Saturday, November 30, 2013

Why Hayek’s Theory of Prices and Knowledge is Flawed

Frederic S. Lee explains in the passage below from insights by the British economist George Richardson:
“After reading Friedrich Hayek’s article on economics and knowledge (Hayek, 1937), Richardson became concerned with the theoretical problem of the market conditions under which the enterprise could expect to generate the necessary information on which to base its investment decisions. Approaching the problem theoretically, Richardson first argued that the perfectly competitive model used by economists was incapable of answering the problem. He then argued that the market conditions which enabled the enterprise to obtain the requisite information generally included coordination among the market enterprises and social constraints on their market action. More specifically, Richardson argued that the information necessary for making investment decisions could be only obtained in markets where the market price was unchanged for many sequential transactions and did not represent the market conditions peculiar to each transaction. It was in this manner that Richardson came to consider the relationship between social-economic rules and institutions and the market price … .

Richardson approached the relationship between social-economic institutions and market prices by considering two types of prices with respect to investment decisions – short-period fluctuating prices and long-period stable prices. The former prices, through short-period price competition, were responsive to the conditions surrounding each and every transaction in the market and, hence, were market-clearing prices. Thus, as the short-period conditions continually changed, so would the market price change. However, because of its fortuitous, flexible nature, the short-period market price could not generate the information needed by enterprises for making investment decisions. On the one hand, buyers could not make long-term buying plans, such as the buying of investment goods or consumer durables, based on the goods’ relative prices since they could change in a haphazard unpredictable manner; on the other hand, if the total sales of the enterprise were associated with many different prices, then it could not make long-term sales predictions based on sales trend, stock movements, state of orders, or market share. The information needed by the enterprise to make investment decisions would consequently simply not exist.

To eliminate short-period fluctuating prices, Richardson argued, enterprises resorted to developing codes of behavior and social-economic institutions to enforce them. For example, to eliminate secret price shading and therefore the possibility of price wars, a social rule against price cutting would be propagated throughout the market and backed by social-economic institutions such as open-price systems, price notification schemes, cartels, trade associations, or price leaders. Specifically, to eliminate short-period fluctuating market prices, the market enterprises would establish codes of social behavior and social institutions which would establish a single market price based on the normal cost prices of the enterprises in the market that would remain unchanged for many transactions – that is, a stable long-period market price. As a result, sales trends would provide the information enterprises needed to make long-term investment decisions, since the price/quantities combinations which make it up would not be related to short-term market conditions. Thus not only was the socially determined market price stable over time, it also generated the investment information the enterprises required since the indicators would reflect the permanent market conditions.” (Lee 1998: 135–136).
Of course, inside the comparatively small sector of the economy where flexprices really are important, the informational role of prices in terms of communicating knowledge about supply and demand has some merit, but so much of any modern market economy is not flexprice.

The private sector mostly shuns the price flexibility of neoclassical and Austrian price theory, and itself establishes many practices and conventions for stabilising prices.

But, above all, it is administered prices which allow the price stability that is highly useful in investment decisions. As Nicholas Kaldor argued, in normal times (outside, say, a very severe recession) “in actual adjustment of supply and demand, prices play only a very subordinate role, if any [sc. role]” (Kaldor 1985: 25).

In the mark-up pricing sector, therefore, prices cannot be communicating relevant and important Hayekian information about changes in demand and supply or relative scarcity.

For Richardson’s work in general, see Richardson (1960, 1965, 1967 and 1972).

Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.

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

Richardson, G. B. 1960. Information and Investment: A Study in the Working of the Competitive Economy. Oxford University Press, Oxford.

Richardson, G. B. 1965. “The Theory of Restrictive Trade Practices,” Oxford Economic Papers 17: 432–449.

Richardson, G. B. 1967. “Price Notification Schemes,” Oxford Economic Papers 19: 359–369

Richardson, G. B. 1972. “The Organization of Industry,” Economic Journal 82.327: 883–896.

Mark-up Pricing in New Zealand

Miles Parker, in the paper cited below, examines price setting behaviour in New Zealand, and reports on the results of a survey of 5,300 firms selected as a representative sample of all sectors of the New Zealand economy (Parker, pp. 1–2).

The results are as follows:
Price Setting methods (averages)
(1) Costs plus profit mark-up | 54%

(2) Influence of competitors’ prices | 29%

(3) Rule of thumb | 10%

(4) Other | 8%.
(Parker, pp. 14).
Evidence suggests that the “rule of thumb” category involves mark-up pricing too (as in regulated health and education sectors), as does the category “other,” so that, as in other studies, the total percentage of mark-up prices is likely to be higher than the reported figure of 54%.

Parker notes that many other studies show that firms struggle to even determine what their marginal costs are (Parker, pp. 13). But it seems that the survey did not bother to inquire whether it was total average unit costs that were the normal method of cost calculation used in setting mark-up prices, an obvious shortcoming.

The average firm reviews prices twice a year but changes its prices only once a year (Parker, pp. 28).

An interesting insight is that sales, clearance sales and even temporary price reductions seem to be considerably less important than most people think.

When asked whether temporary price reductions were important, the following results were found:
(1) not at all | 44%

(2) a little important | 17%

(3) moderately important | 16%

(4) very important | 13%.

(5) don’t know | 10%
(Parker, pp. 17).
From this, it follows that 61% of firms regard temporary price reductions as either marginally important or mostly not important at all to their price setting policies: a finding that is entirely consistent with the view that modern economies have relatively rigid mark-up prices which are relatively inflexible downwards.

Another finding is that price rigidity is quite important in markets for intermediate goods and wholesale markets (Parker, pp. 6–7).

Parker, Miles. “Price-Setting Behaviour in New Zealand”,Miles.pdf

Mark-up Pricing in Australia

Park et al. (2010) reports the results of a two-part survey by the central bank of Australia, the first conducted from 2004–2006 and involving around 700 firms, and a second survey conducted around 2008 (Park et al. 2010: 7). The firms were selected from all sectors of the Australian economy.

The results from the first survey from 2004–2006 are the most important, and can be seen below:
(1) Mark-up Pricing | 49%

(2) More Demand-focused 45%
(2.a) Market conditions | 25%

(2.b) Competitors’ prices | 11%

(2.c) Level of demand | 4%

(2.d) Customer sets price | 5%
(3) Other | 6%
(Park et al. 2010: 9, Table 2).
If we take the figures as reported, the largest type of price setting behaviour is mark-up pricing at 49%. Furthermore, of those firms that use mark-up pricing, 23% use costs plus a fixed mark-up, and 26% use costs plus a variable mark-up.

However, as in other studies, there are reasons for wondering whether the figure for mark-up pricing is an underestimate.

In some other nations where these kinds of surveys are done, it is often the case that the category of “Competitors’ prices” conceals more mark-up pricing, so that if, say, a further 5% of firms here practice mark-up pricing the total percentage rises to around 54%.

In addition, the category of “other” seems mostly to refer to fixprices set by government regulation which are often mark-up prices are well, so that when this category is added to the original figure, a final estimate for total mark-up pricing may go up to at least 60%.

This is consistent with the other finding that only 25% of firms change prices more than once a month, and that 55% of firms had changed prices once in the past year or not at all (Park et al. 2010: 11).

In Australia, demand-focused prices are largely confined to the agriculture, mining and tourism industries (Park et al. 2010: 9, Table 3), where global demand factors (especially for the first two) are important in determination of prices.

Park, Anna, Rayner, Vanessa and Patrick D’Arcy. 2010. “Price-Setting Behaviour – Insights from Australian Firms,” Reserve Bank of Australia Bulletin (June Quarter): 7–14.

Friday, November 29, 2013

Mark-up Pricing in Japan

Nakagawa et al. (2000) reports the results of a survey from April to May 2000 of 630 Japanese companies listed in the first section of the Tokyo Stock Exchange, including both manufacturing and non-manufacturing businesses (Nakagawa et al. 2000: 3–4).

The first interesting finding is that 60–70% of companies focus on the idea of “rate of return on capital” (Nakagawa et al. 2000: 5) as a management strategy, which also is applicable to price setting. This idea appears to be strongly related to the target rate of return version of mark-up pricing: firms attempt to create a given level of profits by calculating average costs of production, an expected volume of sales, and then a profit mark-up to achieve the planned profit level.

Around 90% of Japanese companies reported that competition had become severe by 2000 compared with the late 1990s, owing to decreased demand, increases in imports and foreign competition, and deregulation (Nakagawa et al. 2000: 6).

This is not surprising given that Japan was still in the last years of its Lost Decade in 2000 and had experienced demand shocks from the East Asian economic crisis in the later 1990s and increased international competition, especially from China.

