“The basis of current doctrine on the price and output policy of the entrepreneur is that he expands production to the point where marginal revenue and marginal cost are equal. In the special case of perfect (or ‘pure’) competition in the market for the product, marginal revenue is equal to price, to which marginal cost is equated. In the special case of pure competition in the market for the factors, marginal cost is equal to the cost of the additional factors necessary to expand output by one unit, and this is equated to marginal revenue. In all other cases (except where discriminating prices may be charged), marginal revenue is less than price, and marginal cost is greater than the cost of additional factors, and the only rule of equilibrium within the firm is that marginal revenue and marginal cost are equated.” (Hall and Hitch 1939: 13).The problem continues in the most recent empirical studies, where the concept of “marginal cost” has to be re-expressed because “most businesspeople might not easily understand this terminology”! (Fabiani et al. 2006: 16).
“For the above analysis to be applicable it is necessary that entrepreneurs should in fact: (a) make some estimate (even if implicitly) of the elasticity and position of their demand curves, and (b) attempt to equate estimated marginal revenue and estimated marginal cost. We tried, with very little success, to get from the entrepreneurs whom we saw, information about elasticity of demand and about the relation between price and marginal cost. Most of our informants were vague about anything so precise as elasticity, and since most of them produce a wide variety of products we did not know how much to rely on illustrative figures of cost. In addition, many, perhaps most, apparently make no effort, even implicitly, to estimate elasticities of demand or marginal (as opposed to average prime) cost; and of those who do, the majority considered the information of little or no relevance to the pricing process save perhaps in very exceptional conditions.” (Hall and Hitch 1939: 18).
Also of interest is what Keynes said in 1939, apparently from his own knowledge of the Oxford Economists’ Research Group’s (OERG) findings (which Hall and Hitch were themselves dependent on):
“Indeed, it is rare for anyone but an economist to suppose that price is predominantly governed by marginal cost. Most business men are surprised by the suggestion that it is a close calculation of short-period marginal cost or of marginal revenue which should dominate their price policies. They maintain that such a policy would rapidly land in bankruptcy anyone who practised it.” (Keynes 1939: 46).
Fabiani, S., M. Druant, I. Hernando, C. Kwapil, B. Landau, C. Loupias, F. Martins, T. Mathä, R. Sabbatini, H. Stahl and A. Stokman. 2006. “What Firms’ Surveys tell us about Price-Setting Behavior in the Euro Area,” International Journal of Central Banking 2.3: 3–47.
Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.
Keynes, J. M. 1939. “Relative Movements of Real Wages and Output,” The Economic Journal 49.193: 34–51.