Saturday, October 26, 2013

Lee’s Post Keynesian Price Theory: Chapter 11

Chapter 11 of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) begins Lee’s summing up and overview of the doctrine of administered prices in Post Keynesian economics. Lee draws on over 100 empirical studies to draw together the elements of this theory (Lee 1998: 201).

First, a misunderstanding should be dispelled. Post Keynesian price theory does not deny the existence of flexprice markets (Lee 1998: 203, n. 7). In any given capitalist economy, commodity markets (defined as those for goods and services) and asset markets are divided into (1) flexprice and (2) fixprice markets. Administered prices constitute the major form of the latter.

Flexprice markets are prevalent in primary commodities and asset markets, while newly produced goods and services tend to be fixprices. A “flexprice” market – as the name suggests – indicates that prices are generally flexible and are determined by the dynamics of supply and demand, either in (1) competitive auction-like markets or (2) markets where a buyer and seller haggle and negotiate an individual price for an individual exchange (as in the oriental bazaar). Of course, destructive price wars can also lead to flexible prices that deviate from costs of production (Lee 1998: 203, n. 7), but it is notable how frequently businesses shun such price wars.

Administered prices generally seem to represent the majority of prices in most advanced market economies. Empirical studies conducted since the publication of Lee’s book confirm this.

For example, in the Eurozone, the percentage of administered prices in a given nation ranges from about 50% to 65%. The average for the Eurozone as a whole is 54% (Fabiani et al. 2006: 18, Table 4). Once other fixprices caused by government regulation are added to this, the percentage for fixprices generally appears to rise to about 60% to 70% of prices – which is the overwhelming majority (I conservatively assume about 10% of the third category of prices called “other” in Fabiani et al. [2006: 18, Table 4] represent prices fixed by government regulation, but the Eurozone average is actually 18%, so that 68% to 83% might actually be a more realistic estimate).

Enterprises that adopt administered prices employ a cost accounting system that calculates direct factor input costs (the direct costs) plus overhead costs (Lee 1998: 201–202).

The cost of a product is then calculated at standard, estimated or budgeted output or capacity utilisation (Lee 1998: 202–203). The mark-up is then added to the cost to create a price.

Lee distinguishes three types of administered prices which differ owing to the type of cost accounting systems that underlie the calculation of average costs:
(1) standard mark-up pricing;

(2) normal cost pricing, and

(3) target rate of return pricing. (Lee 1998: 204–205).
However, all involve a mark-up for profit over average costs, and types (2) and (3) are the most prevalent (Lee 1998: 206).

Administered pricing is not restricted to monopolies, oligopolies, or cartels: it also occurs in competitive markets. But even here businesses tend to establish a similar administered price, and shun price wars, as Lee points out:
“Consequently, co-ordination is required among the enterprises if destructive price competition is to be avoided and an acceptable, single market price established. Business enterprises have therefore utilized a range of private market institutions, such as cartels and price leadership arrangements, buttressed by an array of ancillary conventions, traditions, and restrictive trade agreements to establish an orderly market with a single market price. When the private market institutions have failed to control price competition, enterprises have turned to quasi-government or purely government organizations, legal decrees, and laws in order to establish an orderly market with a single market price.” (Lee 1998: 207).
Within private administered price markets with competition, often the most powerful business acts as a “price leader” by setting a price that competitors follow: when average costs differ, other businesses adjust their profit mark-up to set roughly the same price (Lee 1998: 207–208).

When governments offer goods and services for sale, they too often adopt the very same administered price procedures to set the price of their products (Lee 1998: 207). In this respect, there is nothing “unnatural” about such government price “fixing”: governments simply follow the same practice as the private sector.

For the private sector, administered pricing provides security and stability of profits, to allow businesses to survive over time and grow (Lee 1998: 208–209).

A consequence of administered pricing is that many such prices generally remain stable and fixed from periods varying from three months to a year (Lee 1998: 209). Administered prices consequently do not normally change when demand changes, which violates a fundamental tenet of neoclassical price theory. Moreover, administered prices are not market clearing prices and are not even intended to be.

A fixed and predictable price allows businesses to build “goodwill” relationships with their customers, a practice which is very important to businesses (Lee 1998: 212).

Most astonishing of all is that empirical studies show that many products do not have well behaved demand curves:
“Where reported … business enterprises stated that variations in their prices within practical limits, given the prices of their competitors, produced virtually no change in their sales, and that variations in the market price, especially downward, produced little if any changes in market sales in the short term. Moreover, when the price change is significant enough to result in a non-insignificant change in sales, the impact on profits has been sufficiently negative to persuade enterprises not to try the experiment again.” (Lee 1998: 207).
The significance of this is that, if many administered price businesses tried to clear their product markets by price reductions (as one fundamental step in a convergence to a general equilibrium), then it would simply not work or would result in massive losses and most likely mass bankruptcy of many businesses.

When administered prices are changed, the change tends to be driven by (1) labour and materials costs or (2) changes in the profit mark-up (Lee 1998: 213).

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.

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

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