While companies reported that price reductions, “product differentiation” (70%), and cutting costs were a response to severe competition, it appears that in manufacturing non-price measures such as product differentiation rather than price reduction were the preferred response to competitive pressures (Nakagawa et al. 2000: 8).

Unfortunately, the results of this survey are somewhat contradictory and difficult to interpret owing to the unusual way they are reported.

Around 18% of firms reported that direct cost plus fixed mark-up pricing was important in their price setting behaviour (Nakagawa et al. 2000: chart 9). Unfortunately, it is unclear whether “direct cost” means (1) total average cost or (2) variable cost, or whether the survey even bothered to ask what kind of costs were used in calculating the mark-up.

Furthermore, Nakagawa et al. did not ask businesses whether they used variable mark-up pricing, where the profit mark-up is changed more frequently – a serious shortcoming in their survey.

Although 36% of companies reported that “market condition” was important in their price setting behaviour and that prices were set at the upper limit permitted by the market with demand and supply factors being important, nevertheless Fabiani et al. (2007: 190) argue that this finding is actually compatible with a type of mark-up pricing too, presumably just a more competitive one where the mark-up is variable: that is to say, because of the competition that Japanese manufacturing companies face, they must adjust their profit mark-up to remain competitive.

If this is so, then about 54% of Japanese firms appear to have reported that mark-up pricing is an important element of price setting behaviour.

That result would be consistent with the price rigidity as reported in the survey, in which just over 50% of manufacturing companies had changed prices once or twice in the previous year and about 19% of manufacturing companies had not changed prices at all (Nakagawa et al. 2000: 10)

Other studies, though based on smaller samples, confirm the existence of mark-up pricing, and other details.

Baba (1995) finds that many Japanese manufacturing firms use mark-up pricing.

Hsu (1999) confirms this and the existence of mark-up prices in other sectors too, but sometimes of a different form than in the West (Hsu 1999: 164).

Some unusual pricing practices exist that relate to the way that Japan is an export-oriented economy. Some firms allegedly base their export mark-up prices on variable costs alone to make their prices far more competitive overseas, but raise domestic prices to a higher level that is sufficient to recoup fixed costs (Hsu 1999: 165).

Baba, N. 1995. “On the Cause of Price Differentials between Domestic and Overseas Markets: Approach through Empirical Analyses of Markup Pricing,” Bank of Japan Monetary and Economic Studies 13.2: 45–74.

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.

Hsu, Robert. 1999. “Pricing Practices in Japan,” Global Business and Economics Review 1.2: 164–171.

Nakagawa, S., R. Hattori and I. Takagawa, 2000. “Price-Setting Behaviour of Japanese Companies,” Bank of Japan Research Paper

Frederic Lee on Real World Prices

Frederic S. Lee has a nice post here on the empirical evidence on real world price and wage setting:
Frederic S. Lee, “What if There Are No Conventional Price Mechanisms?,” New Economic Perspectives, November 26, 2013.
As Lee notes,
“since the 1930s, it has been known that price stability dominate the industrial, wholesale, and retail areas of the American economy. The 40–50 studies in the past fifteen years by Alan Binder and others which cover developed countries around the world further support the existence of price stability. One basis for its existence is the administered cost-plus pricing mechanism (used by virtually all business enterprises to set the prices) which neutralizes the impact of changing sales on costs hence prices.”

Thursday, November 28, 2013

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 (FCth).

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 (FCth), 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.

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.

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

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.

Wednesday, November 27, 2013

Mises on the Prices of Factor Inputs: A Critique

The essence of Mises’ views are below:
The prices of the goods of higher orders are ultimately determined by the prices of the goods of the first or lowest order, that is, the consumers’ goods. As a consequence of this dependence they are ultimately determined by the subjective valuations of all members of the market society. It is, however, important to realize that we are faced with a connection of prices, not with a connection of valuations. The prices of the complementary factors of production are conditioned by the prices of the consumers’ goods. The factors of production are appraised with regard to the prices of the products, and from this appraisement their prices emerge. Not the valuations but the appraisement are transferred from the goods of the first order to those of higher orders. The prices of the consumers’ goods engender the actions resulting in the determination of the prices of the factors of production. These prices are primarily connected only with the prices of the consumers’ goods. With the valuations of the individuals they are only indirectly connected, viz., through the intermediary of the prices of the consumers’ goods, the products of their joint employment.” (Mises 2008: 330–331).

The market determines prices of factors of production in the same way in which it determines prices of consumers’ goods. The market process is an interaction of men deliberately striving after the best possible removal of dissatisfaction. It is impossible to think away or to eliminate from the market process the men actuating its operation. One cannot deal with the market of consumers’ goods and disregard the actions of the consumers. One cannot deal with the market of the goods of higher orders while disregarding the actions of the entrepreneurs and the fact that the use of money is essential in their transactions. There is nothing automatic or mechanical in the operation of the market. The entrepreneurs, eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor. The entrepreneurs are eager to outdo one another by bidding higher prices than their rivals. Their offers are limited on the one hand by their anticipation of future prices of the products and on the other hand by the necessity to snatch the factors of production away from the hands of other entrepreneurs competing with them.” (Mises 2008: 332–333).

“The competition among the entrepreneurs is ultimately a competition among the various possibilities open to men to remove their uneasiness as far as possible by the acquisition of consumers’ goods. The decisions of the consumers to buy one commodity and to postpone buying another determine the prices of factors of production required for manufacturing these commodities. The competition between the entrepreneurs reflects the prices of consumers’ goods in the formation of the prices of the factors of production.” (Mises 2008: 335).
The crucial concept is that of “value imputation.” The notion of value imputation is explained by Hülsmann:
“The kernel of Mises’s theory of calculation is this: while calculation in terms of money prices is the essential intellectual tool of entrepreneurs acting in a market economy, calculation in terms of ‘value’ is impossible. A calculus can only be performed with multiples of an extended unit; for example, one can add one apple to another apple or one grain of silver to another grain of silver. In contrast, one cannot add a telephone to a piano concerto and still less can one add wittiness to silence. These things are incommensurable and therefore cannot be linked through mathematical operations. So it is with value. One cannot quantify the value of a thing because value is not extensive and therefore not measurable.

However, value can be qualitatively ‘imputed’ from consumer goods to factors of production, in the sense of a value-dependency: those factors of production are valuable only because they serve to produce valuable consumer goods. But there is no such thing as quantitative value and thus no value calculation; there is only price calculation.” (Hülsmann 2007: 399–400).
That is confirmed by Mises’s statement that “[e]conomic calculation always deals with prices, never with values” (Mises 2008: 332).

In Mises’s view, capitalists do not value factor inputs directly but indirectly for the goods they can produce.

Thus the subjective value of factors of production to entrepreneurs are ultimately determined by the value of consumer goods. That is not an unreasonable insight, but it does not follow that all prices are formed in the way Mises imagines: that is, in a flexible manner in auction-like markets where capitalists are bidding against each other.

The fundamental failing of Mises’ analysis is that even factor inputs such as capital goods can have prices set by the producers based on average costs of production per unit plus a profit mark-up.

In particular, durable capital goods tend to have mark-up prices, and this is confirmed in the relative inflexibility of producers’ goods prices (Greenslade and Parker 2012: F4)

In this case of mark-up pricing, Mises has it the wrong way around: the prices of the relevant factor inputs used in production determine the prices of mark-up capital goods, not consumer prices.

Greenslade, Jennifer V. and Miles Parker. 2012. “New Insights into Price-Setting Behaviour in the UK: Introduction and Survey Results,” Economic Journal 122.558: F1–F15.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism. Ludwig von Mises Institute, Auburn, Ala.

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.

Joseph Stiglitz’s Review of Skidelsky’s Keynes: The Return of the Master

The review below is actually a very good read and has a letter from Paul Davidson at the end:
Joseph Stiglitz, “The Non-Existent Hand” (review of Robert Skidelsky, Keynes: The Return of the Master), London Review of Books 32.8 (22 April), 2010: 17–18.
Joseph Stiglitz is a New Keynesian and his interpretation of Skidelsky is interesting, not least of all for his insights into debt deflation.

Tuesday, November 26, 2013

Mises on Market Clearing Prices and Demand Curves: A Critique

The crucial passage is below:
“It is ultimately always the subjective value judgments of individuals that determine the formation of prices. Catallactics in conceiving the pricing process necessarily reverts to the fundamental category of action, the preference given to a over b. In view of popular errors it is expedient to emphasize that catallactics deals with the real prices as they are paid in definite transactions and not with imaginary prices. The concept of final prices is merely a mental tool for the grasp of a particular problem, the emergence of entrepreneurial profit and loss. The concept of a ‘just’ or ‘fair’ price is devoid of any scientific meaning; it is a disguise for wishes, a striving for a state of affairs different from reality. Market prices are entirely determined by the value judgments of men as they really act.

