Tuesday, December 3, 2013

Mises on Marginal Cost: A Critique

Mises discusses marginal cost and prices here:
“The planning entrepreneur is always faced with the question: To what extent will the anticipated prices of the products exceed the anticipated costs? If the entrepreneur is still free with regard to the project in question, because he has not yet made any inconvertible investments for its realization, it is average costs that count for him. But if he has already a vested interest in the line of business concerned, he sees things from the angle of additional costs to be expended. He who already owns a not fully utilized production aggregate does not take into account average cost of production but marginal cost. Without regard to the amount already expended for inconvertible investments he is merely interested in the question whether or not the proceeds from the sale of an additional quantity of products will exceed the additional cost incurred by their production. Even if the whole amount invested in the inconvertible production facilities must be wiped off as a loss, he goes on producing provided he expects a reasonable surplus of proceeds over current costs.” (Mises 2008: 340).
According to Mises, an established firm – and let us be generous here and assume that Mises is thinking of your average firm or of firms in general – that has already paid out sunk costs and continues to incur overhead (or fixed) costs is unconcerned with recovering these overhead/fixed costs. Instead, the firms are concerned with marginal cost, not average total costs.

And what, you might ask, is the evidence for this? Mises provides none (apart from the implied belief that he can know it a priori by praxeology), and the empirical evidence from the real world could not be clearer: Mises is wrong, and badly wrong.

Evidence from numerous surveys shows that mark-up prices are the largest form of pricing in real world capitalist economies, and often not just the largest form of pricing but the majority of prices (anywhere from 50% to 70% of prices).

Mark-up pricing businesses use total average unit costs to calculate prices, not marginal cost. In fact, “marginal cost” is a concept some business people have difficulty even understanding (Blinder et al. 1998: 216–218, 102: “marginal cost” is “not a natural mental construct for most executives”; Fabiani et al. 2006: 16; Ólafsson et al. 2011: 12, n. 8).

Most businesses do not use marginal cost in calculating prices, but instead use full costs (that is, total average costs) (Hall and Hitch 1939: 18; Govindarajan and Anthony 1986: 31; Drury et al. 1993; Shim and Sudit 1995: 37; Maher et al. 2004: 225).

For example, Govindarajan and Anthony (1986: 31) and Shim and Sudit (1995: 37) found that from the 1980s to the 1990s full cost pricing accounted for roughly 70% to 85% of US industrial prices.

Furthermore, Blinder et al. (1998: 105, 302) also found that many firms have fixed costs that can be very high relative to variable costs, and as much as 40% of total costs on average.

If most firms were to actually behave in the way Mises imagines – producing in a way where price will be above marginal cost but ignoring average cost – then they would simply go bankrupt.

And, while neoclassical economists have tried (albeit lamely) to explain the widespread existence of mark-up pricing, and do at least acknowledge the empirical evidence contrary to their original theory (indeed the debate goes back to the 1940s and 1950s, as in, e.g., Robinson 1950; Machlup 1946; and Heflebower 1955), by contrast Austrian economists like Mises never even progressed that far.*

* This is surely true, unless one wants to regard Fritz Machlup as an Austrian in the late 1940s, but there seems widespread agreement that, like Schumpeter, he had essentially converted to neoclassical theory by then (Vaughn 1994: 36):
“The entire fourth generation of Austrian economists—brilliant young men like Hayek, Machlup, Haberler, Morgenstern, and Rosenstein-Rodan—were thus shaped by the Wieserian mold before they set off on their own intellectual paths. Largely ignorant of Menger’s Principles (out of print since the 1880s), they were trained in the spirit of the neoclassical synthesis. As a result of these circumstances, there was strictly speaking no fourth generation of ‘Austrian’ economists in the Mengerian sense. All the young men who are commonly held to be fourth-generation members were in fact lost to the neoclassical school—with the possible exception of Hayek, who decades later rediscovered some Mengerian themes in his work on the Counterrevolution of Science (1954)” (Hülsmann 2007: 160–161).

