes downwards… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 11

• How about firm as “price taker”? Price What if we “assume” price-taking? – Assumes can sell as Irrational belief: P(Q+q)=P(Q) much as it likes at P(Q) Rational belief: P(Q+q)<P(Q) market price… – Sure—but this is irrational, not rational – If the market demand curve slopes downwards, then any increase in output, no matter how small, must cause market price to fall, however Q Q+ q infinitesimally. • Neoclassical result dependent upon irrational behavior… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 12

What if we “assume” price-taking? • Expand assumption that P(Q+q)=P(Q): • Use Taylor’s Theorem: • Where q>0 this is an approximation: • Even for q<<Q we get: • So the individual atomistic firm’s demand curve slopes down… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 13

Stigler’s escape route… • Most neoclassicals don’t know that d. P/dq=d. P/d. Q • Those who do take comfort with Stigler’s argument: • “Run that by me again…” ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 14

Stigler’s escape route… • Stigler’s convergence to perfect competition argument: Cancel Q’s, move P’s Market elasticity of demand where • “this last term goes to zero as the number of sellers increases indefinitely” (Stigler 1957: 8) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 15

Stigler’s “Way out”? • Stigler’s formula correct: – Marginal revenue for individual firm will converge to market price as number of firms rises – If they are profit maximisers, market price will be the “monopoly” price (P>MC), not “competitive” price (P=MC) – Novel discovery: profit maximisers don’t equate marginal revenue and marginal cost… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 16

Neither “price takers” nor “price makers” • Each competitive firm has small but non-zero impact on market price • Each firm’s behaviour affects others indirectly – One firm’s output doesn’t alter as consequence of any other (independent firms); but – Change in one firm’s output does affect revenue of all others via change in market quantity & price – Change in revenue for one firm a product of both its behaviour and independent behaviour of all other firms: • So what impact does this ignored component have? ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 17

Neither “price takers” nor “price makers” • Firm maximises profits by making gap between total revenue & total costs as big as possible. • Total costs function of firm’s behavior only BUT • Total revenue depends on what other firms do especially since individual “atomistic” firm can’t influence what they do. • “Marginal revenue” as defined by neoclassical economists – focuses on second half of change in revenue equation ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 18

Equating MC & MR doesn’t maximise profits • To calculate true profit maximisation, have to set total differential to zero: This is 1 given atomism”: • Expanding total differential: if jth firm increases output by 1, market output rises by 1 This is 0 when j<>i and MC(qi) when j=i ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 19

Equating MC & MR doesn’t maximise profits • First term is zero when j<>i and P(Q) when j=i: • Second term is n copies of qi times P’(Q): • Rearrange to introduce MR(qi): • True profit maximisation where MR>MC since P’(Q) < 0 • Rearranging further: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 20

Equating MC & MR doesn’t maximise profits • Given that • Substitute into • Can also derive result by assuming all firms do set MR=MC and add up the result (next few slides…) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 21

Equating MC & MR doesn’t maximise profits • Aggregate effect of equating MC & MR: n copies of P Replace with Q Move a P… & a MC… This is MR(Q) (industry, not firm) ©Steve Keen 2006 n copies of MC Rearranging this: Advanced Political Economy, Economics & Finance, University of Western Sydney 22

Equating MC & MR doesn’t maximise profits • “Profit maximising” strategy of each firm maximising profit w. r. t. its own-output results in aggregate output level where marginal cost exceeds marginal revenue • Why? Own-output marginal revenue is not total marginal revenue: that formula again: • -(n-1). (P-MC) is the collective impact of feedback effect of other firms output changes on each other… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 23

Equating MC & MR doesn’t maximise profits • So if equating MR & MC doesn’t maximise profits, what does? – Aggregate (market level, not firm) MC(Q) & MR(Q) still shows profit maximum for all firms – Set this to zero in formula and see what individual firms should do: • Rearrange to put MR(Q)-MC(Q) on one side: • Set this to zero to identify Q that maximises industry profits ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 24

Equating MC & MR doesn’t maximise profits • Take terms in P and MC inside summation sign: – (divide both by n) • This gives true profit maximisation formula: firm maximises profit by setting: • Lots of consequences: – Monopoly & competition have identical effects given same costs – Supply curve can’t be drawn because P>MC in all industry structures… – “Welfare loss due to monopoly” is actually “welfare loss due to profit maximising behaviour” ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 25