If one says that prices tend toward a point at which total demand is equal to total supply, one resorts to another mode of expressing the same concatenation of phenomena. Demand and supply are the outcome of the conduct of those buying and selling. If, other things being equal, supply increases, prices must drop. At the previous price all those ready to pay this price could buy the quantity they wanted to buy. If the supply increases, they must buy larger quantities or other people who did not buy before must become interested in buying. This can only be attained at a lower price.

It is possible to visualize this interaction by drawing two curves, the demand curve and the supply curve, whose intersection shows the price. It is no less possible to express it in mathematical symbols. But it is necessary to comprehend that such pictorial or mathematical modes of representation do not affect the essence of our interpretation and that they do not add a whit to our insight. Furthermore it is important to realize that we do not have any knowledge or experience concerning the shape of such curves. Always, what we know is only market prices – that is, not the curves but only a point which we interpret as the intersection of two hypothetical curves. The drawing of such curves may prove expedient in visualizing the problems for undergraduates. For the real tasks of catallactics they are mere byplay.” (Mises 2008: 329–330).
What Mises is saying here is as follows:
(1) the formation of prices on markets is “ultimately always” caused by the subjective value judgments of individuals, and prices are “entirely determined” by value judgements of people who “really act.”

(2) prices in product markets tend towards a point where total demand by buyers is equal to total supply offered for sale by sellers. This, of course, is a market clearing price. However, this is immediately qualified by the observation that if supply increases, prices must drop “other things being equal”: the ceteris paribus assumption that allows the usual exceptions Austrians like Mises invoke to explain rigid prices, such as government price controls, labour unions, and so on, as this passage confirms:
“The market interaction brings about a price at which demand and supply tend to coincide. The number of potential buyers willing to pay the market price is large enough for the whole market supply to be sold. If government lowers the price below that which the unhampered market would set, the same quantity of goods faces a greater number of potential buyers who are willing to pay the lower official price. Supply and demand no longer coincide; demand exceeds supply, and the market mechanism, which tends to bring supply and demand together through changes in price, no longer functions.” (Mises 2011: 101).
(3) If there is any doubt that Mises has in mind market clearing prices in this passage this completely removes the doubt:
“It is possible to visualize this interaction by drawing two curves, the demand curve and the supply curve, whose intersection shows the price.”
This “point” is nothing but the market clearing price.

(4) but then Mises says this:
“Furthermore it is important to realize that we do not have any knowledge or experience concerning the shape of such curves.”
One can presume that Mises is here saying that we cannot know the real shape of real world downward-sloping demand curves, but Mises is not questioning the general assumption that well-behaved downward-sloping demand curves are the norm, because if he really were implying the latter, his whole argument would be badly undermined.
Let us now expand on point (4). It is a serious problem: the idea that, generally speaking, goods have well behaved downward sloping demand curves is both theoretically and empirically questionable.

The theoretical evidence is discussed here and here.

If we turn to the empirical evidence, it has been known for a long time that reductions by suppliers in the prices of factor inputs do not necessarily induce more purchases of a factor by a producer if the latter’s sales are stagnant or falling (Lee 1998: 108).

And as Lee notes:
“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).
With the understanding that demand curves can in theory have any shape at all and the empirical evidence that many goods do not have well behaved demand curves, it follows that the whole idea that real world markets have a strong tendency to market clearing becomes implausible.

This is before we get to real world price setting behaviour such as mark-up pricing, which also utterly discredits the idea that product markets in real world market economies tend to have flexible prices that move towards their market clearing values.

And I have yet to see one shred of evidence that Mises ever discussed administered/mark-up pricing and its consequences.

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

Mises, L. von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Mises Institute, Auburn, Ala. pp. 201–232, 324–394.

Mises, L. von. 2011. A Critique of Interventionism. Mises Institute, Auburn, Ala.

Monday, November 25, 2013

Mark-up Prices in Iceland

Ólafsson et al. (2011) reports the results of a survey of Icelandic firms that was conducted in June to July of 2008, and that involved 580 firms selected from all sectors – including manufacturing, the financial sector, construction, and services – and in proportion to the composition of these different sectors of the Icelandic economy (Ólafsson et al. 2011: 7).

The firms were asked directly about the price setting of their main product, or that product that accounts for 60–80% of the firm’s annual turnover (Ólafsson et al. 2011: 8).

Curiously, those companies and businesses whose prices were set by regulation or by a parent company were excluded (Ólafsson et al. 2011: 8).

That would suggest that the final data are not entirely representative since businesses whose price are set as a mark-up by a parent company are excluded.

One finding was that 73% of firms surveyed had long-term relationships with their customers and this factor is conducive to greater price stickiness (Ólafsson et al. 2011: 9).

The second finding is as follows:
Cost-based pricing with variable or constant mark-up is found to be the most common price setting method, as 45 per cent of firms claim to use this method of price setting. Almost 35 per cent of firms set their prices with reference to competitors’ prices, and a fifth of firms index their prices to the consumer price index …. Price indexation is especially common in the financial, construction, and other services sectors. In wholesale, retail, transport, and various services, 60 per cent of firms set prices using a constant or variable mark-up on costs.” (Ólafsson et al. 2011: 12).
Mark-up pricing is thus the most prevalent form of price setting in Iceland, higher than both other categories.

As in other studies, it seems possible that the category of prices “dependent on competitors’ prices” conceals more mark-up firms, since in some mark-up pricing markets a market leader sets the standard mark-up price and other businesses follow the price leader.

This is confirmed in my mind by the later finding that costs rather than demand are the major factor driving price changes.

Firms were asked what the principal determinant of price changes was. The results are as follows:
Price Increases
(1) Costs | 68.7%
(2) Exchange rate changes | 22.9%
(3) Competitors’ price | 1.5%
(4) Demand | 6.9%

Price Decreases
(1) Costs | 37.6%
(2) Exchange rate changes | 20%
(3) Competitors’ price | 20.8%
(4) Demand | 21.8%
(Ólafsson et al. 2011: 18).
Also of extraordinary interest but concealed in a footnote is this statement about how the survey avoided the use of the term “marginal cost”:
“We follow a common procedure within the literature and do not use the term ‘marginal cost’ in our questionnaire as it has generally been found that it is hard to question firms about their marginal costs. The concept is both complicated to explain in layman’s words and hard for firms to compute.” (Ólafsson et al. 2011: 12, n. 8).
How on earth can it be that in neoclassical economics prices are thought to be strongly related to “marginal cost,” and yet businesses not only have difficulty understanding the concept (even when explained in “layman’s words”), but also find it hard to calculate?

Of course, the answer is that marginal cost is irrelevant for many – possibly most firms – and that neoclassical price theory is badly flawed.

A further datum from the survey is that time dependent price setting – where firms only review prices periodically – is predominant in Iceland: about 40% of firms have purely time-dependent price reviews, and 47% mainly time dependent reviews with some state dependent ones (Ólafsson et al. 2011: 14).

In contrast to New Keynesian Phillips curve analysis where forward-looking price setters are an important element, about 68% of firms “evaluate their prices mainly on the basis of current information and past developments and are therefore backward-looking” (Ólafsson et al. 2011: 14).

In any case, it is clear that even in small, open economies like Iceland mark-up prices are still very important.

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

Saturday, November 23, 2013

Marginalism versus Post Keynesianism on Mark-up Pricing

One important response to the theory of full cost and mark-up pricing and the threat it poses to neoclassical economics is to argue that the actual result of mark-up pricing – on the basis of average unit costs and profit mark-up – is the same as if a firm deliberately and consciously were to equate marginal cost and marginal revenue (Keen 2011: 168, citing Langlois 1989).

This type of argument is made, for example, by Langlois:
Langlois, Catherine. 1989. “Markup Pricing versus Marginalism: A Controversy Revisited,” Journal of Post Keynesian Economics 12.1: 127–151
This article provoked a symposium and a number of replies in the Journal of Post Keynesian Economics Winter 1990–1991 issue:
Symposium: The Marginalist Controversy and Post Keynesian Price Theory

Frederic S. Lee. 1990–1991. “Introduction,” Journal of Post Keynesian Economics 13.2: 233–235.

Mongin, Philippe. 1990–1991. “The Early Full-Cost Debate and the Problem of Empirically Testing Profit Maximization,” Journal of Post Keynesian Economics 13.2: 236–251.

