Sunday, November 3, 2013

Lavoie on Mark-up Pricing in Neoclassical Theory

Marc Lavoie writes here:
“While Post Keynesians have long endorsed cost-plus pricing, mainstream economists have recently begun to make use of markup pricing. Mainstream authors … usually point out that a markup over unit variable costs is consistent with profit maximization – the markup depends on the elasticity of demand and is set to equate marginal cost and marginal revenue. This interpretation can also be found in some earlier works of Kalecki and has been endorsed by Cowling (1982). On this view markup pricing appears to be profit maximization under conditions of imperfect competition, in a trial-and-error disguise.

There are two responses to this claim. First, a number of authors have pointed out that demand elasticities computed in empirical studies are inconsistent with this profit-maximizing interpretation of markup pricing. In particular, Koutsoyiannis (1984) found that for most industries the price-elasticity of demand is below one. This implies that marginal revenue is negative, which contradicts the hypothesis of profit maximization, for marginal costs cannot be negative. Second, accounting studies and economic surveys have shown that the most frequent pricing procedure is normal-cost pricing. But normal-cost pricing, in its modern incarnation, takes unit fixed costs or unit overhead costs into account, and not just marginal or variable costs. Normal cost-pricing and target-return pricing are thus incompatible with profit-maximizing neoclassical theories, since the latter presume that overhead costs or fixed costs play no role in the determination of prices.” (Lavoie 2001: 25).
The lesson is to beware of neoclassical re-interpretations of administered pricing.

One must not confuse the neoclassical concept of marginal costs with average costs of production per unit. The two are not the same thing.

And, above all, the administered pricing behaviour of many firms is inconsistent with the idea of profit-maximisation in neoclassical theory.

Koutsoyiannis, A. 1984. “Goals of Oligopolistic Firms: An Empirical Test of Competing Hypotheses,” Southern Economic Journal 51.2: 540–567.

Lavoie, M. 2001. “Pricing,” in Richard P. F. Holt and Steven Pressman (eds.), A New Guide to Post Keynesian Economics. Routledge, London and New York. 21–31.


  1. Uhm, so "number of authors" equals one? And by the way, Koutsoyiannis paper depends on the assumption that market elasticity is the same as firm elasticity, i.e. industries operate de-facto as monopolies, which seems rather unrealistic. See: Dickson, V. A. (1986). Goals of Oligopolistic Firms: Comment. Southern Economic Journal, 52(4), 1151.

    1. "Uhm, so "number of authors" equals one?"

      Not at all. There are numerous studies:

      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.

      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.

      Hall, S., Walsh, M. and A. Yates. 2000. “Are UK Companies’
      Prices Sticky?,” Oxford Economic Papers 52.3: 425–446.

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

    2. All these papers deal with price stickiness, not profit maximization per se. The fact that firms change prices only infrequently doesn't automatically mean they're not profit maximizers. Stickiness might be explained as firm's optimal decision in face of fixed adjustment costs or information frictions.

    3. The New Keynesian explanations of price stickiness such as menu costs, nonprice competition, and costly information problems --- which you refer to here -- are simply not well supported by the empirical evidence.

      See Melmiès, J. 2010. “New-Keynesians Versus Post-Keynesians on the Theory of Prices,” Journal of Post Keynesian Economics 32.3: 445-466, at p. 453.

  2. I would have thought the most obvious response to the old Kaleckian/Robinsonian argument from the 1930s would be the surveys undertaken of firms like Alan Blinder's and others from decades ago. They all definitely show that most firms do not think of themselves as setting MR = MC.

  3. Is the point here that firms do not, in fact, seek to maximise profits or simply that profit maximisation cannot be adequately explained using concepts of marginal cost and marginal revenue?

    1. Both. The points are that administered price businesses (using full cost and mark-up pricing) do not equate price and marginal revenue with marginal cost, and that such firms do not maximise profits in the neoclassical sense.

    2. In saying that firms do not maximise profits, you use the caveat "in the neo-classical sense". Does that mean that you think there is a different sense in which they do maximise profits?

    3. It is would be better to say that administered prices are used to actively create and stabilise profits -- and help to reduce uncertainty associated with the level of profits.

  4. I know it's standard for economists to reverse the sign of the PED, but within the context of this article it was particularly confusing.

  5. UE, he's not reversing the sign, he just gets it wrong. For some reason Lavoie seems to think that an elasticity of less than one implies a negative marginal revenue. It doesn't. Judging by the overall quality of Lavoie's paper I somehow doubt he's referring to estimates which find positively sloped demand curves. Rather he's just confused.

    I *think* that what's he's trying to get at is that an estimate of elasticity <1 would imply that firms are pricing on the inelastic portion of their demand curve, which would indeed be inconsistent with profit max, at least for a monopoly.

    Anyway, we can check the source paper...

    (getting into JStor... searching...)

    Yup. Koutsoyiannis does not estimate positively sloped demand curves and/or elasticities which imply negative MR. Just possibly inelastic portion of demand.

    Couple things though. First that paper is based on the conjectural variation approach which has been discredited as internally inconsistent (though that was, IIRC, after this paper came out). Second, if taken at face value, the results would just imply that limit pricing is a better characterization of some market than, say, Cournot, or Bertrand. Third, as ivansml points out (and what the comment notes) oligopolistic markets are not monopolies so you can't draw the inference that the author does.

    Overall, pretty pretty thin.