Keynes on Marginal Cost and Price

Keynes’ article “Relative Movements of Real Wages and Output” (The Economic Journal 49.193 [1939]: 34–51) was inspired by the criticisms of the General Theory of Employment, Interest, and Money (1936) by Dunlop (1938) and Tarshis (1939) on real and nominal wages. Keynes also considered the work of Kalecki in this article too.

In the General Theory, Keynes had still equated the real wage with the marginal product of labour (King 2002: 12), but his 1939 article is normally taken to be a repudiation of this, even if it was a somewhat guarded concession (Keynes 1939: 50–51).

But this article contains much more than just comments on wages and the marginal product of labour: Keynes also examines price theory and the theory of the firm.

Keynes notes that Kalecki had assumed many real firms face constant marginal real cost curves, and even that in situations where the economy has idle resources and considerable excess capacity marginal costs may be falling (Keynes 1939: 44). Furthermore, Keynes seems to have accepted that in the conditions of the 1930s marginal costs were falling or flat – and that this reinforced the case for expansionary fiscal policy (Keynes 1939: 45).

Nevertheless, Keynes maintained the following:

“Even if one concedes that the course of the short-period marginal cost curve is downwards in its early reaches, Mr. Kahn’s assumption that it eventually turns upwards is, on general common-sense grounds, surely beyond reasonable question; and that this happens, moreover, on a part of the curve which is highly relevant for practical purposes. Certainly it would require more convincing evidence than yet exists to persuade me to give up this presumption.” (Keynes 1939: 44–45).

Subsequent empirical work shows that Keynes was probably too conservative here. While in the long run, he may have been right that some firms may face rising marginal cost, for practical purposes very many firms do not, because of the way in which engineers design plants to have excess capacity. On this, we can point to the empirical evidence of Eiteman and Guthrie (1952) and Blinder (1998).

Eiteman and Guthrie (1952) was a survey in which 334 companies were shown a number of different cost curves, and asked to specify which one best represented the company’s cost curve. A stunning 95% of managers chose cost curves with constant or falling costs, which is contrary to marginalist theory (Keen 2011: 125).

Blinder (1998) conducted much the same type of survey, which involved 200 US firms in a sample that should be representative of the US economy at large. Blinder found that about 40% of firms reported falling variable or marginal cost, and 48.4% reported constant marginal/variable cost (Blinder 1998: 102).

To return to Keynes’ article, he goes on to discuss price and marginal cost.

Keynes notes that the whole concept of marginal cost as the main cause of price determination is grossly exaggerated:

“Indeed, it is rare for anyone but an economist to suppose that price is predominantly governed by marginal cost. Most business men are surprised by the suggestion that it is a close calculation of short-period marginal cost or of marginal revenue which should dominate their price policies. They maintain that such a policy would rapidly land in bankruptcy anyone who practised it. And if it is true that they are producing more often than not on a scale at which marginal cost is falling with an increase in output, they would clearly be right; for it would be only on rare occasions that they would be collecting anything whatever towards their overhead. It is, beyond doubt, the practical assumption of the producer that his price policy ought to be influenced by the fact that he is normally operating subject to decreasing average cost, even if in the short-period his marginal cost is rising. His effort is to maintain prices when output falls and, when output increases, he may raise them by less than the full amount required to offset higher costs including higher wages. He would admit that this, regarded by him as the reasonable, prudent and far-sighted policy, goes by the board when, at the height of the boom, he is overwhelmed by more orders than he can supply; but even so he is filled with foreboding as to the ultimate consequences of his being forced so far from the right and reasonable policy of fixing his prices by reference to his long-period overhead as well as his current costs. Rightly ordered competition consists, in his opinion, in a proper pressure to secure an adjustment of prices to changes in long-period average cost; and the suggestion that he is becoming a dangerous and anti-social monopolist whenever, by open or tacit agreement with his competitors, he endeavours to prevent prices from following short-period marginal cost, however much this may fall away from long-period average cost, strikes him as disastrous.” (Keynes 1939: 46–47).

Keynes’ views here were probably derived from his knowledge of the work of the Oxford Economists’ Research Group (OERG) on prices, the findings of Hall and Hitch (1939), and the work of Gardiner Means (discussed here and here).

Furthermore, on these points, subsequent empirical research on price determination supports Keynes on virtually all his points here.

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

Dunlop, John T. 1938. “The Movement of Real and Money Wage Rates,” The Economic Journal 48.191: 413–434.

Eiteman, Wilford J. and Glenn E. Guthrie. 1952. “The Shape of the Average Cost Curve,” American Economic Review 42.5: 832–838.

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

Keen, Steve. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn.). Zed Books, London and New York.

Keynes, J. M. 1939. “Relative Movements of Real Wages and Output,” The Economic Journal 49.193: 34–51.

King, J. E. 2002. A History of Post Keynesian Economics since 1936. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Tarshis, Lorie. 1939. “Changes in Real and Money Wages,” The Economic Journal 49.193: 150–154.