Lee, Frederic S. 1990–1991. “Marginalist Controversy and Post Keynesian Price Theory,” Journal of Post Keynesian Economics 13.2: 252–263.

Earl, Peter E. 1990–1991. “Normal Cost versus Marginalist Models of Pricing: A Behavioral Perspective,” Journal of Post Keynesian Economics 13.2: 264–281.

Langlois, Catherine C. 1990–1991. “The Empirical Testing of Pricing Rules: Response to a Symposium,” Journal of Post Keynesian Economics 13.2: 282–292.
I have yet to read all these papers, but I hope to review and comment on this debate when time permits.

The argument put to me recently is that, if marginal cost and average cost are the same or tend to coincide (given the shape of a marginal cost curve), then a neoclassical profit-maximizing firm will use average cost as a proxy for a profit-maximizing mark-up.

But do marginal cost and average cost really tend to coincide given that mark-up pricing obviously uses unit fixed costs or overhead costs,* as well as variable costs? Marginalism assumes that fixed costs (or overhead costs) are not used in setting prices, but it would appear that certain discretionary fixed costs (such as marketing and advertising, maintenance, and R&D) can be rather expensive.

Even given that average costs probably decline for many firms, if that firm has a constant marginal cost below average cost, then average cost and marginal cost will not be equal, nor will they tend to coincide if average cost stabilises at some point above marginal cost.

Thoughts on this (and the relationship between marginal cost and average variable cost) from people who know the specialist literature and empirical data better than I do are welcome.

* Some notes are below on different types of costs for those who may be confused by the whole topic:

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. Standard theory says that the average total cost curve is U-shaped, because eventually firms face diseconomies of scale. However, empirical evidence suggests that most firms’ long-run average cost curves within realistic output ranges do not hit diseconomies of scale, so that long-run average cost curves are L-shaped.

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.

Sunk costs
These are defined as those costs that a business cannot recover if it ceases operation, such as plant or machinery that cannot be re-used or resold. These constitute barriers to entry.

Earl, Peter E. 1990–1991. “Normal Cost versus Marginalist Models of Pricing: A Behavioral Perspective,” Journal of Post Keynesian Economics 13.2: 264–281.

Frederic S. Lee. 1990–1991. “Introduction,” Journal of Post Keynesian Economics 13.2: 233–235.

Heflebower, R. F. 1955. “Full Costs, Cost Changes, and Prices,” Business Concentration and Price Policy. Princeton University Press, Princeton. 361–392.

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

Langlois, Catherine C. 1989. “Markup Pricing versus Marginalism: A Controversy Revisited,” Journal of Post Keynesian Economics 12.1: 127–151.

Langlois, Catherine C. 1990–1991. “The Empirical Testing of Pricing Rules: Response to a Symposium,” Journal of Post Keynesian Economics 13.2: 282–292.

Lee, Frederic S. 1990–1991. “Marginalist Controversy and Post Keynesian Price Theory,” Journal of Post Keynesian Economics 13.2: 252–263.

Mongin, Philippe. 1990–1991. “The Early Full-Cost Debate and the Problem of Empirically Testing Profit Maximization,” Journal of Post Keynesian Economics 13.2: 236–251.

Mark-up Pricing in Norway

I summarise the findings of Langbraaten et al. (2008), a survey conducted in the period from February to May 2007 by the Norges Bank, the central bank of Norway (Langbraaten et al. 2008: 26). This involved a well-sampled survey of 725 firms throughout many sectors of the Norwegian economy, including manufacturing, wholesale and retail trade, services, tourism, transport and banking (Langbraaten et al. 2008: 14).

As an aside, this study confirms the basic neoclassical economic theory that runs through central banks: the authors assume that money is only non-neutral in the short run, and in the long run that money is neutral (Langbraaten et al. 2008: 13). This view is of course wrong, but I digress.

The survey asked firms to indicate to what extent they set prices as a mark-up over costs from a scale of 1 (very limited extent) to 4 (very large extent). The results can be seen below:
To what extent are prices set as a mark-up over costs?
(1) Very limited extent: 13%

(2) Fairly limited extent: 18%

(3) Fairly large extent: 32%

(4) Very large extent: 37%.
The conclusion of this survey, then, is that about 69% of Norwegian businesses and firms set their prices as administered prices to a significant degree.

That figure is remarkably high: an overwhelming majority of firms.

What is especially interesting in this survey is that it strongly confirms my conclusions in this post about Ireland and in this post about the UK: the direct reported number of mark-up firms in surveys from these nations are very likely to be underestimates, because many mark-up firms have chosen to report their price setting behaviour as one “dependent on” or “following” their main competitors.

This makes sense because many smaller or medium sized mark-up pricing firms in many competitive markets simply follow a mark-up pricing “leader” firm that sets the price for the whole market.

Langbraaten et al. report the following the important insight:
“ … the prices charged by firms in the survey are determined to an even greater extent by the prices of their competitors. Almost four out of five firms indicated that their price depends on competitors’ prices to a “fairly great extent” or a “very great extent” (see Chart 6). ...

Questions about whether firms set prices as a mark-up over costs and whether prices depend on competitors’ prices have also been asked in many of the national surveys in the euro area. Generally speaking, more firms there responded that prices are set as a mark-up over costs than that prices depend on competitors’ prices. Although prices can be set as a mark-up over costs and still depend on competitors’ prices, the differences between the results from Norway and the euro area may nevertheless be interpreted as an indication that there is generally stronger competition between firms in the Norwegian market.” (Langbraaten et al. 2008: 16).
That is, a firm can be both a mark-up pricing firm and one dependent on competitors’ prices. This is an important datum for evaluating the results of other price setting surveys.

Yet another finding was that when asked
“to what extent they take account of different types of information when setting prices. We gave them three options and, as in the previous question, asked them to assign a score to each of these options. The three options were:

• Information about present and past developments in relevant factors (inflation, demand, costs, competitors’ prices, etc.)

• Information about future developments/forecasts in these factors

• The firm uses a rule-of-thumb (such as indexation based on the consumer price index/wage growth). (Langbraaten et al. 2008: 16)
The result was that 70% of firms chose factor (1) as the most important one.

The rigidity of most prices was also made clear by the finding that nearly 50% of firms said that they only changed their product price once a year, and about 23% of firms said that they changed the price twice a year (Langbraaten et al. 2008: 18).

This survey also confirms the findings of other studies that the New Keynesian idea of “menu costs” as a major reason for price stickiness is largely rejected by firms: about 54% said “menu costs” were not important at all and about 40% said they were only slightly important (Langbraaten et al. 2008: 22). The idea that “administrative costs” – or “costly information” problems – is a major source of price stickiness is also discredited by the survey (Langbraaten et al. 2008: 22). These data can only be understood as a stunning blow to New Keynesian theory.

Langbraaten, Nina, Nordbø, Einar W. and Fredrik Wulfsberg. 2008. “Price-setting Behaviour of Norwegian Firms – Results of a Survey,” Norges Bank Economic Bulletin 79.2: 13–34.

Friday, November 22, 2013

Mark-up Pricing in Ireland

Keeney, Lawless and Murphy (2010) provide empirical evidence on the price setting behaviour of one thousand Irish firms in a survey in which firms were directly asked how they set prices (Keeney, Lawless and Murphy 2010: 3).

The result was that 44% of firms reported that their prices were set based on costs and a self-determined profit margin (Keeney, Lawless and Murphy 2010: 3).

Although this was the largest and most prevalent category of price setting reported in their data and is certainly significant, nevertheless it looks rather low compared to other nations.

But an examination of the other findings strongly suggests that Keeney, Lawless and Murphy’s other categories conceal mark-up prices too:
(1) No autonomous price setting* | 11.1%
(2) Price set by customer(s) | 5.5%
(3) Price set following main competitors | 33.3%
(4) Price based on costs and self-determined profit margin | 44.2%
(5) Other | 5.9%

* Because “the price is regulated, or it is set by a parent company/group” (Keeney, Lawless and Murphy 2010: 6).
Category (1) would appear to be a strong candidate for some extra mark-up pricing firms whose price is set by their parent company (in addition to regulated price companies which are also present there), and even category (3) is not inconsistent with some more mark-up firms whose administered price is based on price leaders in their respective markets who set the price. Although (3) no doubt also has a number of flexprice firms too, the point remains that some of the firms there could really belong to category (4).

This seems to be confirmed later in the data when firms were asked to assess how likely it was that they would adjust prices downwards in response to a negative demand shock.