Equating MC & MR doesn’t maximise profits • Some numerical proof that “MR=MC” doesn’t maximise profits – n identical firms – Demand curve P(Q)=a-b. Q • Where Q=nq – Marginal cost mc(q)=c+dq • So total cost is k + cq + ½dq 2 – Which formula maximises profit? • Or: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 26

Equating MC & MR doesn’t maximise profits • Marginal cost for single firm: • Marginal revenue for single firm: Identical firms so qi=q • and d. P/d. Q: So mc(qi) is Identical firms so qi=q • Equate marginal revenue & marginal cost: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 27

Equating MC & MR doesn’t maximise profits • Solve for q: • Put q’s on same side: • Take c to other side: • Group q’s • Rearrange: • “Profit maximising” output level according to MR=MC formula for profit maximisation ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 28

Equating MC & MR doesn’t maximise profits • Set gap between marginal revenue & marginal cost to (n-1)/n * gap between Price & Marginal cost: • Put mc(q) on same side • Expand & group mc(q): • Collect terms in mc(q): ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 29

Equating MC & MR doesn’t maximise profits • Expand for terms in q: • q’s everywhere! But let’s expand & see what happens… • Now take terms not in q (a & c) to one side: • Terms in a & c group easily: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 30

Equating MC & MR doesn’t maximise profits • Now group q: • Reorganise b: • Cancel n/n term in b • Subtract terms in b • Whew! • Now equate this to the other side: • Divide through: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 31

Equating MC & MR doesn’t maximise profits • Two predictions for profit-maximising level of output – MR=MC prediction: – Gap prediction: • Feed them into formula for profit and see which one is bigger: – Profit=Revenue-Cost: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 32

Equating MC & MR doesn’t maximise profits • Sample: a=100, b= 1/1, 000, k=10, 000, c=20, d= 1/100, 000, n=100 • Revised formula “hits the spot” • Neoclassical formula produces almost twice profit-maximising output • Involves loss on additional output above profit • And it’s not just a numerical maximising level quirk… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 33

My number is bigger than your number… Profit for ith firm (in general) Using MC=MR Using correct formula Profit gap: • Conventional formula only true for a monopoly… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 34

My number is bigger than your number… • Huge gap between true profit maximization level & mc=mr level: • (Example with a=100, b=1/1000000, c=20, d=1/100000, k=10000) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 35

Stigler’s “Way out”? • If equate mc & mr: • If maximise profits: • Solving for P yields • Marginal revenue=marginal cost > price: • Market price is “monopoly” price • Price greater than marginal cost (since E<0) • Price independent of number of firms in industry • Profit maximisation incompatible with “welfare maximising” P=MC ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 36

What about “game theory”? • Game theory – Accepts firms are profit maximisers, but • Sees profit-maximising behaviour as constrained by strategic interactions with other firms • Firms set output level based on expected strategic reactions of other firms – Interactions make “MR=MC” the “best response” strategy – As shown above, MR=MC converges to P=MC as number of firms rises – An example… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 37

What about “game theory”? • Linear demand curve P(Q)=a-b. Q • Two firms with identical costs tc(q)=k+cq+ ½dq 2 • “Payoff matrix” shows output combinations if: – Both firms produce profit-maximising amount – Both firms produce where MR=MC – Or combination of strategies… • MC=MR output clearly higher • What about profit levels? ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 38

What about “game theory”? • “Defector” clearly gains, “Cooperator” clearly loses: • But both lose with twin “Defect” strategies vs twin “Cooperate” • Note: no longer accurate to describe strategies as “cooperate” vs “defect” since firms can work out profit-maximising output level without collusion… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 39

What about “game theory”? • At first glance, looks clearcut… – “Cooperate” (“Keen strategy”) yields highest shared profit; but – “Defector” gains from defection – Both “defect” (“Cournot strategy”); higher output, lower profit from strategic interaction… – Limit of process (as number of firms rises) is “perfect competition” • However, as usual, problems on deeper examination: – Cournot strategy locally unstable (new result); – Problem of repeated games (old result) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 40

