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

2. 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

3. 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

4. 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…

5. 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

6. “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?

7. “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…

8. “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:

9. 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

10. 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?

11. 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…

12. 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?

13. 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

14. 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:

15. 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…

16. 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

17. 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”

18. 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:

19. 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:

20. 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

21. 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):

22. 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:

23. 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:

24. 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:

25. 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…

26. 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…

27. My number is bigger than your number…
Huge gap between true profit maximization level & mc=mr level:
(Example with a=100, b=1/ , c=20, d=1/100000, k=10000)

28. 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

29. 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!

30. 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

31. 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

32. 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

33. 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

34. 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.)

35. 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...

36. 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)

37. (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.”

38. (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

39. (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”?

40. (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)

41. (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.”

42. (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…

43. (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:

44. (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

45. (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)

46. (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

47. (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”

48. (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.)

49. 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

50. “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?

51. 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

52. 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…”

53. 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)

54. 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):

55. 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

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

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

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