What was discovered is that a majority of firms said that negative demand shocks were of little or no relevance to pricing decisions! The data can be seen here:
(1) Manufacturing | 69.1%
(2) Construction | 77.6%
(3) Distribution | 58.6%
(4) Other Services | 69.1%
(5) Total | 66.5%
(Keeney, Lawless and Murphy 2010: 6).
It seems incredible that so many firms could report this if only 44.2% were using mark-up pricing, since mark-up pricing firms are precisely the ones for whom demand is relatively unimportant.

More likely, the number of Irish mark-up firms is much higher than the direct number reported, and, as argued above, categories (1) and category (3) conceal a number of additional mark-up firms.

I think this is consistent with similar conclusions that can be made about UK price setting data.

Keeney, Mary, Lawless, Martina, and Alan Murphy. 2010. “How Do Firms Set Prices? Survey Evidence from Ireland,” Central Bank of Ireland, Research Technical Papers, no 7/RT/10.

Downwards Rigidity of Prices and Mark-up Pricing

Empirical studies show that prices in modern market economies tend to be more flexible upwards than downwards when costs change (Peltzman 2000; Fabiani et al. 2007: 46, 49; Blinder et al. 1998: 156). That is, there is marked downwards rigidity in prices.

The explanation most probably lies in the administered price sector. It is clear that administered prices can remain stable or move in any direction in any phase of the business cycle (Lee 1998: 214).

Administered price firms that can avoid it, when they face no strong competitive pressures, such as through radical technology changes or productivity growth, simply prefer not to reduce their prices when factor input prices decrease, because the ability to increase sales from price reductions can be uncertain and the price reductions could reduce profits, as Lee points out:
“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).
One important reason for the tendency for prices to rise over time is most likely that many businesses will increase the profit mark-up and maintain prices when costs fall: there is a strong tendency for inflation, rather than deflation (Lee 2013: 475, citing Álvarez et al. 2006; Blinder et al. 1998; Fabiani et al. 2007).

This can be seen even in recessions since 1945 which are generally disinflationary – but disinflation is still a form of general rising prices, albeit at a lower rate than in previous years.

Thus the sources of modern price inflation are far more complicated than morality tales about reckless money supply growth or demand-side inflation explanations that rely on prices actually responding rapidly to supply and demand factors – when many mark-up prices simply do not adjust in this way.

Álvarez, Luis J., Dhyne, Emmanuel, Hoeberichts, Marco, Kwapil, Claudia, Le Bihan, Hervé, Lünnemann, Patrick, Martins, Fernando, Sabbatini, Roberto, Stahl, Harald, Vermeulen, Philip and Jouko Vilmunen. 2006. “Sticky Prices in the Euro Area: A Summary of New Micro-evidence,” Journal of the European Economic Association 4.2/3: 575–584.

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

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.

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

Lee, Frederic S. 2013. “Post-Keynesian Price Theory: From Pricing to Market Governance to the Economy as a Whole,” in G. C. Harcourt and Peter Kriesler (eds.), The Oxford Handbook of Post-Keynesian Economics. Volume 1: Theory and Origins. Oxford University Press, Oxford and New York. 467–484.

Peltzman, Sam. 2000. “Prices Rise Faster than They Fall,” Journal of Political Economy 108.3: 466–502.

Thursday, November 21, 2013

Investment and Retained Earnings

A simple empirical fact: in the decades before 2002 about 50% of US investment spending was financed by retained earnings, and about 50% by debt and new equity issues (Moore 2002: 147). Historically, investment from retained earnings was probably more important than in more recent times.

Business retained earnings – when not re-invested in real capital or other real assets – are often held in the form of financial assets, like stocks, shares, bonds, bank accounts (such as corporate demand deposits and savings accounts), or fixed term deposits. In other words, these are monetary savings. Yet these “savings” can be held over long periods of time before being drawn on.

A rise in business spending on these secondary financial assets (from their monetary profits) does not induce employment, and when this happens the corresponding fall in real capital investment is an important factor in recessions and periods of insufficient investment and high involuntary unemployment.

The changing liquidity preferences of businesses thwart Say’s law-like equalisation of investment and monetary saving.

Furthermore, the importance of retained earnings is an even more important blow to the idea that investment is a simple function of interest rates: that is, the idea that a flexible interest rate that allegedly moves towards a Wicksellian natural rate can clear all capital goods markets.

Even though interest rates do have a real and significant effect on investment, the process is variable and depends on the state of business expectations and demand signals, and many businesses do not rely on money loans to fund new investment.

For the business that funds its investment through retained earnings, it is, above all, sales volume, demand, expected demand and expectations that influence capital investment and hiring decisions.

Moore, B. J. 2002. “Saving and Investment: The Theoretical Case for Lower Interest Rates,” in Paul Davidson (ed.), A Post Keynesian Perspective on 21st Century Economic Problems. Edward Elgar, Cheltenham. 137–157.

Wednesday, November 20, 2013

A Simple Question for Austrian Apriorists

The Austrian school is famous for its apriorist economic method called praxeology. This, in its Misesian form, takes up the notion of Kantian synthetic a priori knowledge and holds that praxeology can arrive at economic theories that describe reality and in an a priori manner with necessary and apodictic truth, so that empirical evidence cannot refute praxeological theories.

A simple question can demonstrate the absurdity of his approach:
Can you sit in an armchair and use deduction from the action axiom to determine how all prices are actually set in real world capitalist economies and with apodictic truth?
The notion that anyone can do this is just ridiculous, and anyone who claims they can would quickly be shown to be deluded and mistaken.

One can no doubt construct abstract analytic a priori models, but those models must be given an empirical hearing and checked against reality to determine whether they do in fact describe the real world.

The point is that the really interesting and important questions about real world market economies can only be determined by hard empirical research and study, not by mere deduction from a few trivial axioms.

For more on Austrian praxeology and its failings, see here.

Tuesday, November 19, 2013

A Poor Critique of Keynes

... can be found in the video below. This is an interview of an economist called G. P. Manish by the Austrian Thomas Woods in an attempt to summarise and criticise the economic ideas of Keynes.

Some comments:
(1) The discussion of “animal spirits” is rather poor. The term was used by Keynes but three times in the whole General Theory, and all towards the end of Chapter 12. Keynes uses “animal spirits” in the sense of “a spontaneous [human] urge to action rather than inaction,” but this was a mere element of his broader point that expectations of economic agents – particularly business-people – are subjective, and that future events that are vitally important to them cannot be given objective, numeric probability scores.

Now whether or not humans have a “spontaneous urge to action rather than inaction” is a matter for modern psychology, evolutionary psychology, neuroscience and cognitive science, and all that Keynes needed to say is that human beings can and do act in the face of uncertainty.

But in truth the entire concept of “animal spirits” could be dropped completely from modern heterodox Keynesian treatments of subjective expectations without any problem at all. The Austrian and libertarian fixation on “animal spirits” is mostly an utter red herring, as I have argued here in an earlier post.

The crucial point that Keynes was really making is that much of the future is not a matter of mathematical calculation, and that agents face uncertainty about the future.

The sheer stupidity here is that Austrians, more or less, say the same thing about expectations: they are subjective. Yet the Austrians are forever trying to “refute” Keynes on a point that is part and parcel of their own economic theory and that they themselves are committed to supporting.

Now Keynes of course also argued that, because expectations are subjective and investment decisions are not a matter of “mathematical calculation,” business confidence and expectations can shift between periods of optimism and pessimism, so that the aggregate level of investment is unstable.

Pessimistic and shocked expectations can lead to prolonged slumps and lowering of interest rates will not lead to a sufficient increase in demand for investment loans and hence real capital investment.

But neither Manish nor Thomas Woods have refuted this point.

(2) G. P. Manish in his comments from 11.17 (which you can hear directly below) shows us that he does not understand the real world price system and – like all free market apologists – lives in a fantasy world.

Manish tells us that
“as to why we would not expect the economy to settle in that kind of recessionary spiral or recessionary equilibrium is simply because of the fact that on the market it is through price flexibility that markets recover. So, essentially, as Austrian economists and even others have argued ... that at the end of a bust – when the boom turns into a bust – you need price flexibility to reallocate resources … back in line with consumer preferences, because what the boom represented was a misallocation of resources, which in turn was caused by meddling with the monetary … the amount of money in the system, and the creation of fiduciary media, as Mises would call it. And, therefore, if you do this mechanism of price flexibility and especially the actions of entrepreneurs – who are always looking to make profits and therefore always trying to appraisal the future and always trying to move resources back to … in a way that is in line with consumer preferences – we would expect the market to use up resources to the best available way and to the best available level.”
But this sort of price adjustment is precisely what does not happen in modern capitalist economies. The widespread relative rigidity of prices and wages – especially downwards – is an overwhelmingly confirmed empirical fact about modern market economies.

