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.

Marginal Cost and Public Goods

In neoclassical theory, firms are supposed to maximise profit by seeking a level of output where they equate marginal revenue with marginal cost. For most real world firms, however, this is an absurd policy that would result in insolvency and bankruptcy, because most firms need to recoup both variable costs and overhead/fixed costs before they can be profitable.

Neoclassical economics can cause havoc when applied to the pricing policies of certain types of public utilities or public goods, as Steve Keen argues:

“The flaws in economic reasoning … have a very direct impact on public policy in the area of the pricing of public services. Because economists believe that competitive industries set price equal to marginal cost, economists normally pressure public utilities to price their services at ‘marginal cost.’ Since the marginal costs of production are normally constant and well below the average costs, this policy will normally result in public utilities making a loss. This is likely to mean that public utilities are not able to finance the investment they need in order to maintain the quality of services over time. This dilemma in turn interacts with the pressure that economists also apply to privatize public assets, and to let individuals ‘opt out’ of the public provision of essential services. The end result, as Galbraith so eloquently put it, is ‘private affluence and public squalor.’

Ironically, economic theory also makes economists essentially ‘anti-capitalist,’ in that they deride real businesses for pricing by a markup on cost, when theory tells them that prices should be set at the much lower level of marginal cost. Industrialists who have to cope with these attitudes in their dealings with government-employed economists are often among the greatest closet anti-economists of all. Maybe it’s time for them to come out of the closet.” (Keen 2011: 123, 124).

Excepting those public goods that are, and should be, free at the point of delivery, other public goods for which a price will be charged will make losses if they equate price with marginal cost, so that the government will have to subsidise them.

Even if they charge a mark-up over marginal cost, that may not be enough to turn a profit, since the relevant cost of production for most businesses is total average unit costs, not marginal cost.

There is a strange paradox at work if a public utility is forced to charge prices at marginal cost: the public will get a much cheaper good, but the government will need to subsidise it and provide the money needed for investment and growth, and the losses will be used by critics of public goods as an argument that they should be privatised, even though the problem stems from the rotten economic theory that such critics themselves hold.

That is to say, if public goods are priced at marginal cost, then losses are most probably inevitable and there is no “failure” involved when governments must subsidise these public utilities.

Keen’s last point is also a crucial one (and was made by Galbraith in the The New Industrial State): businesses are sometimes accused of having unfair prices or “price fixing,” but that charge often makes no sense once we see that the marginalist pricing theory on which it is based is mostly rubbish and irrelevant to real world businesses.

BIBLIOGRAPHY
Galbraith, J. K. 1985. The New Industrial State (4th edn.). Houghton Mifflin, Boston.

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

Lee on the Three Types of Mark-up Prices

A price that is set by a firm on the basis of average unit costs of production plus a profit mark-up is an “administered price.” These prices are also sometimes called “mark-up prices,” “average cost prices,” “full cost prices,” “normal cost prices,” or “cost-plus prices.”

However, these are all essentially the same type of price, but differences exist mainly in mere accounting conventions used to calculate them.

Lee clarifies these differences and identifies three fundamental types of such prices, as follows:

(1) standard mark-up pricing
This takes average direct/variable costs at actual or estimated output, and then adds to this a mark-up which covers both (1) average “shop expenses” and average “enterprise expenses” (overhead/fixed costs) and (2) an allowance for profit;

(2) normal cost pricing
This begins by calculating average direct/variable costs at a target or expected output level, and adds to this average “shop expenses” and average “enterprise expenses” (overhead/fixed costs). Finally, a mark-up for profit is added to this;

(3) target rate of return pricing
This is calculated by taking normal average total costs (including overhead/fixed costs) and marking this up by a certain percentage to achieve a specific rate of return or profit at projected sales in relation to the firm’s capital assets. (Lee 1998: 204–205).