Repeated Games • Quoting Varian: “The prisoner’s dilemma has provoked a lot of controversy as to … what is a reasonable way to play the game. The answer seems to depend on. . . whether the game is to be repeated an indefinite number of times. If … just one time, the strategy of defecting … seems … reasonable… However, … In a repeated game, each player has the opportunity to establish a reputation for cooperation, and thereby encourage the other player to do the same. ” (2003: 503) • Conclusion: Game theory “unstable” proof of competitive outcome. Given repeated games, “monopoly” outcome likely. ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 41

Local instability • “Defect/Cooperate” interpretation of Prisoner’s Dilemma implies “Cooperate” (“Keen”) strategy unstable – Defector increases profit by producing where MR=MC • Much higher output, slightly lower market price – Cooperator suffers • Lower output, slightly lower market price • However, this interpretation implies – (a) One firm will not react when other changes output – (b) Each firm “knows everything” about what other firm might do • “Real world” closer to – (a) One firm will react when other changes output – (b) Each firm “knows nothing” about what other firm might do ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 42

Local instability • Assume firms start at Cournot output level – What happens to profits of both if “Column” Firm (C) increases output by 1 unit? C’s output change – How is “Row firm” (R) likely to react? C’s profit change • Table shows changes in profit for +/- 3 units: R’s output change ©Steve Keen 2006 R’s profit change Advanced Political Economy, Economics & Finance, University of Western Sydney 43

Local instability • Firm getting negative result from output change will change its strategy… • C increases output by 1 & R does nothing, both lose… • R increases by 1, both lose… • R decreases by 1, R loses & C gains… • But if C reduces output & so does R, both win: reinforcing result applies… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 44

Local instability • Interaction between competitors in vicinity of Cournot output level causes movement away from it by reducing output – Position is locally unstable: not a true equilibrium • On the other hand, Keen output level locally stable: – No combination of moves that cause both parties to gain; one’s move counters the others, so dynamics will oscillate around Keen equilibrium level… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 45

Local instability • Implies profit-maximising firms will “grope” way towards Keen equilibrium. • Checking this out experimentally: define “instrumentally rational profit maximiser” (IRPM): – Changes output (either increase or decrease); – If profit rises, continues to change output in same direction – If profit falls, changes direction • Test outcome of virtual market with defined demand curve P(Q)=a-b. Q and population of IRPMs ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 46

Virtual market • The program: Seed random number generator Initial outputs randomly allocated between Keen & Cournot levels Arguments: Initial price based on initial aggregate output No. of firms Randomly allocated fixed amount by which each firm alters its output each iteration; mean 0, st. dev. 1% of Cournot output level Iterations Random seed Each firm alters its output by its dq amount Demand parameters Cost parameters Repeat this loop for r iterations Calculate new price Each firm works out whether its profit has risen; if so, no change; if profit has fallen, each firm changes sign of its dq Return matrix of each iteration for each firm • The results: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 47

Virtual market • Market output converges towards Keen prediction: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 48

Virtual market • 1, 000 firm industry produces aggregate amount very close to neoclassical “monopoly” prediction: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 49

Virtual market • Individual dynamics much more complex than aggregate outcome: • Important issue in evolutionary economics – very simple entities (as here!) can give rise to very complex behaviours – complexity arises from mainly relations between firms, rather than properties of each firm ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 50

Virtual market • Second example: another sample of firms from same run… • Identical agents • Very simple underlying behaviour • Extremely complex and differentiated manifest behaviours ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 51

So what are the consequences? Costs & Revenue • (1) The action is not “where the curves intersect”: Profit maximizing output level for ith firm in n-firm industry True profit maximizing rule • Individual firms have to produce MC where MR>MC for aggregate MR=MC • Conventional theory P = AR > MR makes aggregation error MR Conventional economic belief Quantity ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 52

So what are the consequences? • (2) Profit-maximising competitive firms produce same amount as monopoly & sell for same price… Price Profitmaximizing price • Profit Deadweight loss maximisation due to profit maximization incompatible with welfare maximisation st al n i g ar co M Marginal revenue 0 ©Steve Keen 2006 Profit. Welfare maximizing Efficient quantity Demand Quantity Advanced Political Economy, Economics & Finance, University of Western Sydney 53

So what are the consequences? • (3) Supply & demand analysis not possible even with competitive markets – Supply curve only exists if firms produce where marginal cost equals price – Profit maximisers produce where MR>MC • For individual firm: – Price slightly larger than marginal revenue; – marginal revenue > marginal cost • For industry – Price much greater than marginal revenue; – Marginal revenue equals marginal cost – No “supply curve” at individual firm or market level ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 54

