Steve Keen, Debunking Economics, Chapter 5: Theory of the Firm

I review Chapter 5 of Steve Keen’s Debunking Economics (the rev. and expanded 2011 edn.) below, which is a discussion of the Post Keynesian theory of the firm.

Neoclassical theory assumes that in the short run as output rises productivity falls: that is, increasing levels of output will result in higher prices, and the marginal cost curve of a firm slopes upwards (Keen 2011: 103).

That is, a typical neoclassical firm will face diminishing marginal productivity and rising marginal cost, so that the “profit maximising” firm will stop producing when marginal cost of production equals the marginal revenue from sales (Keen 2011: 107–108).

Therefore the level of output is determined by the point where marginal revenue equals marginal cost (Keen 2011: 108), and the average firm cost curve is U-shaped.

The trouble with this theory is that, for most firms, it is untrue and the empirical evidence blatantly contradicts it:

“Economic theory also doesn’t apply in the ‘real world’ because engineers purposely design factories to avoid the problems that economists believe force production costs to rise. Factories are built with significant excess capacity, and are also designed to work at high efficiency right from low to full capacity. Only products that can’t be produced in factories (such as oil) are likely to have costs of production that behave the way economists expect.

The outcome is that costs of production are normally either constant or falling for the vast majority of manufactured goods, so that average and even marginal cost curves are normally either flat or downward sloping.” (Keen 2011: 104).

As Keen notes, Piero Sraffa’s article “The Laws of Returns under Competitive Conditions” (Economic Journal 36.144 [1926]: 535–550) argued long ago that this “law of diminishing marginal returns” does not, generally speaking, apply to modern industrial economies (Keen 2011: 108). Instead, the general tendency would be constant marginal costs and horizontal cost curves.

Secondly, firms do not make full use of their resources and operate with unused excess capacity. This can be seen in the graph below of total US capacity utilisation since 1967 as a percentage of resources used by corporations and factories in their production of goods in manufacturing, mining, and electric and gas utilities.

Even during the strong boom in the late 1960s US capacity utilisation was below 90%, and in the boom of the late 1980s only climbed to about 85%.

Spare capacity is the normal state of affairs, and indeed often essential for firm survival in a market economy, because the best way to deal with an uncertain future with sudden, unexpected changes in demand is to vary capacity utilisation (with use of inventories) (Keen 2011: 125).

One can even note how with the abandonment of Keynesian full employment policies of the 1945 to mid-1970s era (the so-called golden age of capitalism) there has been a persistent falling trend in average capacity utilization. Modern market economies since the late 1970s have had a plague of unused or underused resources from unemployed labour to underutilised factories.

Keen notes the paradox pointed out by Janos Kornai: that the old communist economies had persistent problems of scarce resources that limited production, whereas capitalist economies normally have relative abundance and a significant volume of unused resources, so that production is limited mainly by demand for output (Keen 2011: 115).

Finally, Keen points 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).

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

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

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

Sraffa, P. 1926. “The Laws of Returns under Competitive Conditions,” Economic Journal 36.144: 535–550.

Steve Keen, Debunking Economics, Chapter 6: Wages

I review Chapter 6 of Steve Keen’s Debunking Economics below, which is a discussion of wages and labour markets.

Neoclassical economics analyses labour as a commodity, like any other, governed by the law of supply and demand (Keen 2011: 129).

Two crucial requirements of standard neoclassical analysis of labour markets are that (1) labour demand curves are necessarily downward-sloping and supply curves upwards-sloping, and (2) each worker tends to be paid the marginal product of labour (Keen 2011: 130–131).

Yet labour is fundamentally different from other commodities: whereas demand for some commodity like bread is determined by consumers and supply decisions by producers, the supply of labour is offered by consumers, and demand decisions are made by producers (Keen 2011: 129).