Now, as has been noted, both “shop expenses” and “enterprise expenses” constitute overhead costs (Lee 1998: 201–202), so that for most businesses it is ultimately total average unit costs – including both (1) direct/variable costs and (2) overhead/fixed costs – that matter and are the basis of the mark-up price. Fundamentally, all involve a mark-up for profit over total average costs, and types (2) and (3) are the most prevalent (Lee 1998: 206).

Why does this matter? First, if you are doing a price setting survey and ask businesses if they set prices based on direct/variable costs, then many will no doubt answer “yes.” However, standard mark-up pricing firms, as in (1) above, are adding a mark-up to this that includes overhead/fixed costs and an allowance for profit. Therefore it is highly misleading and wrong to conclude that firms are generally only using direct/variable costs as their cost base.

For instance, in a recent study of price setting behaviour in the Eurozone, Gaspar et al. (2007: 238) report that about half of Eurozone firms set their prices as a mark-up over average variable costs, but they fail to understand that the mark-ups of many, and probably most, of these firms will include average overhead/fixed costs as well, so that it is total average unit costs that should be the fundamental cost base of interest to economists.

Secondly, while some administered prices can be based only on direct/variable costs, this practice appears to be far less important than the use of total average unit costs. For example, Govindarajan and Anthony (1986: 31) found that 85% of the US companies they surveyed used full cost pricing, and Shim and Sudit (1995: 37) conducted a survey in 1993 of US industrial companies, and found that 69.5% were using full cost pricing.

So, in contrast to conventional marginalist theory, most businesses certainly do take account of fixed/overhead costs. “Sunk costs” can be important in determining the administered price.

As I noted in the last post, the failure to understand these facts causes deep confusion, and the wrong idea that firms generally use average variable/direct unit costs only, and that they are therefore doing this as a good general proxy for marginal cost.

That is why dynamic stochastic general equilibrium (DSGE) models that assume prices are set as a markup over marginal costs are also mistaken, and almost wholly irrelevant models for real world pricing.

And, finally, it appears to be “now well established in the industrial economics literature that the average variable cost data … may be a poor proxy for the theoretical concept of marginal cost,” and it is not irrational for firms to use overhead/fixed costs in calculating price.

All in all, the marginalist theory of prices has severe problems: it simply does not reflect reality.

Addendum
As noted in the comment below, Godley and Lavoie (2007: 263–276) have a good discussion of mark-up pricing, and they note that overhead/fixed costs are the important average unit cost basis (Godley and Lavoie 2007: 266–267, 272). They also argue that costing margins are generally set to include any increase in interest rate costs (Godley and Lavoie 2007: 265).

Godley, Wynne and Marc Lavoie. 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. Palgrave Macmillan, New York, N.Y.

BIBLIOGRAPHY
Fabiani, Silvia, Suzanne Loupias, Claire, Monteiro Martins, Fernando Manuel and Roberto Sabbatini. 2007. Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York.

Gaspar, Vítor, Levin, Andrew, Martins, Fernando and Frank Smets. 2007. “Policy Lessons and Directions for Ongoing Research,” in S. Fabiani, C. Suzanne Loupias, F. M. Monteiro Martins and Roberto Sabbatini (eds.), Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York. 235–249.

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

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Pittman, Russell. 2009. “Who Are You Calling Irrational? Marginal Costs, Variable Costs, and the Pricing Practices of Firms,” Economic Analysis Group Discussion Paper 09-3
http://www.justice.gov/atr/public/eag/248394.htm

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

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.*

Note
* 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).

BIBLIOGRAPHY
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
www.sedlabanki.is/lisalib/getfile.aspx?itemid=8891‎

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.

Price, Average Total Cost, Average Variable Cost and Marginal Cost

The graph below illustrates the cost curves of a typical real world firm as understood in the Post Keynesian theory of the firm. Such a firm is also a mark-up pricing firm.

We have the firm’s marginal costs (MC), average variable costs (AVC), total average unit costs (UC), point of full capacity (FC), and point of theoretical full capacity (FC_th).

It is assumed that average variable cost is a reasonable proxy for marginal cost (an assumption widely held, as in, for example, the Areeda-Turner predation rule [Areeda and Turner 1975]).