So what are the consequences? • (4) Maybe monopoly is better…? – Competitive & monopoly produce where aggregate MR=MC – So structure with lower marginal costs will produce more at lower price – Which is likely to have lower costs—monopoly or competitive? • Monopoly—large firms likely to have – Economies of scale • Large ship moves containers more cheaply than small) – More specialisation ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 55

Monopoly better than PC? With lower marginal costs, yes: Welfare gain Price due to monopoly Competitive price Monopoly price ve t i t ti os e p lc m a Co rgin Ma Another problem for theory: cost curves identical (as shown in textbooks) Marginal revenue only under 3 very Competitive Monopoly quantity limited conditions! ©Steve Keen 2006 oly p o n o M ost c l a n i Marg Demand Quantity Advanced Political Economy, Economics & Finance, University of Western Sydney 56

Monopoly better than PC? E. g. , Gas • “… the necessary first investment in infrastructure is the construction of the pipeline itself… (A)t the outset, the selection of pipe diameter is a critical ingredient in determining the economics of future expansions of the installed pipe: the larger the diameter, the more efficient are the future additions of capacity and hence the lower the marginal costs of future units of output. " output (Rosput 1993: 288) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 57

From Fallacies to Reality • End result: conventional theory incoherent – Can’t achieve welfare ideal of Marginal Cost=Price if firms profit-maximize – Supply and demand analysis impossible • No independent supply curve: – Point of supply depends on demand curve shape • Results extend to monopsony: with upward-sloping labour supply curve, all industries are monopoly-monopsony trade -offs! – Theory is a shambles… • (Including other conundrums not covered here— limitations on shape of marginal cost curves for comparability of monopoly and PC, etc. ) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 58

From Fallacies to Reality • Welfare results of theory turned on head: – “PC” prices at same level as monopoly – “Deadweight loss of monopoly” actually “deadweight loss of profit maximization” – Profit maximization incompatible with welfare maximization – General equilibrium analysis invalidated – Monopoly better than competition according to corrected neoclassical theory: same pricing policy, lower costs via economies of scale… – Competition policy obsession not justified ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 59

From Fallacies to Reality • In numerous surveys – Andrews, Bishop, Downie, Eiteman and Guthrie, Haines, Hall & Hitch, Lee, Means, Tucker, the ‘Oxford Economic Research Group’, … (see Lee 1998 for full details), Blinder et al 1998… – 95% of real firms report • “marginal revenue/cost” irrelevant, foreign concepts – Every extra sale adds to profit – Average costs fall with output (high fixed costs, constant or falling variable costs) • Prices set by markup on average costs • Firms operate well within capacity (not at margin) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 60

Cost functions as seen by managers • Eiteman & Guthrie 1952 showed managers 8 hypothetical average cost curves: • 3 -5 neoclassical: • “ 5… high at minimum output, … decline gradually to a least-cost point near capacity, after which they rise sharply. ” ©Steve Keen 2006 • “ 6… high at minimum output, … decline gradually to a least-cost point near capacity, after which they rise slightly; 7… high at minimum output, … decline gradually to capacity at which point they are lowest. ” (Eiteman & Guthrie 1952: 835) Advanced Political Economy, Economics & Finance, University of Western Sydney 61

Cost functions as seen by managers Curve Indicated Number of companies 1 0 2 0 3 1 4 3 5 14 6 113 7 203 8 0 Total 334 Only 18 out of 336 fit neoclassical vision of diminishing marginal productivity, rising marginal cost Almost 2/3 rds have lowest unit costs at maximum output ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 62

Cost functions as seen by managers • Neoclassical concept of cost curves fits just 5% of companies & products • Other 95% experience constant or falling marginal cost • Don’t even get to first base on “MR=MC” – MC has to rise for MR=MC to be any guide to profit maximisation (even with modified formula) – Otherwise average costs above marginal cost • How come? What happened to “diminishing marginal productivity”? ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 63

Modern industrial production • Modern factories & absence of diminishing returns: – Engineers design factories “so as to cause the variable factor to be used most efficiently when the plant is operated close to capacity. Under such conditions an average variable cost curve declines steadily until the point of capacity output is reached. A marginal cost curve derived from such an average cost curve lies below the average cost curve at all scales of operation short of capacity, a fact that makes it physically impossible for an enterprise to determine a scale of operations by equating marginal cost and marginal revenues. ” revenues. (Eiteman 1947) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 64

