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