Political Economy: Critique of Neoclassical Economics Wrong answers to the wrong questions: Supply

Last week, 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 week: neoclassical theory of the firm is bollocks

Supply & Demand Often-overlooked pre-requisite of supply and demand analysis is perfect competition or equivalent Without “Price equals marginal cost”, supply curve does not exist Different “point of supply” for every demand curve P Demand and supply inter-dependent unless market competitive—hence importance of “perfect competition” to neoclassical economics P1 MCSupply P2 D1 D2 “Supply curve”? MR1 MR2 Q1 Q2 Q

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 dP/dQ<0, dP/dq=0… Graphically: whereas market demand curve slopes downwards (forgetting last week’s lecture!…), demand curve for individual firm is horizontal E.g., from Mankiw Ch. 14…

Profit Maximization for the Competitive Firm... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Profit Maximization for the Competitive Firm... Costs and Revenue The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC MC2 Q2 ATC P = AR = MR P=MR1 QMAX AVC MC1 Q1 Known to be mathematically false since 1957! Quantity

“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! What’s this mean?

“Horizontal” Firm Demand Curve Using the Chain Rule, slope of individual firm’s demand curve dP/dqi can be broken down into Slope of Market demand curve (dP/dQ) Times how much market output changes for a change in output by one firm (dQ/dqi) For textbook argument that dP/dqi=0, dQ/dqi would have to equal zero But Stigler says it equals 1… Which is correct? Stigler! dQ/dqi=1 simply a statement that competitive firms are independent: change in output by one firm does not directly cause change in output by any other firm: dqj/dqi=0 Stigler thought he had a way out…

“Horizontal” Firm Demand Curve Expanding out dP/dqi: Apply Chain Rule Q sum of output of n firms Expanding out summation Expanding out differentials All are zero except dqi/dqi Therefore dP/dqi=dP/dQ:

Horizontal demand curves: the 1st Fallacy The graphical intuition: If the market demand curve slopes down, then any tiny part of it slopes down with the same slope: Price “Zoom in” & both axes compress: still same slope: P “Can’t we just assume dP/dqi=0? After all, ‘assumptions don’t matter’…” Only if it “doesn’t matter” to assume that zero equals minus one!: dP “S” P-DP D q Q dq Q+DQ Quantity

What if we “assume” price-taking? Start with and assume Split industry into ith firm and the rest QR Independent firms so dQR/dqi=0 Only possible if : a logical contradiction What if we just assume that dQR/dqi=-1?

What if we “assume” price-taking? Expanding dQR/dqi=-1: (not including qi) Either one of the dqx/dqi’s is minus one—so that one firm deliberately counters what firm i does (so they’re not independent [we’ll discuss game theory later]); or dqj/dqi=-1/n…; Huh? Other absurdities also result: can’t get away from dP/dqi=dP/dQ. So the individual firm’s demand curve slopes downwards…

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: Lots! So what impact does this ignored component have?

Equating MC & MR doesn’t maximise profits “Marginal revenue” as defined by neoclassical economists focuses on second half of change in revenue equation Effectively assumes first half is zero Only possible if other firms don’t change their outputs—but of course they will! So “MR=MC” won’t maximise profits if other firms change their outputs. What will it do? Assume all firms do set MR=MC and add up the result

Equating MC & MR doesn’t maximise profits Aggregate effect of equating MC & MR: n copies of P n copies of MC Replace with Q Move a P… & a MC… This is MR(Q) (industry, not firm) Rearranging this:

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…

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

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”

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-bQ Where Q=nq Marginal cost mc(q)=c+dq So total cost is k + cq + ½dq2 Which formula maximises profit? Or:

Equating MC & MR doesn’t maximise profits Marginal cost for single firm: Marginal revenue for single firm: Identical firms so qi=q and dP/dQ: So mc(qi) is Identical firms so qi=q Equate marginal revenue & marginal cost:

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

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):

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:

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:

Equating MC & MR doesn’t maximise profits We now have 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:

Equating MC & MR doesn’t maximise profits Sample: a=100, b= 1/1,000,000, 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-maximising level And it’s not just a numerical quirk…

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…

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)

So what are the consequences? (1) The action is not “where the curves intersect”: Profit maximizing output level for ith firm in n-firm industry Individual firms have to produce where MR>MC for aggregate MR=MC Conventional theory makes aggregation error MC Costs & Revenue P = AR > MR True profit maximizing rule MR Conventional economic belief Quantity

So what are the consequences? (2) Profit-maximising competitive firms produce same amount as monopoly & sell for same price… Profit maximisation incompatible with welfare maximisation Quantity Demand Marginal revenue Marginal cost Profit- maximizing price Deadweight loss due to profit maximization Welfare Efficient quantity Profit- maximizing Price "Perfect competition" ain't perfect!

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

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

Monopoly better than PC? With lower marginal costs, yes: Welfare gain due to monopoly Price Competitive price Competitive Marginal cost Monopoly price Another problem for theory: cost curves identical (as shown in textbooks) only under 3 very limited conditions! Monopoly Marginal cost Marginal revenue Demand Competitive quantity Monopoly quantity Quantity

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." (Rosput 1993: 288) Economies of scale favour concentrated markets

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.)

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 But it's all bollocks anyway...

From Fallacies to Reality In numerous surveys Andrews, Bishop, Downie, Eiteman, 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)

(1) Cost functions as seen by managers Eiteman & Guthrie 1952 showed managers 8 hypothetical average cost curves: “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) 3-5 neoclassical: “5… high at minimum output, … decline gradually to a least-cost point near capacity, after which they rise sharply.”

(1) Cost functions as seen by managers Curve Indicated Number of companies 1 2 3 4 5 14 6 113 7 203 8 Total 334 Only 18 out of 336 fit neoclassical vision of diminishing marginal productivity, rising marginal cost Almost 2/3rds have lowest unit costs at maximum output

(1) 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”?

(2) 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.” (Eiteman 1947)

(2) 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.”

(3) 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…

(3) 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:

(3) Sraffa’s critique of “supply curve” It’s either: Interdependent supply & demand curves: different demand curve for every point on supply curve… Wheat output Or... Price/ bushel “Agriculture” Supply Price ? Quantity? ? Dq1 Q1 Q2 Q3 Dq3 Dq2 Labour input with constant labour/land ratio Price & Cost Falling average cost Constant Marginal Cost Wheat

(3) 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)

(4) 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

(4) Kornai: “demand-constrained” economies Empirical data supports Kornai: even during boom years, US capacity utilisation well below 90%: Excess capacity the rule, not “scarcity”

(4) 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.)

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 papers on it!); why? Empirical literature ignored because incompatible with accepted theory

“Let’s assume the wrong thing…” This literature target of Friedman’s (in)famous 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?

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 week: “General equilibrium” can’t be in equilibrium

Stigler’s escape route… Most neoclassicals don’t know that dP/dq=dP/dQ Those who do take comfort with Stigler’s argument: “Run that by me again…”

Stigler’s escape route… Stigler’s convergence to perfect competition argument: Market elasticity of demand Cancel Q’s, move P’s where “this last term goes to zero as the number of sellers increases indefinitely” (Stigler 1957: 8)

But... Stigler’s “Way out”? Stigler’s formula correct: Marginal revenue for individual firm will converge to market price as number of firms rises But... If they are profit maximisers, market price will be the “monopoly” price (P>MC), not “competitive” price (P=MC):

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

mc(q) q P mcc Q n.q MC(Q=n.q) mcm

mc(q) q P mcc Q n.q MC(Q=n.q) mcm c mc(x) x

mc(q) q P Q n.q mcm c x