The Marginalist Controversy Anil Kumar Bharti Assistant Professor
The Marginalist Controversy Anil Kumar Bharti Assistant Professor Department of Economics Central University of Jammu
Marginalism and Neoclassical Economics Ø Although “neoclassical economics” and “marginalism” were used synonymously until the early 1950 s, they are usually treated as distinctive concepts in contemporary discussions. ØMarginalism comprises a body of theory concerned with maximization by using marginal concepts, which are associated with a specific change in the quantity of a service or good. ØFor a firm, marginalism postulates the maximization of profits at a point where marginal costs are equal to marginal revenues. ØNeoclassical economics can be understood as a more general framework that includes marginalist concepts and incorporates definitions of supply, demand, costs, equilibrium, scarcity and economic efficiency. ØConsumer utility maximization and profit maximization by firms are central elements to the neoclassical framework.
Marginalist Controversy Between 1946 and 1953 the American Economic Review (A. E. R. ) published several papers on the relevance or otherwise of the marginalist theory of the firm, the collection of which constitutes the marginalist controversy. Ø Among these papers, the leading articles were by Lester (1946) and Machlup (1946), who took aggressively opposite stands. Ø Marginalist controversy also refers to the closely related discussions over theory of the firm that took place for a longer span of time (from 1939 to around 1955), and in a variety of English and American journals and conferences. Ø The full-cost pricing (FCP) controversy, which was started by the Oxford economists Hall and Hitch (1939), is the single most important of these related discussions. Ø
Neoclassical Theory of the Firm The conventional theory of the firm, argued Hall and Hitch, asserts that firms attempt to maximize their profits by choosing the outputprice combination (or output in the case of perfect competition) in such a manner that marginal revenue is equal to marginal cost. Ø This marginalist approach yielded theoretical solutions for equilibrium in the case of pure competition, monopoly or monopolistic competition. Ø But this theoretical method failed when the structure was oligopolistic. Ø In oligopolistic structure, because of interdependency between firms, individual demand marginal revenue curves were indeterminate and, hence, the firm could not use the marginalistic approach for the maximisation of profits. Ø
Neoclassical Theory: Main Assumptions There is a single-owner entrepreneur which means that there is no separation between ownership and management. Ø The firm has a single goal, that of profit maximization. Ø This goal of profit maximisation is attained by the application of the marginalist principle MC=MR Ø The world is one of certainty implying that the firm had perfect knowledge of its cost and demand functions and of its environment. Ø Entry considerations differ according to the type of market structure. Ø The firms acts with a certain time horizon which depends on the factors such as the rate of technological progress, the capital intensity, the nature and gestation period of the product etc. Ø
Hall and Hitch Report and the Full Cost Policy Ø Hall and Hitch published their Paper ‘Price Theory and Business Behaviour’ in 1939. Ø The purpose of the paper was to examine the way in which businessmen decide about the price and output of their products. Ø Their study raised doubt on the general applicability of the conventional analysis of price and output policy in terms of marginal cost and marginal revenue. Ø Hall and Hitch interviewed 38 British entrepreneurs , out of which 33 were manufacturers of a wide variety of products, 3 were retailers, and 2 builders.
Continued. . Based on these interviews, they pointed to a wide gap between the presumptions of conventional analysis and the reality of business practices. Ø Instead of equating marginal revenue and marginal cost in an attempt to maximize profits, it was found that businessmen applied a simple ‘rule-of-thumb’ which Hall and Hitch called ‘full-cost’ pricing. Ø This full-cost price was determined first by an ex-ante estimate of average costs. Ø Then two percentage margins were added to this cost base to arrive at the final price. The first was a mark-up to coverhead costs and the second had the function of a profit margin. Ø
Continued. . . Ø Ø Ø Firms justified their submission to the ‘full-cost’ pricing by arguing that it was the ‘right price’ and its application was considered as a ‘fair’ practice toward their competitors. When entrepreneurs were questioned by Hall and Hitch about not charging a price higher than that implied by the ‘full-cost’ principle, most of them cited their uncertainty regarding the response of competitors. When requested to explain about not charging a price lower than ‘full-cost’, the businessmen stated primarily the fear that competitors would follow and would match the lower price. Other reasons included the unresponsiveness of demand moral objections to selling below costs. As reasons for not changing prices (however fixed), businessmen explained that they wished not to ‘disturb’ the stability of market prices and also that buyers had a ‘conventional’ price in mind and ‘disliked’ price changes.