One of the principal reasons for this is the private sector practice of administered prices and the desire of businesses to shun price wars and destructive competition. The general unwillingness of workers to accept nominal wage cuts also makes wage flexibility a permanent fact about modern economies – contrary to the fairy tales about self-adjusting, equilibrating markets.

(3) On “idle resources,” Keynesians are not referring to frictional or seasonal unemployment or deliberate failure to use capital goods because of mere “seasonal” factors (say, the winding down of summer tourism industries during the winter or when seasonal demand is in a slack phase).

Idle resources are, above all, those factors such as capital or labour which are not used during recessions because of an aggregate demand failure, even though workers and capitalists do wish to use their resources and earn money.

At any rate, Manish admits that in recessions many capital goods might indeed be “economically idle,” but his explanation of recessions as only caused by interference in markets is totally unconvincing, not least of all because he never even refuted Keynes’ explanation of the unemployment equilibrium as primarily caused by pessimistic expectations of businesses and the instability of the investment function.

Monday, November 18, 2013

Ethics in Modern Analytic Philosophy

This post is based on Chapter 8 of Stephen P. Schwartz’s A Brief History of Analytic Philosophy: from Russell to Rawls (2012). I also draw on some of my earlier posts, and discuss the influence of George E. Moore on John Maynard Keynes.

For a long time, George E. Moore’s Principia ethica (Cambridge, 1903) – mainly a work of metaethics – was the most influential treatise on ethics in analytic philosophy. Under the influence of logical positivism, ethical statements were widely considered either not to be objectively true or to not have cognitive content at all (that is, to not have a true or false value) (Schwartz 2012: 264).

One of Moore’s most important conclusions was that the concept of “good” was a simple, non-natural and indefinable property (Schwartz 2012: 266–267). Nevertheless, our notions of the “good” are apprehended by our moral intuitions (Schwartz 2012: 267).

According to Moore, all naturalist ethical theories commit the “naturalistic fallacy,” which is the attempt to equate “goodness” with a natural property (Schwartz 2012: 268).

Note that the “naturalistic fallacy” is not simply a crude fallacy called the “appeal to nature,” which is the assertion that what is natural is therefore inherently moral. Nor is the “naturalistic fallacy” the same as Hume’s “is–ought” problem.

Moore’s “naturalistic fallacy” consists in the fallacy of identifying the property of goodness with some natural property or thing.

For example, one could say:
(1) Pleasure is good.
This is a proposition, but it has two possible meanings, as follows:
(1) Pleasure is a thing that has the independent property of being good.

(2) Pleasure is identical with the concept “good.” That is, they are one and same thing.
In order to understand what Moore means, we must understand the somewhat confusing grammatical differences in the way the word “is” is used in English.

The verb “is” has 3 possible grammatical uses in English:
(1) to convey identity, e.g., “He is John” (They are one and same thing);

(2) predication (as the so-called copula or linking verb), e.g., “This desk is white” (that is, this desk has the property of being “white,” but obviously the “desk” per se is simply not the same thing as “white”), and

(3) existence or being, e.g., “There is a high mountain two miles from here” (that is, there exists a mountain that is two miles from this location).
Just because we can use the word “good” with “is” in sense (2), Moore says, it does not follow that anything supposedly having the property goodness can be identified with the “good” in sense (1) (that is, identity). To assert that anything natural x is actually identical with the “good” in sense (1) is the “naturalistic fallacy.”

As noted above, Moore therefore contends that the “good” is an ineffable and non-natural property, even though Moore did think the “good” was real and that good and bad conduct has a rational basis: Moore thought that personal affection and appreciation of the beautiful are intrinsically good (Schwartz 2012: 268–269).

Moore thought that actions that create the most good are right, but that people cannot necessarily know which actions these are (Schwartz 2012: 269).

Moore’s Principia ethica greatly influenced the Bloomsbury Group and John Maynard Keynes (Schwartz 2012: 269). Keynes in particular was concerned with how we can have knowledge of the consequences of our actions in order to produce morally good ends, and the epistemological status of this knowledge and how it is acquired (Skidelsky 1983: 151). Keynes’s answer was that our knowledge must be probabilistic, since we cannot obtain certainty in knowing all future consequences of actions in the present (Skidelsky 1983: 151). Keynes’ interest in this subject dates from a paper he read to the Cambridge Apostles group called “Ethics in Relation to Conduct” (delivered on 23 January, 1904).

Thus Keynes’ concern with consequentialist ethics, via Moore, was the great inspiration of Keynes’ work on probability theory that occupied much of his spare time between 1906 and 1914, and that resulted in the Treatise on Probability (1921) (Skidelsky 1983: 151–152). Keynes contended that we cannot have certain knowledge of the future, especially the far future, and that non-objective probabilistic arguments should be used to defend ethical actions (Skidelsky 1983: 153).

Nevertheless, to return to the main subject, it is far from clear that Moore was right in his fundamental views on ethics, and analytic philosophers still debate Moore’s arguments (Schwartz 2012: 268).

A fundamental distinction between modern ethical theories is that between (1) cognitivist and (2) non-cognitivist theories, which can set out as follows:
(1) Non-cognitivism
(1) Emotivism (Spinoza, Hume, C. L. Stevenson, A. J. Ayer)
(2) Prescriptivism (R. M. Hare)
(3) cognitivist expressivism (S. Blackburn; M. Timmons; T. Horgan)
(2) Cognitivism
(i) Anti-realism
(a) Moral subjectivism
(b) Error theory

(ii) Moral realism
(a) Ethical naturalism
Non-theological natural rights theory
neo-Aristotelian ethical naturalism (P. Foot; R. Hursthouse)

(b) Ethical non-naturalism
G. E. Moore ethical intuitionism/agathistic consequentialism
Platonist ethics
divine command ethics
Kantian ethics
The cognitivist theories of ethics – which include most of the historical normative ethical theories – hold that moral statements do have real cognitive content and can be true or false (either in an objective or subjective sense).

The non-cognitivist theories of ethics contend that moral statements do not actually express propositions and have no truth values, and instead have a non-cognitivist, emotive or imperative meaning. That is to say, an ethical statement expresses an emotive judgement or attitude of approval or disapproval towards an action or idea.

This “emotivist” view of ethics was taken by some of the logical positivists, such as A. J. Ayer.

Another non-cognitivist theory of ethics is the prescriptivism of Richard M. Hare (1919–2002), who was an Oxford philosopher under the influence of post-WWII ordinary language philosophy (Schwartz 2012: 272). According to prescriptivism, the moral statement is really a special kind of command (or imperative). Sentences with the word “ought” (“You ought not to steal”) really conceal an imperative, a command.

The conclusion of R. M. Hare is that a moral statement is not really a declarative sentence that can carry a truth value (that is, being either true or false). We are mistaken in thinking this. Moral statements are really just commands, and they urge action. Many moral injunctions are really universalisable imperatives (Schwartz 2012: 274). That is, they invoke types or kinds and are addressed to the world at large, to people in general.

Hare also argued that moral action can be debated rationally because moral discourse is fundamentally about logic of imperatives and how to achieve ends (Schwartz 2012: 274).

From the 1960s onwards, substantive normative ethics experienced a rebirth in analytic philosophy (Schwartz 2012: 264).

The first development was the counterargument that Moore’s naturalistic fallacy is not a logical fallacy at all, and that his “open question” argument is seriously inadequate (Schwartz 2012: 275).

Foot (1958), for example, contended that definitions of the “good” cannot be arbitrary and people can readily identify definitions of the good based on self-interest as unsatisfactory. The “good” can be connected with things that are worthwhile, beneficial or valuable in a general or universal way (Schwartz 2012: 277).

The next obstacle to an analytic normative ethics was the “fact” versus “value” dichotomy (Schwartz 2012: 279), a divide which was challenged by Philippa Foot.

The results of these new criticisms of older ethical ideas led analytic philosophers to return to normative ethics and applied ethics by the late 20th century (Schwartz 2012: 280–281).

For example, new forms of consequentialism have been proposed, and Philippa Foot and G. E. M. Anscombe have developed a modern form of virtue ethics (inspired by Aristotle), which emphasises moral character rather than moral “oughts” (Schwartz 2012: 280).

John Rawls (1921–2002) developed a form of human rights ethics in terms of a social contract theory in A Theory of Justice (1971), which sought to reconcile elements of Kantian ethics with utilitarianism, while overcoming the shortcomings of them both (Schwartz 2012: 285–286). Rawls’s ethics has also been criticised and developed by Martha Nussbaum.