It is furthermore assumed that marginal cost is constant (which is supported by the finding of Blinder et al. 1998: 103 that 88% of businesses reported that marginal costs are constant or declining).

Between full capacity (FC) and theoretical full capacity (FC_th), marginal costs and average variable costs will increase, because of overtime payments, cost of increased maintenance of machines, and possible increased costs of replacement for machines whose operation life will be decreased (Lavoie 1992: 120, 125–126).

However, firms generally do not produce beyond the point of full capacity, so that the rising cost curves to the right of the point FC are mostly irrelevant to real would firms (Lavoie 1992: 121).

Empirical studies have confirmed that the U-shaped cost curves of neoclassical analysis are irrelevant for many real world firms, because firms prefer to avoid production beyond the point FC. Therefore realistic total average long-run cost curves for such firms are L-shaped and average variable (or direct or prime) cost curves are constant (Lavoie 1992: 122, citing Johnston 1960; Walters 1963; Lee 1986). Marginal cost is also found to be generally constant up to full capacity (Lavoie 1992: 122).

Reserves of capacity are the norm in many firms and the actual rate of capacity utilisation will be below FC and normally within the 80–90% range (Lavoie 1992: 122). The reason for this is that firms have excess capacity available to deal with unexpected increases in demand, and full capacity itself might be increased in line with demand (Lavoie 1992: 124, citing Kaldor 1986). Thus excess capacity is a way for firms to reduce the uncertainty related to demand fluctuations, and in this sense firm demand for excess capacity is analogous to the precautionary demand for money and other highly liquid financial assets (Lavoie 1992: 124–125).

The effective use of excess capacity can also deter other firms from entering a market, and can therefore function as a barrier to entry (Lavoie 1992: 124).

Neoclassical price theory holds that firms equalise marginal revenue and marginal cost: price tends towards marginal cost.

One of the neoclassical responses to heterodox mark-up pricing is to argue that it is compatible with standard marginalist theory. A standard view is that, in imperfectly competitive markets, firms will set a price that is a markup over marginal cost (Fabiani et al. 2006: 16).

Yet mark-up businesses normally use total average unit costs to calculate prices, not marginal cost or average variable costs. In fact, marginal cost is a concept some business people have difficulty even understanding (Blinder et al. 1998: 216–218, 102; Fabiani et al. 2006: 16; Ólafsson et al. 2011: 12, n. 8), and most do not use it in calculating prices (Hall and Hitch 1939: 18; Govindarajan and Anthony 1986: 31; Shim and Sudit 1995: 37). These findings simply refute the idea that firms in general are using marginal cost (or only average variable costs) in calculating prices.

Another attempted neoclassical explanation is that, if marginal cost and total average unit costs roughly coincide, then a profit maximizing firm will use total average unit costs as a proxy for marginal cost. But, as we have seen, it is generally thought that average variable costs are the best proxy for marginal cost, not total average unit costs. In addition, many firms report that total fixed costs (an important part of total average costs) can be very high: as much as 40 percent of total costs on average (Blinder et al. 1998: 105, 302; and cited by Keen 2011: 126).

And if firms really are so concerned with the concept of marginal cost, then why do they show such a lack of interest in it or even confusion in understanding it? This is simply inconsistent with the second purported explanation.

Furthermore, if we turn back to the graph above, while total average unit costs fall towards average variable costs, the total average unit costs will not equal average variable costs (which is taken as a proxy for marginal cost).

And of course the actual price of a mark-up pricing firm will be some point above total average unit costs. If the firm reduces its price as total average unit costs fall, then the price will appear as a curve-like line above the total average unit costs curve. If, however, the firm maintains a fixed price above total average unit costs, then the price will be a vertical line above total average unit costs and profits will increase as total average unit costs fall.

