Saturday, April 12, 2014

The Marginalist Pricing Controversy Revisited

While neoclassical theory holds that firms generally set their prices by equating marginal revenue with marginal cost, the reality is quite different.

The accounting research literature has provided strong evidence that firms generally use total average unit costs (or full costs or normal costs) as the basis for mark-up price setting (Gordon, Cooper, Falk and Miller 1980; Scapens et al. 1983; Govindarajan and Anthony 1983; Cooper 1990; Emore and Ness 1991; Bright et al. 1992; Shim and Sudit 1994; Drury and Tayles 2000).

These results were already known in the 1930s and 1940s (Hall and Hitch 1939) and the “full cost” reality gave rise to the “marginalist controversy” in which neoclassical economists tried desperately to explain away the gap between their theory and reality (Lucas 2003: 203).

Defenders of neoclassical theory included Edwards (1952), Alchian (1950), Pearce (1956), and Simon (1959).

One solution was the doctrine of “implicit marginalism”: the idea that, while firms do not deliberately and consciously equate marginal revenue with marginal cost, in practice they nevertheless act as if they were doing so (Lucas 2003: 203). This was usually related to the methodological instrumentalism of Milton Friedman in his famous essay “The Methodology of Positive Economics” (Friedman 1953), in which Friedman argued that the best test of a theory is whether it predicts outcomes (Lucas 2003: 204), not tests of its assumptions.

Both “implicit marginalism” and Friedman’s instrumentalism have provided neoclassical economics with an absurd escape hatch to evade empirical reality.

Friedman, for example, claimed to use an empiricist (or positivist) method, but his belief that it is not necessary to test the fundamental assumptions of a theory and that only predictive powers of theories matter is utterly unconvincing.

In responding to charges that neoclassical theory was grossly unrealistic, Friedman dismissed such charges as follows:
… criticism of this type is largely beside the point unless supplemented by evidence that a hypothesis differing in one or another of these respects from the theory being criticized yields better predictions for as wide a range of phenomena. Yet most such criticism is not so supplemented; it is based almost entirely on supposedly directly perceived discrepancies between the ‘assumptions’ and the ‘real world.’ A particularly clear example is furnished by the recent criticisms of the maximization-of-returns hypothesis on the grounds that businessmen do not and indeed cannot behave as the theory ‘assumes’ they do. The evidence cited to support this assertion is generally taken either from the answers given by businessmen to questions about the factors affecting their decisions – a procedure for testing economic theories that is about on a par with testing theories of longevity by asking octogenarians how they account for their long life – or from descriptive studies of the decision-making activities of individual firms. Little if any evidence is ever cited on the conformity of businessmen’s actual market behavior – what they do rather than what they say they do – with the implications of the hypothesis being criticized, on the one hand, and of an alternative hypothesis, on the other.” (Friedman 1953: 31).
There you have it: a theory that claims to explain how a firm acts cannot be tested by asking business people how they act!

Now, while it is true that the evidence of econometrics cannot necessarily be used to settle debates in economics, the empirical evidence of direct surveys and case studies has a much greater value than econometric evidence in questions about the behaviour and decision making of firms.

The concocted analogy that Friedman gives to try and dismiss the value of empirical surveys here is a ridiculous one. While it may well be that asking old people how they personally account for their long life cannot test scientific theories of longevity, it does not follow that their evidence has no value in testing such theories: on the contrary, one can ask them how they lived and what lifestyles they had in terms of diet, exercise, smoking, drinking etc., which would be highly relevant to such theories.

And marginalist theories of price setting can be tested by asking business people whether their decision making and actions conform to the assumptions of the theory and the prior model of what constitutes rational or profit-maximising behaviour.

To return to Friedman’s statement above, he, not wishing to seem like a bizarre anti-empiricist extremist, quickly qualified his position in a footnote:
“I do not mean to imply that questionnaire studies of businessmen’s or others’ motives or beliefs about the forces affecting their behavior are useless for all purposes in economics. They may be extremely valuable in suggesting leads to follow in accounting for divergencies between predicted and observed results; that is, in constructing new hypotheses or revising old ones. Whatever their suggestive value in this respect, they seem to me almost entirely useless as a means of testing the validity of economic hypotheses.” (Friedman 1953: 31, n. 22).
But this qualification does very little to soften the extremism of Friedman’s position, which, if anything, reads more like the apriorist fantasies of Ludwig von Mises than any empiricist method, in its unwillingness to accept that empirical evidence can refute an economic theory.

Assumptions of economic theories (and indeed any theory) matter very much. One could, for example, concoct all sorts of theories with unrealistic and even absurd assumptions that manage to predict outcomes consistent with the observed data, but one must have a criterion for deciding which one is most likely the true and the best theory: here testing the fundamental assumptions of theories is necessary.