Al-Najjar, Nabil, Baliga, Sandeep and David Besanko. 2008. “Market Forces meet Behavioral Biases: Cost Misallocation and Irrational Pricing,” The RAND Journal of Economics 39.1: 214–237.

Balakrishnan, R. and K. Sivaramakrishnan. 2002. “A Critical Overview of the use of Full-Cost Data for Planning and Pricing,” Journal of Management Accounting Research 14: 3–31.

Blinder, A. S. et al. (eds.). 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York.

Drury, C., Braund, S., Osborne. P. and M. Tayles. 1993. “A Survey of Management Accounting Practices in UK Manufacturing Companies,” ACCA, London.

Fabiani, S., M. Druant, I. Hernando, C. Kwapil, B. Landau, C. Loupias, F. Martins, T. Mathä, R. Sabbatini, H. Stahl and A. Stokman. 2006. “What Firms’ Surveys tell us about Price-Setting Behavior in the Euro Area,” International Journal of Central Banking 2.3: 3–47.

Govindarajan, V. and R. Anthony. 1986. “How Firms use Cost Data in Price Decisions,” Management Accounting 65: 30–34.

Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.

Heflebower, R. F. 1955. “Full Costs, Cost Changes, and Prices,” in Business Concentration and Price Policy. Princeton University Press, Princeton. 361–392.

Horngren, C, Foster, G., and S. Datar. 2000. Cost Accounting (9th edn.). Prentice Hall, Upper Saddle River, NJ.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism. Ludwig von Mises Institute, Auburn, Ala.

Machlup, F. 1946. “Marginal Analysis and Empirical Research,” American Economic Review 36: 519–554.

Maher, M., Stickney, C, and R. L. Weil. 2006. Managerial Accounting (10th edn.). South-Western, Mason, OH.

Mises, L. von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Murphy, Robert P. and Amadeus Gabriel. 2008. Study Guide to Human Action. A Treatise on Economics: Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Ólafsson, Thorvardur Tjörvi, Pétursdóttir, Ásgerdur, and Karen Á. Vignisdóttir. 2011. “Price Setting in Turbulent Times: Survey Evidence from Icelandic Firms,” Working Paper Central Bank of Iceland

Robinson, A. 1950. “The Pricing of Manufactured Products,” Economic Journal 60: 771–780.

Shim, Eunsup, and Ephraim Sudit. 1995. “How Manufacturers Price Products,” Management Accounting 76.8: 37–39.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition. Cambridge University Press, Cambridge and New York.


  1. A little off topic, but here goes

    There is something that has always bothered me about the endogenous money folks. If we accept, for the sake of argument, that a recession is a minskyite flight to credit-risk free assets, (like cash and government bonds) and we have a mainly endogenous monetary system, then why doesn't the banking system create MORE money when there is a shortage? In other words, why isn't endogenous money creation counter cyclical instead of pro-cyclical? Thats why I am so skeptical when i see post Keynesians stoutly assert that we 'have and ENDOGENOUS monetary system!" Keynes wrote about it in the GT, Im not sure where, saying that if money were an asset completely created by the private sector, recessions would be eliminated, because producers enter a market where there is high demand for an asset and produce that asset eventually in abundant quantities

    1. Imagine you own a small bank and there is an economic downturn. Would you give more loans to the customers, even if it is very likely you are going to write-off those loans due to bankruptcies? Would the customers take those loans knowing that their circumstances are bad and they might go broke because of the loan?
      Essentially, if all debtors and creditors coordinated to create more credit and investment during recessions, they'd have mitigated economic downturns alright. But discoordination is fundamental and unavoidable.

    2. ...we have a mainly endogenous monetary system, then why doesn't the banking system create MORE money when there is a shortage?

      Because credit money creation (bank money, the largest type of money) requires demand from private sector agents for loans to be created: in a recession that demand falls, is stagnant, or insufficient to drive an economy back to full employment.

      And Keynes in the GT assumed exogenous money. In the Treatise on Money he did understand endogenous money.