Modern industrial production • As some of Eiteman’s survey respondents put it: – “The amazing thing is that any sane economist could consider No. 3, No. 4 and No. 5 as representing business thinking. It looks as if some economists, assuming a premise that business is not progressive, are trying to prove the premise by suggesting curves like Nos. 3, 4 & 5” – “Even with the low efficiency and premium pay of overtime work, our unit costs would still decline with increased production since the absorption of fixed expenses would more than offset the added direct expenses incurred. ” ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 65

Sraffa’s critique of “supply curve” • Concept of “diminishing marginal productivity” assumes – One input to production fixed in short run – One input variable in short run – Generates “rising supply curve” • Supply curve must be independent of demand curve for “supply & demand analysis” • Sraffa (1926) disputed concept of “fixed factor in short run” – If define “factor” & industry broadly (e. g. , “capital” & “agriculture”) then any increase in intensity of usage will drive up price of factor – Change in price will affect distribution of income – This will affect demand—can’t have independent supply & demand curves… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 66

Sraffa’s critique of “supply curve” – If define “factor” & industry narrowly (e. g. , “stapling gun” & “cardboard boxes”) then amount in one industry can’t be fixed • Extra stapling guns can easily be acquired from other industries with – little impact on price of other industries – trivial impact on demand for cardboard boxes • Factors “stapling guns” and “labour” thus employed at ideal ratio, & productivity constant: not subject to diminishing marginal productivity – Cardboard box output a linear (non-decreasing) function of labour input – “Marginal product” constant so cost constant: ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 67

– Interdependent supply & demand curves: different demand curve for every point on Dq 2 supply curve… Supply Dq 3 Dq 1 Price ? ? ? ? Labour input with constant labour/land ratio Price & Cost Price/ bushel • It’s either: Wheat output Sraffa’s critique of “supply curve” Falling average cost Constant Marginal Cost ©Steve Keen 2006 Q 1 Q 2 Q 3 Quantity? “Agriculture” Wheat Advanced Political Economy, Economics & Finance, University of Western Sydney 68

Modern industrial production – As Sraffa put it… – “Business men, who regard themselves as being subject to competitive conditions, would consider absurd the assertion that the limit to their production is to be found in the internal conditions of production in their firm, which do not permit of the production of a greater quantity without an increase in cost. The chief obstacle against which they have to contend when they want gradually to increase their production does not lie in the cost of production-which, indeed, generally favours them in that direction-but in the difficulty of selling the larger quantity of goods without reducing the price, or without having to face increased marketing expenses. ” (Sraffa 1926) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 69

Kornai: “demand-constrained” economies • Neoclassical model of capitalism “supply constrained” – “Unlimited wants” – “Scarce resources” • Kornai: modern capitalism “demand constrained” – Excess capacity the rule • Not “waste” but “opportunity” • In growing economy, new factory must have much more capacity than needed now; • In uncertain world, excess capacity needed to react to opportunities – Income distribution limits effective demand – Main problem for firms not producing with diminishing productivity, but selling what they can produce given constrained effective demand ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 70

Kornai: “demand-constrained” economies • Empirical data supports Kornai: even during boom years, US capacity utilisation well below 90%: • Excess capacity the rule, not “scarcity” ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 71

Kornai: “demand-constrained” economies • Not weakness of capitalism (“inefficient”) but strength – Existence of excess capacity & competitors vying for same market forces innovation • Cost reduction (“dynamic efficiency”) vs neoclassical focus on statics • Product innovation (diversity) vs neoclassical focus on “homogeneous products” – Approach of neoclassicism • Blinds economists to true strengths of capitalism • Falsely identifies scarcity & efficiency as main weaknesses (rather than insufficient aggregate demand, income distribution, etc. ) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 72

Things haven’t changed since Eiteman… • Most recent survey work (Blinder et al. 1998): – “Over 89 per cent of respondents indicated that ‘marginal’ costs either declined or stayed constant with changes in output (sometimes involving discrete jumps). Finally, only four [of 200] enterprises had both elastic demand curves and increasing marginal costs. ” (Downward & Lee 2001, reviewing Blinder) – “Fixed costs appear to be more important in the real world than in economic theory. ” (Blinder) • Neoclassical economists ignore this research (over 140 published papers & books on it!); why? – Empirical literature ignored because incompatible with accepted theory ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 73

