Saturday, January 18, 2014

Downward’s Pricing Theory in Post-Keynesian Economics: Chapter 3

Chapter 3 of Paul Downward’s Pricing Theory in Post-Keynesian Economics: A Realist Approach (Cheltenham, UK, 1999) provides an assessment of Post Keynesian price theory, a review of the literature, and identifies the fundamental theoretical core of this price theory.

Downward provides a literature review of a sample of the work on mark-up prices – beginning with the early literature – including the studies of Gardiner C. Means; R. L. Hall and C. J. Hitch; P. W. S. Andrews; Michał Kalecki; Athanasios Asimakopulos; K. Cowling and M. Waterson and Alfred Eichner.

This is a very useful part of Downward’s book and I will summarise it below.
(1) Gardiner C. Means
Berle, Adolf A. and Gardner C. Means. 1932. The Modern Corporation and Private Property. Macmillan, New York.

Means, G. C. 1992 [1933]. “The Corporate Revolution,” in Frederic S. Lee and Warren J. Samuels (eds.), The Heterodox Economics of Gardiner C. Means: A Collection. M.E. Sharpe, Armonk, N.Y.

Means, G. C. 1935. Industrial Prices and their Relative Inflexibility. US Senate Document no. 13, 74th Congress, 1st Session, Government Printing Office, Washington DC.

Means, G. C. 1936. “Notes on Inflexible Prices,” American Economic Review 26 (Supplement): 23–35.

Means, G. C. 1939–1940. “Big Business, Administered Prices, and the Problem of Full Employment,” Journal of Marketing 4: 370–381.

Means, G. C. 1962. Pricing Power and the Public Interest. Harper and Brothers. New York.

Means, G. C. 1972. “The Administered Price Thesis Reconfirmed,” American Economic Review 62: 292–306.
Gardiner C. Means studied price setting by modern corporations in the United States, and was one of earliest and most important economists who examined mark-up pricing. He coined the term “administered pricing” to describe it.

He concluded, after extensive empirical research, that prices of goods produced in many corporations are set by administrative fiat before transactions occur. They are also set as a mark-up on cost of production (Downward 1999: 50). While administered prices might change when costs change, they are relatively inflexible with respect to demand.

Means was clear that the neoclassical price theory with its ideas of flexible prices adjusted by agents in auction or auction-like transactions is not a description of reality for most markets:
“Basically, the administered-price thesis holds that a large body of industrial prices do not behave in the fashion that classical theory would lead one to expect. It was first developed in 1934–35 to apply to the cyclical behavior of industrial prices. It specifically held that in business recessions administered prices showed a tendency not to fall as much as market prices while the recession fall in demand worked itself out primarily through a fall in sales, production, and employment.” (Means 1972: 292).

“... the actual behavior of administration-dominated prices … tends to differ so sharply from the behaviour to be expected from classical theory as to challenge the basic conclusions of that theory. However well the theory may apply to market-dominated prices, it would not seem to apply to the bulk of the administration-dominated prices in the sample or to that part of the industrial world which they typify.

Until economic theory can explain and take into account the implications of this nonclassical behavior of administered prices, it provides a poor basis for public policy. The challenge which administered prices make to classical economics is as fundamental as that made by the quantum to classical physics.” (Means 1972: 304).
(2) Hall and Hitch
Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.
The Oxford Economists’ Research Group (OERG) was a group of researchers that was instituted at Oxford University in 1936, and involved economists such as Hubert Henderson, James Meade, and George L. S. Shackle.

Hall and Hitch were part of the Oxford Economists Research Group, and their empirical research work led them to postulate the “full cost” theory of pricing. That is, the view that many prices in modern market economies are set by business people by taking variable/direct/price costs per unit as a base for the price, and then adding an allowance to cover overhead costs and finally a mark-up as a profit allowance (Downward 1999: 46).

The determinant of the percentage mark-up for profit is historically specific in each industry and often a matter of convention, even though competition does constrain the price of the same mark-up product in a particular market (Downward 1999: 46).

Hall and Hitch, then, contended that many prices were quite stable instead of normally varying with demand, were based on “full cost” (average variable costs and overhead costs), and that the mark-up and price is constrained by competition (Downward 1999: 46–47).

(3) Michał Kalecki
Kalecki, M. 1939. Essays in the Theory of Economic Fluctuations. Allen and Unwin, London.

Kalecki, M. 1939–1940. “The Supply Curve of an Industry under Imperfect Competitions,” Review of Economic Studies 7: 91–112.

Kalecki, M. 1954. Theory of Economic Dynamics. Allen and Unwin, London.

Kalecki, M. 1971. Selected Essays on the Dynamics of the Capitalist Economy. Cambridge University Press, Cambridge.
Michał Kalecki’s work on prices shows an evolution over the course of his life. In some respects, his theory was not wholly divorced from marginalism. Hall and Hitch’s work influenced Kalecki’s views on prices (Downward 1999: 51).

Kalecki (1939) treats mark-up prices as set by means of production costs and profit. He also noted the important role of excess capacity in industries.