Hall and Hitch’s Main Findings � The firms do not act atomistically as they are continuously conscious of the reactions of their competitors. � Firms do not attempt to maximise short-run profits by marginalist rule MC=MR, but aim at long-run profit maximisation. � Firms set their price on the full cost principle (average-cost Principle) which covers the average variable cost, the average fixed cost and a ‘normal’ profit margin P=AVC+ AFC+ profit margin.
Reasons for Breakdown of Marginalism � As per Hall and Hitch, firms do not know their demand curve nor their marginal costs, hence the application of the marginalist rule MC=MR is impossible. � Firms believe ‘full cost price’ is the ‘right’ price as it covered the costs of production and allowed a ‘fair’ profit when the plant was ‘normally’ utilised. � Prices of manufacturers were fairly sticky, despite changes in demand costs while the traditional theory predicted a change in price and output in response to changes in demand costs at least in the short run.
Gordon’s Attack on Marginalism � Gordon (1948) attacked the basic assumptions and postulates of the traditional theory of the firm. � He argued that the determinants of demand costs vary continuously and marginal adjustments for all changes simultaneously are beyond the ability of entrepreneurs. � Uncertainty makes impossible the accurate knowledge of future demand cost conditions making marginalist behaviour inapplicable. � Empirical evidence has shown that firms use average-cost pricing widely. � In empirical studies firms have been reported to pursue a multitude of goals. � Any attempt to build additional goals into cost and revenue functions before proceeding with the marginalist equality leads to tautological predictions.
The Marginalists’ Counterattack � The proposition that the firms did not try to maximize their profits and were in contentment with the quiet life of ‘full-cost’ pricing was not universally accepted by economists. � Leading the neoclassicists’ counterattack, Machlup (1946) argued that the reasons given by the empirical researchers such as Hall and Hitch (1939) and Lester (1946) for the rejection of marginal analysis were in fact baseless. � He criticised Hall and Hitch and their followers on the basis of the following shortcomings: (1) a failure to properly understand the essence of marginal analysis, (2) faulty research techniques, and (3) mistaken interpretations of empirical findings.
Continued. . � Machlup stressed that the procedure by which the firms equated marginal revenue and marginal cost must be interpreted with great care. � First, the magnitudes for the relevant variables were ‘subjective estimates, guesses and hunches. ’ � They reflected the perceptions, opinions, and beliefs of the businessman and were not necessarily equal to the corresponding ‘objective’ magnitudes as they might be observed by ‘outside’ parties. � Second, the businessmen need not be engaged in tedious data collection and complicated calculations in order to equate marginal revenue and cost.
Continued. . � Hall and Hitch further suggested that entrepreneurs did not make use of concepts such as ‘demand elasticity, ’ ‘marginal revenue’ and ‘marginal cost, ’ and in many cases did not even understand them, but according to Machlup, this also did not invalidate the standard theory. � As per Machlup, while entrepreneurs might have failed to understand the marginal concepts as presented to them by Hall and Hitch, they have not necessarily failed the crucial test of marginalism.
Continued. . � Marginalists attacked ‘full-cost’ pricing on methodological grounds. � In defence of marginalism, Friedman(1953) argued that theory should be judged not on the basis of the realism of its assumptions but on the basis of its predictions. � According to Friedman, Traditional theory should be judged as being a satisfactory theory as it has produced reasonably good predictions. � J. S. Earley (1955) provided evidence that firms do in fact apply marginalist rules in their decision-making.
To Sum Up � To sum up, it can be said that the Marginalist controversy cannot be considered as resolved. � The observed ‘stickiness’ of prices in the face of changing conditions of the environment suggests that marginalism is not applied, at least in the short run. � If one attempts to incorporate time and uncertainty or additional goals in a single set of appropriately ‘doctored’ long-run demand cost schedules, then marginalism reduces to a tautology. � It is not certain that the pricing practices reported by businessmen in the context of various studies are inconsistent with marginalism or that the average cost pricing theories provide an alternative to the model of marginalism.
References � Hall and Hitch, “Price Theory and Business Behaviour”, Oxford Economic Papers (1939), reprinted in T. Wilson and P. W. S. Andrews (eds. ), Oxford Studies in the Price Mechanism (Oxford University Press, 1952). � F. Machlup, “Marginal Analysis and Empirical Research’, American Economic Review (1946). � M. Friedman, “The Methodology of Positive Economics”, in Essays in Positive Economics (University of Chicago Press, 1953). � R. A. Gordon, “Short-Period Price Determination in Theory and Practice”, American Economic Review (1948). � A. Koutsoyiannis, “Modern Microeconomics”, Mac. Millan Press Ltd (1979).
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