But, by the end of the 20th century, anti-realism in ethics made a return in analytic philosophy. Moral fictionalism is the idea that all moral claims either do not have truth values or are false: morality is thus a useful fiction (Schwartz 2012: 317).

In short, modern analytic philosophy has explored a wide range of normative ethical theories, as well as criticising traditional ethics.

Foot, Philippa R. 1958. “Moral Arguments,” Mind 67: 502–513.

Moore, George Edward. 1903. Principia ethica. Cambridge University Press, Cambridge.

Rawls, John. 2005 [1971]. A Theory of Justice. Belknap Press, Cambridge, Mass.

Schwartz, Stephen P. 2012. A Brief History of Analytic Philosophy: From Russell to Rawls. Wiley-Blackwell, Chichester, UK.

Skidelsky, R. J. A. 1983. John Maynard Keynes: Hopes Betrayed 1883–1920 (vol. 1). Macmillan, London.

Sunday, November 17, 2013

Downward and Lee on Blinder’s Asking about Prices

Downward and Lee (2001) provide a critical review of Blinder’s now classic Asking about Prices: A New Approach to Understanding Price Stickiness (New York, 1998).

Downward and Lee show that Blinder’s findings are better explained by Post Keynesian price theory, as opposed to New Keynesian theory.

Except for the most irrelevant types of general equilibrium theory, the existence of sticky prices is a widespread “stylised fact” even in mainstream economics (Downward and Lee 2001: 466).

Downward and Lee note that the merit of Blinder’s Asking about Prices is that it rejects questionable econometric methods for a direct well sampled survey of 200 US businesses and managers in interviews and questionnaires (Downward and Lee 2001: 466–467).

Blinder found that about 72% of firms changed product prices less than four times a year, with 45% reviewing their prices only once a year (Downward and Lee 2001: 468):
“Although there is a small ‘auction-market’ sector in the U.S. economy, there certainly appears to be enough price rigidity in most sectors to matter for macroeconomic purposes. According to the survey results, the typical commodity is repriced roughly once a year: and more than 75 percent of GDP is repriced quarterly or less frequently. The mean lag between shifts in supply or demand and the eventual response of prices is about three months; but there is huge variability across firms.

Prices appear to be most sticky in the service sector (which is, of course, the majority of the economy) and least sticky in wholesale and retail trade.” (Blinder et al. 1998: 105).
About 85% of business sales were from repeat customers (Downward and Lee 2001: 469). Moreover, 89% of firms reported that marginal costs either declined or were constant as output changed (Downward and Lee 2001: 469) and over 50% of firms said that they would not increase their prices when demand increased (Downward and Lee 2001: 476).

More importantly, Blinder et al. found the causes of price stickiness that received the most support – as reported by business-people themselves – were cost-based pricing, coordination failure, nonprice competition, and implicit contracts (Downward and Lee 2001: 469; Blinder et al. 1998: 304). Cost-based pricing received an acceptance rate of over 50% (Downward and Lee 2001: 469).

Downward and Lee point out that Blinder et al.’s findings discredit their own assumption that most firms seek to maximise profits in the neoclassical sense (Downward and Lee 2001: 476).

Despite Blinder’s misgivings about how representative Hall and Hitch’s earlier sample was in their research into pricing behaviour in the UK (Hall and Hitch 1939), Downward and Lee (2001: 478) argue that Blinder et al. have actually confirmed Hall and Hitch’s conclusions that most firms base pricing decisions on mark-up and full cost pricing systems, and that firms are so greatly concerned with customer goodwill that they feel frequent price changes will betray this and alienate their client base – an insight also made long ago by Nicholas Kaldor (1985: 26, 19–21).

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

Downward, Paul and Frederic Lee. 2001. “Post Keynesian Pricing Theory ‘Reconfirmed’? A Critical Review of Asking about Prices,” Journal of Post Keynesian Economics 23.3: 465–483.

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

Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.

Saturday, November 16, 2013

Two Marketing Studies on US Administered Prices

Two useful studies from accounting and marketing research – as opposed to economics – provide interesting empirical data on “full cost” pricing, a type of administered price, in the US:
Govindarajan, V. and R. Anthony. 1986. “How Firms use Cost Data in Price Decisions,” Management Accounting 65: 30–34.

Shim, Eunsup, and Ephraim Sudit. 1995. “How Manufacturers Price Products,” Management Accounting 76.8: 37–39.
Govindarajan and Anthony (1986) conducted a survey in which over 500 US industrial companies answered a questionnaire on how they set prices. They found that 85% of companies surveyed used full cost pricing (Govindarajan and Anthony 1986: 31), and, in contrast to conventional marginalist theory, most businesses certainly do take account of fixed and allocated costs: therefore “sunk costs” are important in determining the administered price.

Govindarajan and Anthony also found that relatively few business managers could estimate the demand curve for their product: that is, an estimate of the quantity that would be demanded at a particular price (Govindarajan and Anthony 1986: 32).

Shim and Sudit (1995: 37) – the next study – conducted a survey in 1993 of US industrial companies, and found that 69.5% used full cost pricing.

Both surveys, then, suggest that from the 1980s to the 1990s full cost pricing accounted for roughly 70% to 85% of US industrial prices.

These findings have shocked neoclassical economists, who resort to special pleading to explain such price setting away as a kind of “irrational” behaviour by managers and firms (e.g., Al-Najjar, Baliga, and Besanko 2008).

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.

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

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

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

Galbraith on US Federal Debt

A short but good interview with James Galbraith here on the nature of the US federal debt, fiat money and trade deficits.

Friday, November 15, 2013

Robert Murphy at Sea on MMT

The Austrian economist Robert Murphy was recently interviewed on MMT:
“Tom Woods Talks MMT With Me,” Free Advice, 14 November, 2013. (You can access interview from this post).
Like most of his other efforts, it ends in disaster.

Murphy tells us that he understands the point of MMTers that the government is not revenue constrained, yet his major attempt to refute MMT is an analogy (from 14.05) where he just assumes that the government is like a private household. The analogy also bizarrely assumes that government deficit spending is not just immoral but criminal, in a totally absurd example of begging the question by assuming the truth of libertarian ethics.

Murphy is also committed to the flawed and unrealistic Austrian theory of price inflation. He seems oblivious of any of the empirical evidence on administered prices and the way that demand drives private sector output and employment.

Murphy is also guilty of astonishing intellectual inconsistency. At 22.43 onwards, Murphy’s explanation of recessions and idle resources invokes the Austrian business cycle theory (ABCT) that he himself says is grossly flawed by its reliance on the Wicksellian natural rate of interest (see Murphy 2003). But both the arguments of Murphy’s PhD and this paper are conveniently forgotten as he preaches to the choir and invokes the ABCT – and blames the lowering of the rate of interest below its natural rate – as the explanation of recessions.

Here is a man who tells us that he agrees with John Maynard Keynes that interest rates are a monetary phenomenon, but then in this interview throws that to the wind and requires that the interest rate is a real phenomenon caused by loanable funds and the real forces of productivity and thrift, despite the fact that his other published writings logically require a rejection of both ideas.

Further evidence of Murphy’s hapless inability to understand MMT – or even Keynesianism – is Murphy’s implied belief (from 24.58) that he thinks that MMTers or Keynesians wish to stop or abolish all frictional or seasonal unemployment. That is just rubbish.

One can note that the interviewer – one Tom Woods – is even more ignorant and incapable of understanding MMT or the theories underlying it.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest. PhD dissert., Department of Economics, New York University.

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”

A Bibliography on Austrian Price Theory

Since I have been concerned with Post Keynesian price theory in recent months, here below is a short bibliography of Austrian price theory for the interested reader.

Austrian price theory – like the worst forms of neoclassical price theory – is flawed by its inability to understand real world administered price setting and the consequences of this.

High, J. 1994. “The Austrian Theory of Price,” in Peter J. Boettke (eds.), The Elgar Companion to Austrian Economics. E. Elgar, Aldershot. 151–155.

Miller, Stephen C. 2010. “Price: The Ultimate Heuristic,” in Peter J. Boettke (ed.), Handbook on Contemporary Austrian Economics. Edward Elgar, Cheltenham and Northampton, Mass. 67–76.

Callahan, Gene. 2004. Economics for Real People. Ludwig von Mises Institute, Auburn, Ala.

Taylor, Thomas C. 1980. An Introduction to Austrian Economics. Ludwig von Mises Institute, Auburn, Ala. pp. 52–62.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition. Cambridge University Press, Cambridge and New York.

Endres, A. M. 1995. “Carl Menger’s Theory of Price Formation Reconsidered,” History of Political Economy 27.2: 261–287.