In Kalecki (1954 and 1971), he developed his theory of prices. He divided prices in market economies into two types, as follows:
(1) cost determined prices; and

(2) demand determined prices.
Most finished goods are cost determined, while many raw materials and primary commodities are demand determined (that is, flexprice markets).

Most manufactured goods have prices that are cost determined. Prices are set under conditions of uncertainty and, crucially, profits are not, strictly speaking, maximised in the neoclassical sense (Downward 1999: 52).

(4) P. W. S. Andrews
Andrews, P. W. S. 1949 “A Reconsideration of the Theory of the Individual Business,” Oxford Economic Papers n.s. 1.1: 54–89.

Andrews, P. W. S. 1949a. Manufacturing Business. Macmillan, London.

Andrews, P. W. S. 1964. On Competition in Economic Theory. Macmillan, London.
P. W. S. Andrews was a member of the Oxford Economists’ Research Group (OERG), and his work was a great influence on Eichner.

Andrews coined the term “normal cost” pricing, even though this was used synonymously with “full cost” pricing (Downward 1999: 47).

Andrews argued that it was normal for many firms to have excess capacity, a constant average variable/direct/prime curve, and that use of excess capacity is a phenomenon designed to meet uncertain changes in market conditions (Downward 1999: 47).

Generally, changes in costs related to changes in scale of output (say, overtime payments) will not normally change the price since as output rises total average costs fall (Downward 1999: 48).

The mark-up for profit is calculated at a planned or expected quantity of output. Of course, actual sales will determine the actual profit margin and profit mark-up in any given accounting period, but if sales fall below the expected quantity, this does not even necessarily result in price changes. Many businesses will set a projected output/sales level, base their price on this quantity, and maintain the price despite changes in demand: the normal rule is that the price is set and demand is met at that price from inventories or excess capacity (Downward 1999: 49).

Mark-up pricing is normal even in markets where competition exists, or, that is, “irrespective of the degree of competition which the firm has to meet” (Andrews 1949: 58–59). When firms wish to increase market share, it will often be by means of superior quality and reputation, rather than price cuts (Downward 1999: 50).

(5) Athanasios Asimakopulos
Asimakopulos, A. 1975. “A Kaleckian Theory of Income Distribution,” Canadian Journal of Economics / Revue canadienne d’Economique 8.3: 313–333.
Asimakopulos’s work as cited by Downward is more a refinement of Kalecki’s theory (Downward 1999: 55), with an amended pricing equation and the observation that many mark-up businesses face a price leader that constrains price.

(6) K. Cowling and M. Waterson
Cowling, Keith, and Michael Waterson. 1976. “Price-Cost Margins and Market Structure,” Economica 43.171: 267–274.
Cowling and Waterson (1976) represents an attempt to develop Kalecki’s work on pricing and the mark-up, but seems of doubtful importance to modern Post Keynesian economics, since it retains core features of neoclassical theory (Downward 1999: 57).

(7) Alfred Eichner
Eichner, A. S. 1973. “A Theory of the Determination of the Mark-up under Oligopoly,” Economic Journal 83.332: 1184–1200.

Eichner, A. S. 1976. The Megacorp and Oligopoly. Cambridge University Press, Cambridge.

Eichner, A. S. 1980. “A General Model of Investment and Pricing,” in E. J. Nell (ed.), Growth, Profits and Property. Cambridge University Press, Cambridge.

Eichner, A. S. 1991. The Macrodynamics of Advanced Market Economies. M. E. Sharpe, New York.
Alfred Eichner’s pricing theory was intended as a model for the core corporate oligopolistic sector of the US economy and sought to develop Kalecki’s work.

Eichner argued that one important purpose of mark-up prices was to enable firms to finance investment and long run growth (Downward 1999: 58), and Eichner treats corporate dividends as part of fixed costs (Downward 1999: 58).
Downward’s conclusion after a review of this literature is that the work of Cowling and Waterson, Asimakopulos and Eichner cannot be regarded as part of the “core” of Post Keynesian price theory, because they “share essential characteristics of the neoclassical approach in terms of their core assumptions” (Downward 1999: 60).

In contrast, the work of Gardiner C. Means, R. L. Hall and C. J. Hitch, P. W. S. Andrews, and Michał Kalecki is regarded by Downward as fundamentally sound and a foundation for Post Keynesian price theory, even though they all still retain some mistaken marginalist ideas and their theories can be invoked by neoclassicals in a misleading way (Downward 1999: 62–63).

What, then, is the core of Post Keynesian mark-up pricing theory, as argued by Downward?

It is the following:
(1) mark-up prices are set by businesses in an ex ante manner before trade and transactions to achieve objectives in an uncertain world, such as financing for investment;

(2) they are set by a convention involving calculation of average unit variable/direct costs and average overhead/fixed costs plus profit mark-up;

(3) prices are likely to change from cost changes, not demand changes, but they do not “automatically” rise just because cost changes happen.
Downward, Paul. 1999. Pricing Theory in Post-Keynesian Economics: A Realist Approach. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

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