Steve Keen sees a number of problems with the neoclassical analysis:

(1) the labour supply curve can “slope backwards”: e.g., a fall in the wage rate can induce an increase in the supply of labour;

(2) the market power of some employers can result in unfair wages even in neoclassical theory, so that worker trade unions or collective bargaining can make wages fairer;

(3) standard supply and demand analysis can be inappropriate when applied to labour markets in light of Piero Sraffa’s aggregation problem;

(4) the fundamental explanation of labour supply as workers choosing between leisure and work is flawed;

(5) that market demand curves, including labour demand curves, necessarily obey the law of demand is unrealistic.

In regard to (1), Keen notes how a higher wage rate can result in the same income level for a worker if he or she works fewer hours: therefore less labour might be supplied as the wage rises (Keen 2011: 133–134).

Attempts to overcome this problem with the substitution effect are not convincing:

“… it makes no sense to separate the impact of an increase in the wage rate into its substitution effect and income effect: the fact that the substitution effect will always result in an increase in hours worked is irrelevant, since everyone will always have twenty-four hours to allocate between work and leisure.

Since an increase in wages will make workers better off, individual workers are just as likely to work fewer hours as more when the wage rate increases. Individual labor supply curves are just as likely then to slope backwards – showing falling supply as wages rise – as they are to slope forwards.

At the aggregate level, a labor supply curve derived by summing many such individual supply curves could have any shape at all. There could be multiple intersections of the supply curve with the demand curve (accepting, for the moment, that a downward-sloping demand curve is valid). There may be more than one equilibrium wage rate, and who is to say which one is valid? There is therefore no basis on which the aggregate amount of labor that workers wish to supply can be unambiguously related to the wage offered. Economic theory thus fails to prove that employment is determined by supply and demand, and reinforces the real-world observation that involuntary unemployment can exist: that the employment offered by firms can be less than the labor offered by workers, and that reducing the wage won’t necessarily reduce the gap.

This imperfection in the theory – the possibility of backward-bending labor supply curves – is sometimes pointed out to students of economics, but then glossed over with the assumption that, in general, labor supply curves will be upward sloping. But there is no theoretical – or empirical – justification for this assumption” (Keen 2011: 134).

The problem Keen identifies here is that labour supply curves need not be well behaved.

This is just as easy to see in reductions in wages. A strong general characteristic of most households is that they wish to maintain their standard of living, as they face fixed contractual obligations like debt, and hence the need to maintain income levels (Lavoie 1992: 222).

Therefore labour supply often depends on a perceived target wage rate and past standards of living (Lavoie 1992: 222–223), not necessarily on actual movements of the wage rate. If wages fall, this may well increase labour supply as a breadwinner or other members of the household decide to look for more work to maintain household income.

To turn to point (2) above, the real world is far from the perfect or near competition models of neoclassical theory.

Even if one wants to assume that workers should be paid their marginal product, firms with market power will pay wages below this value, so that a trade union acting as a single seller of labour will drive wages higher, so that wages will be fairer (the so-called monopsony argument).

In regard to point (4), neoclassical theory holds work and leisure to be two “goods,” between which workers freely choose as the wage rate changes. In a truly laissez faire society with no welfare or social security, this idea is of course nothing more than a sick joke: either you work for whatever wages so can obtain or starve.

Even in modern welfare states, the idea is still dubious: for most forms of leisure require money and income, and in most full-time work hours worked are strictly set by employers and not often negotiable.

Keen also notes how in recessions or depressions where there is a very high level of (normally) fixed private nominal debt, cutting wages and prices (and hence profits, which are the income of businesses) to increase demand for labour will induce debt deflationary pressures, a self-defeating exercise (Keen 2011: 138).

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

Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Edward Elgar Publishing, Aldershot, UK.

Steve Keen on Debunking Economics

I post here a video talk by Steve Keen, held as an open session of the IIEA Economists Group, 16 November 2011. I think this talk was held in Ireland (but I could be wrong).

Steve Keen Launches the Second Edition of Debunking Economics

This event happened at University College (London), with talks by Ann Pettifor and Steve Keen himself. The video has somewhat poor audio quality (turn the volume up!). Debunking Economics (even in the first edition) is an excellent book, with a very useful Post Keynesian critique of the new consensus macroeconomics.