Either way, it follows that mark-up prices will permanently tend to be set above marginal cost. When the price remains fixed, even with falling total average unit costs, price will not converge to marginal cost, but will be stable and well above it. When industries decide to reduce price given falling total average unit costs and competition, even here price will still be set in the long run above marginal cost.


Glossary
I repeat some definitions of key concepts below.

Average cost
This is total production costs per unit of output produced by a business. This equals (1) total fixed (overhead) costs plus (2) total variable costs divided by the number of units of output produced. Given that many businesses can use economies of scale and increase their output over time, average costs may fall too, because average fixed (overhead) costs fall, since they are divided by more units of output.

Fixed costs or overhead costs
Fixed costs (or overhead costs) are short-run costs that do not vary with the changing volumes of output produced, including rents, depreciation of fixed assets, marketing, etc. Average fixed costs will fall as output increases. Also called indirect costs.

Variable costs
Costs that vary with the rate of output, usually labour and raw materials costs. These are sometimes called operating costs, prime costs, on costs, or direct costs.

Marginal cost
The cost accruing from an additional unit of output.


BIBLIOGRAPHY
Areeda, Phillip and Donald F. Turner. 1975. “Predatory Pricing and Related Practices under Section 2 of the Sherman Act,” Harvard Law Review 88.4: 697–733.

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

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.

Johnston, J. 1960. Statistical Cost Analysis. McGraw-Hill, New York.

Kaldor, N. 1986. “Limits on Growth,” Oxford Economic Papers 38.2: 187–198.

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.

Lee, F. S. 1986. “A Post-Keynesian View of Average Direct Costs: A Critical Evaluation of the Theory and the Empirical Evidence,” Journal of Post Keynesian Economics 8.3: 400–424.

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
www.sedlabanki.is/lisalib/getfile.aspx?itemid=8891‎

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

Shipley, D. D. 1981. “Pricing Objectives in British Manufacturing Industry,” Journal of Industrial Economics 29.4: 429–443.

Walters, A. A. 1963. “Production and Costs: An Econometric Survey,” Econometrica 31.1–2: 1–66.

Hall and Hitch on Marginal Cost and Price

What R. L. Hall and C. J. Hitch discovered in the 1930s is still of interest:

“The basis of current doctrine on the price and output policy of the entrepreneur is that he expands production to the point where marginal revenue and marginal cost are equal. In the special case of perfect (or ‘pure’) competition in the market for the product, marginal revenue is equal to price, to which marginal cost is equated. In the special case of pure competition in the market for the factors, marginal cost is equal to the cost of the additional factors necessary to expand output by one unit, and this is equated to marginal revenue. In all other cases (except where discriminating prices may be charged), marginal revenue is less than price, and marginal cost is greater than the cost of additional factors, and the only rule of equilibrium within the firm is that marginal revenue and marginal cost are equated.” (Hall and Hitch 1939: 13).

“For the above analysis to be applicable it is necessary that entrepreneurs should in fact: (a) make some estimate (even if implicitly) of the elasticity and position of their demand curves, and (b) attempt to equate estimated marginal revenue and estimated marginal cost. We tried, with very little success, to get from the entrepreneurs whom we saw, information about elasticity of demand and about the relation between price and marginal cost. Most of our informants were vague about anything so precise as elasticity, and since most of them produce a wide variety of products we did not know how much to rely on illustrative figures of cost. In addition, many, perhaps most, apparently make no effort, even implicitly, to estimate elasticities of demand or marginal (as opposed to average prime) cost; and of those who do, the majority considered the information of little or no relevance to the pricing process save perhaps in very exceptional conditions.” (Hall and Hitch 1939: 18).

The problem continues in the most recent empirical studies, where the concept of “marginal cost” has to be re-expressed because “most businesspeople might not easily understand this terminology”! (Fabiani et al. 2006: 16).

Also of interest is what Keynes said in 1939, apparently from his own knowledge of the Oxford Economists’ Research Group’s (OERG) findings (which Hall and Hitch were themselves dependent on):

“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.” (Keynes 1939: 46).

BIBLIOGRAPHY
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.

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

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