Economic facts of the firm: detail • How fast do prices adjust? – Economic theory: quickly • Prices adjust to bring demand supply into equilibrium • Adjustment process so fast that non-equilibrium sales (where demand is greater than supply or vice versa) can be ignored – Blinder’s results: slowly • 23% of firms adjust prices instantly after a shock to demand • 20% adjust within a month • 26% take 1 -3 months to adjust prices • 21% take 4 -6 months • 11% take more than six months ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 74

Economic facts of the firm • Frequency of price adjustments a factor in speed of adjustment • Less than 2% of firms adjusted price daily • 50% of firms changed prices only once a year • Extremely sluggish compared to economic model of instantaneous movement from one equilibrium price to another • If supply/demand analysis accurate, most sales occur out of equilibrium ©Steve Keen 2006 Number of Price Changes in a Typical Year Frequen Per Cumulati cy cent of ve Firms Percenta ge Less 10. 20% than 1 1 39. 2% 49. 4% 1. 01 to 2 15. 6% 65% 75 2. 01 to 4 12. 9% 77. 9% Advanced Political Economy, Economics & Finance, University of Western Sydney

Economic facts of the firm ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 76

Economic facts of the firm • To whom do firms sell? – Economic theory: Utility maximising consumers • No buyer/seller relationship; only interest lowest price – Blinder’s results: 85% of sales to repeat customers • “Thus, in the aggregate, sales to nonrepeat customers are almost small enough to be ignored. ” (96 -97) – But conventional economic theory based on this minority! • 38% of GDP sold under written contracts • At least 75% of these fix price for over a year with no discounts • 70% of sales to other businesses; only 21% to consumers (other 9% mainly government) • Type of customers explain infrequent price changes: – wish not to disturb continuing customer relations ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 77

Economic facts of the firm • Regular up/down price movements would – Antogonise consumers in planning budgets – Disturb cost/revenue calculations of other businesses who make up 70% of all sales (and large proportion of repeat business) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 78

Economic facts of the firm • Are firms concerned with nominal or real prices/profits? – Economic theory: only real values matter • Prices should be adjusted to achieve real rather than nominal returns – Blinder’s results: 50% of firms never consider expected price inflation when setting own prices • Less than 1/3 rd do consider expected inflation • “The responses hold bad news for any theory based on the idea that firms seek to set their real price. ” (98) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 79

Economic facts of the firm • Is demand elasticity high or low? – Economic theory: Elasticity of demand an important concept • Most industries competitive & elasticity should be high – Blinder’s results: “most firms … not only do not have an elasticity estimate handy but [also] are unaccustomed to thinking in such terms. ” (99) • 40% of firms said elasticity zero: no change in demand for 10% cut in price • 70% elasticity below 1; only 2. 5% of firms high elasticity (E>5) • “only about one-sixth of GDP is sold under conditions of elastic demand” (E>1) • “the numbers … may offer a simple key to understanding price stickiness because, as even beginning students of economics are taught, only firms with price elasticity of demand greater than unity can increase total revenue by cutting prices. ” (99) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 80

• Firm with elastic demand can increase revenue by reducing cost – Fairly likely to compete on price • Inelastic demand means cut in price will reduce revenue – Unlikely to compete on price Price Economic facts of the firm Elastic D nd ema ic D last Small fall in price, large fall in revenue Ine Small fall in price, large rise in revenue emand Quantity ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 81

Economic facts of the firm • Are fixed costs important? – Economic theory: No. • Fixed costs are “sunk” costs • Variable costs determine scale of output • Firm should operate as long as revenue exceeds variable costs – Blinder’s results: Fixed costs important • “in a fair number of cases—and this was the big surprise —we found that the ‘fixed’ versus ‘variable’ distinction was just not a natural one for the firm to make. ” (101) • 44% of costs fixed and 56% variable • “fixed costs appear to be more important in the real world than in economic theory. ” (101) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 82

Economic facts of the firm • Economic “examples” always “made up”—e. g. , Mankiw Microeconomics 2003—rather than real – Low fixed costs – Fixed costs low percentage of average cost • Why made up examples? – Because can’t find real ones that fit theory… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 83