Endres, A. M. 1997. Neoclassical Microeconomic Theory: The Founding Austrian Vision. Routledge, London. 60–84.

Kirzner, I. 1978. “The Entrepreneurial Role in Menger’s System,” Atlantic Economic Journal 6.3: 31–45.

Menger, C. 2011. Principles of Economics (trans. Grundsätze der Volkswirtschaftslehre [1st edn. 1871] by J. Dingwall and B. F. Hoselitz), Terra Libertas, Eastbourne, UK. pp. 191–225.

Moss, L. S. 1978. “Carl Menger’s Theory of Exchange,” Atlantic Economic Journal 6: 17–29.

Streissler, E. 1972. “To What Extent was the Austrian School Marginalist?,” History of Political Economy 4.2: 426–461.

Tieben, Bert. 2012. The Concept of Equilibrium in Different Economic Traditions: An Historical Investigation. Edward Elgar, Cheltenham, UK and Northampton, MA. pp. 315–319.

Böhm-Bawerk, Eugen von. 1930 [1891]. The Positive Theory of Capital (trans. William Smart). G. E. Stechert & Co. New York. pp. 193–234.

Mises, L. von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Mises Institute, Auburn, Ala. pp. 201–232, 324–394.

Rothbard. M. 2009. Man, Economy, and State: A Treatise on Economic Principles. Scholar’s Edition (2nd edn.), Ludwig von Mises Institute, Auburn, Ala. pp. 103–317.

Kirzner, Israel M. 1985. “Prices, the Communication of Knowledge, and the Discovery Process,” in Kurt R. Leube and Albert H. Zlabinger (eds.), The Political Economy of Freedom: Essays in Honor of F.A. Hayek. Philosophia Verlag, Munich. 193–206.

Kirzner, Israel M. 2000. The Driving Force of the Market: Essays in Austrian Economics. Routledge, London and New York.

Kirzner, Israel M. 2007 [1963]. Market Theory and the Price System. Ludwig von Mises Institute, Auburn, Ala.

Greaves, Bettina B. 1984. Free Market Economics: A Syllabus. Foundation for Economic Education, Irvington-on-Hudson, NY. pp. 37–53.

Shapiro, Milton M. 1985. Foundations of the Market Price System. University Press of America, Inc. Lanham, MD and London.

Monday, November 11, 2013

US Capacity Utilisation is Historically low

According to this graph (open in a new window to view it properly), the US stimulus restored capacity utilisation from the worst plunge in the data shown, but nevertheless it is still relatively low by recent historical standards, which indicates that the US is far from full employment.

Just look at where the rate was back in last booms of the golden age of capitalism (1946–1973): close to 90%. Even the Clinton boom years had a higher rate than now.

The lesson is not that stimulus does not work (look at the V shaped recovery), but that more is necessary. Much more.

IS-LM and Endogenous Money

An interesting discussion here from Steve Keen on loanable funds versus endogenous money in economic models, and a recent comment by Paul Krugman about IS-LM and endogenous money:
Steve Keen, “IS-LM (with endogenous money),” Debtwatch, November 5, 2013.

Sunday, November 10, 2013

Böhm-Bawerk had No Theory of Administered Prices

Occasionally Austrian economists or internet Austrians assert that the theory of administered prices (whether normal cost, mark-up or target rate of return pricing) was actually anticipated or pioneered by Eugen von Böhm-Bawerk.

It is alleged that The Positive Theory of Capital was the source of this, but a reading of the relevant sections of that book shows no such thing. Böhm-Bawerk had no theory of administered or mark-up pricing as this is understood in Post Keynesian economics.

On the contrary, Böhm-Bawerk’s “law of costs” and statements about the role of costs of production in determining prices are marginalist in nature (perhaps with some influence from Classical Economics).

In Book IV, Chapter VII (“The Law of Costs”) of The Positive Theory of Capital, Böhm-Bawerk shows us quite clearly that he had no understanding of mark-up pricing as in Post Keynesianism, and that his idea that, in the long-run, prices will tend to equal costs is nothing but standard Classical Political Economy reborn in Austrian marginalist theory:
“In the sphere of price, as in the theory of subjective value, we find a law firmly rooted in economic literature and accredited by common experience. It tells us that the market price of goods reproducible at will tends to equalise itself, in the long-run, with Costs of Production. The following perfectly valid line of argument is usually adduced in proof of this. The market price of goods reproducible at will cannot, in the long-run, be maintained either much above or much below their cost. If at any time the price of an article rises appreciably above the cost, its production will be particularly profitable to the undertakers. This will not only induce the latter to extend their already nourishing businesses, but will encourage new undertakers to enter the same remunerative branch of industry. Thus the amount of product brought to market will be increased, and finally—according to the law of supply and demand—a fall in price will ensue. If, conversely, at any time the market price falls below costs, continued production will show a loss; many undertakers will reduce their output; the supply of the commodities will be reduced; and this, finally, in virtue of the law of supply and demand, must lead to a raising of the market price.

Round this law of costs has gathered a great mass of theoretical detail, which may, for our purposes, be left entirely on one side. Our whole interest is centred in the question as to the position which the law, so well accredited by experience, takes in the systematic theory of price. Does it run counter to our law of marginal pairs or not ?

Our answer is that it does not. It is as little of a contradiction as we before found to exist between the proposition that the marginal utility determines the height of subjective value, and the other proposition that the costs determine it. The line of thought which, in both cases, leads to the solution of the apparent contradiction is the same, feature for feature; except that, in the present case, in virtue of the intervention of exchange,—in virtue, that is, of the translation of the phenomena out of individual economy into social economy,—there appear richer developments at every station on the line of thought.

In what follows I shall try, as briefly and clearly as possible, to describe the concatenation between Value, Price, and Costs; and I think I am not exaggerating when I say that, to understand clearly this connection, is to understand clearly the better part of Political Economy.

The formation of value and price takes its start from the subjective valuations put upon finished products by their consumers. These valuations determine the demand for those products. As supply, over against this demand, stand, in the first instance, the stocks of finished commodities held by producers. The point of intersection of the two-sided valuations, the valuation of the marginal pairs, determines, as we know, the price, and, of course, determines the price of each kind of product separately. Thus, for instance, the price of iron rails is determined by the relation of supply and demand for rails; the price of nails, by the relation of supply and demand for nails; and, similarly, the price of every other product made out of the productive good iron—such as spades, ploughshares, hammers, sheet-iron, boilers, machines, etc.—is determined by the relation between the supply and demand which obtains for these special kinds of products.” (Böhm-Bawerk 1930: 223–224).
This is nothing but the view that (1) prices tend to be determined by supply and demand and (2) entrepreneurial competition will, in the long run, tend to eliminate profits and losses and drive prices to the costs of production. Furthermore, I see no evidence that Böhm-Bawerk’s expression “costs of production” means anything other than “marginal cost”: that is, the idea that there is a tendency for marginal cost and market price to be equalised.

But that is not administered pricing theory at all. On the contrary, real world mark-up pricing and imperfect competition mean that there cannot be any strong tendency towards a uniform rate of profit or zero profits in a modern capitalist economy (Lee 1998: 226, n. 17). Administered prices are set on average costs of production, not on marginal costs (which many businesses regard as of little interest or irrelevant).

The average costs of production in mark-up prices are direct factor input costs and overhead costs. Businesses then add a profit mark-up to this, and often the set the price of a good before the sale or even production takes place. The administered price is therefore not set by some haggling process between buyers and sellers or in an auction-like market.

The main point of Austrian price and value theory appears to be that costs of production do not determine the utility of a good: that is, the costs of production do not cause or determine the subjective value derived by a consumer from the consumption of a good, since the utility in this sense is subjective and variable between people. But this idea is perfectly consistent with administered price theory and in no way contradicts it, since the latter is a theory of price and not subjective value per se.

The confusion about what early Austrians said seems related to the statements about administered prices in George Reisman’s Capitalism: A Treatise on Economics (1996), where administered prices are mentioned on p. 417 in a context that suggests that Böhm-Bawerk somehow anticipated the doctrine.

But Böhm-Bawerk did no such thing.

Böhm-Bawerk, Eugen von. 1930 [1891]. The Positive Theory of Capital (trans. William Smart). G. E. Stechert & Co. New York.

Catalán, Jonathan Finegold. 2012. “Something to Ponder,” Economic Thought, 30 April

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

Reisman, George. “A Little Known Essential Aspect of Austrian Economics: Böhm-Bawerk and Wieser on the Determination of Price by Cost of Production,”

Reisman, George. 1996. Capitalism: A Treatise on Economics. Jameson Books, Ottawa, Ill. and Chicago.