The empirical evidence of direct surveys and case studies on price setting shows that the marginalist theory of pricing in either (1) an explicit form or (2) the implicit form is mistaken and untenable (Lucas 2003: 207).

Alchian, A. A. 1950. “Uncertainty, Evolution and Economic Theory,” Journal of Political Economy 58: 211–221.

Bright, J., Davies, R. E., Downes, C. A., and R. C. Sweeting. 1992. “The Deployment of Costing Techniques and Practices: A UK Study,” Management Accounting Research 3: 201–211.

Cooper, R. 1990. “Explicating the logic of ABC,” Management Accounting: 58–60.

Drury, C. and M. Tayles. 2000. “Cost Systems and Profitability Analysis in UK Companies: Discussing Survey Findings,” Munich. Paper presented to Annual Congress of the European Accounting Association.

Edwards, R. S. 1952. “The Pricing of Manufactured Products,” Economica 19: 298–307.

Emore, J. R. and J. A. Ness. 1991. “The Slow Pace of Meaningful Change in Cost Systems,” Journal of Cost Management 4.4: 36–45.

Friedman, M. 1953. “The Methodology of Positive Economics,” in M. Friedman, Essays in Positive Economics. University of Chicago Press, Chicago.

Gordon, L., Cooper, R., Falk, H. and D. Miller. 1980. The Pricing Decision. National Association of Accountants Society of Management Accountants of Canada, Hamilton, New York.

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.

Lucas, M. R. 2003. “Pricing Decisions and the Neoclassical Theory of the Firm,” Management Accounting Research 14.3: 201–217.

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

Pearce, I. F. 1956. “A Study in Price Policy,” Economica n.s. 23.90: 114–127.

Scapens, R. W., Gameil, M. Y. and Cooper, D. J. 1983. “Accounting Information for Pricing Decisions,” in J. Arnold, R. W. Scapens, M. Y. Gameil, and D. J. Cooper (eds.), Management Accounting Research and Practice. CIMA, London. 283–306.

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

Simon, H. A. 1959. “Theories of Decision Making in Economies,” American Economic Review 49: 253–283.


  1. Apologies, Philip, I accidentally deleted your comment and my original reply

  2. At any rate, I'll repost my reply:

    Or the Sun causes business cycles?

    As in William Stanley Jevons' "Commercial crises and sun-spots," Nature 19 (1878), pp. 33–37?:

    "In a relatively minor work, "Commercial Crises and Sun-Spots", Jevons analyzed business cycles, proposing that crises in the economy might not be random events, but might be based on discernible prior causes. To clarify the concept, he presented a statistical study relating business cycles with sunspots."

    To be fair to Jevons, though wrong, perhaps it was not as crazy as it sounds at first:

    "To clarify the concept, he presented a statistical study relating business cycles with sunspots. His reasoning was that sunspots affected the weather, which, in turn, affected crops. Crop changes could then be expected to cause economic changes. Subsequent studies have found that sunny weather has a small but significant positive impact on stock returns, probably due to its impact on traders' moods"

  3. One question is what exactly Friedman does think constitutes empirical evidence in favour of/against the marginalist model of the firm. As it stands, he has referenced no evidence and made no falsifiable predictions. So he fails even on his own terms.

  4. Two quick questions.

    Does the theory of mark-up pricing assume zero or very low marginal costs?

    Also, does the theory of mark-up pricing have empirical predictions (aside from how firms actually go about setting prices) or practical applications that yield different results from neoclassical pricing theory.

    1. (1) mark-up pricing does not assume zero or very low marginal costs.

      It does observe that many firms report flat marginal/average variable costs.

      (2) It makes various predictions (on the basis of empirical evidence): e.g., the standard mark-up pricing firm would cut production and employment in recessions, not prices; mark-up prices are market clearing prices etc.

  5. Very interesting.

    In response to (1), in mark-pricing models to markets equilibriate where MR = MC or are in motion towards such equilibrium (since some market imperfection may prevent them from meeting)

  6. There's a quote I'm looking for which is along the lines of:
    "The rentier will tolerate many things, but he will not tolerate 2 percent!"

    Can you find that quote?

    The businessman and the rentier both *demand* a particular rate of return on capital and will not tolerate a lower rate. Firms set prices in order to make this return.

    Basic principle of economics. Veblen apparently recognized this behavior -- and didn't condemn it, because he explains how a firm which doesn't do this gets chewed up.

    Failure to incoporate "mark-up pricing" is one of the reasons microeconomics is rotten. (There are several others: failure to incorporate marketing and product differentiation, for example.)