Economic facts of the firm • Theory makes fixed costs irrelevant anyway • But they’re not “irrelevant” in real world – Fixed costs much higher in absolute terms than theory’s models • Fixed cost of new semiconductor plant well over US$1 billion – & much larger proportion of average total costs – “While we lack a good metric against which to judge these numbers, fixed costs appear to be more important in the real world than in economic theory. ” (101) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 84

Economic facts of the firm • Does marginal cost rise? – Economic theory: Yes! Marginal cost must rise otherwise • Firms in competitive industries would produce infinite amounts • Firms in other industries couldn’t work out a profit maximising level of output – Blinder’s results: only minority have rising marginal cost • 41% of firms have falling marginal costs • 48% of firms have constant marginal costs • Only 11% of firms have rising marginal costs • “The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost. ” (102) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 85

Economic facts of the firm Price • Rising MC needed for “MC=MR rule” to identify maximum profit point • Needed for price theory – Downward sloping marginal cost curves downward sloping supply curve – Increase in demand causes price to fall; good for consumers but bad for economic theory… Pe Supp ly D d an em ©Steve Keen 2006 Qe University of. Quantity Advanced Political Economy, Economics & Finance, Western Sydney 86

Economic facts of the firm • Why are falling marginal costs “bad for theory”? – Because theory sees price as reflecting relative scarcity – If demand rises, relative scarcity rises price should rise • With falling marginal costs, rise in demand fall in price – “price signals” don’t function as economists expect • Maybe prices don’t reflect relative scarcity • Maybe other factors (e. g. , rate of growth of demand) play role economists assume played by prices – Think computer, MP 3 players • Rising demand & falling price • Falling relative price obviously doesn’t make products less profitable to produce ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 87

Economic facts of the firm • Will shifting supply and demand cause fluctuating prices? – Economic theory: Yes • If demand increases then price will rise because supply curve slopes upwards because of rising marginal cost – Blinder’s results: No • “one basic reason for expecting prices to rise in booms and fall in slumps is the presumption that demand curves are shifting in and out along upward-sloping supply curves… If the supply prices of cyclically sensitive goods are more commonly downward-sloping, then we would expect their relative prices to move counter-cyclically instead. Then, if nominal marginal costs rise in booms, nominal prices might not show much cyclicality at all. ” (102 -104) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 88

Economic facts of the firm • Do stocks matter? – Economic theory: No. Markets are “spot” markets; sales occur at equilibrium prices that precisely equate supply and demand – Blinder’s results: Yes • “On average, 54 per cent of output is produced to stock. ” (104) • “Wholesale and retail firms report that they sell primarily from stock” • Fluctuations in stock levels play buffer role between supply and demand that economists assumed performed by prices ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 89

Economic facts of the firm • Is economic theory relevant to management/business? – Economic theory: of course! – Blinder’s results: No—not conventional theory anyway! • “Firms report having very high fixed costs-roughly 40 percent of total costs on average. And many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks. ” (105) ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 90

Economic facts of the firm • Economic facts of the firm conflict strongly with assumptions of (neoclassical) economics – Infrequent price adjustments – Fixed price contracts common – Most sales to other businesses, not “utility maximizing” consumers – Fixed costs very important, large percentage of product costs – Marginal costs fall for most businesses, not rise • So what’s gone wrong with theory? • Ignored reality in order to maintain a priori beliefs in supply and demand • Economic methodology encourages counter-factual theory on false basis of “assumptions don’t matter”… ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 91

“Let’s assume the opposite of reality…” • Literature on actual behaviour of firms was real target of Friedman’s 1953 “assumptions don’t matter” methodology paper: – “the businessman may well say that he prices at average cost, with of course some minor deviations when the market makes it necessary. The. . . statement is [not] a relevant test of the associated hypothesis. ” (Friedman 1953) – Ignore what businesses say they do? – Shouldn’t we instead be modelling what they do? ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 92

A real theory of the firm? • A theory that explains & interprets actual data – Output constrained not by supply (rising costs) but by demand factors: • Heterogeneous goods & consumers • Financial limitations on expansion – “Power law” distribution of firm sizes within industries – Competition on innovation/marketing rather than price • Evolutionary rather than static modelling • A micro (finance & demand constrained) that’s consistent with observed macro (finance & demand constrained) • Next lecture: “General equilibrium” can’t be in equilibrium ©Steve Keen 2006 Advanced Political Economy, Economics & Finance, University of Western Sydney 93