Monday, February 10, 2020

Academic Agent on Excess Capacity

The libertarian “Academic Agent” examines the concept of excess capacity here:

First, Academic Agent is utterly wrong to claim that Austrian theory is only looking at the “price of a good across a whole economy,” and that my analysis of how real-world individual firms behave is somehow irrelevant to Austrian theory.

Austrian economics has a “Theory of the Firm,” just like Neoclassical economics, and Austrian theory says the average firm should be engaged in flexible pricing of its products, in order to clear markets and equate supply with demand.

Academic Agent’s claim that “Austrian theory…. as regards price responsivity to supply and demand does not predict the behaviour of individual firms” (at 5:33–5:36 in the video) is a bizarre and blatant falsehood. While Austrian price theory and the Austrian Theory of the Firm are of course not predicting what all firms do, they nevertheless must predict what the majority of firms do, or the average firm does, because otherwise they would be empirically false.

Austrian theory makes both prescriptive and descriptive claims about how most firms, or the average form, should be behaving.

Consider these statements by Austrian economists:
(1) “Private business prices its goods and services to ‘clear the market,’ so that supply equals demand, and there are neither shortages nor goods going unsold.” (Rothbard 2006a: 259).

(2) “… selling prices will tend toward the market-clearing level, and need not hit the mark every time the firm sets it price. Despite the firms’ lack of perfect knowledge of [demand] and [supply] conditions, they are motivated to seek market-clearing outcomes and avoid disequilibrium outcomes.

For one thing, there is the economic incentive to maximize profits. As we have seen, surplus and shortage outcomes cause the firm less profit than otherwise under the given demand and supply conditions. Thus, in the case of a surplus, the firm will have to slash its [price] below the planned level, whereas in the case of a shortage the firm has missed an opportunity for greater profits by setting its [price] too low or producing less than the market was ready to absorb.

On the other side of this coin is the fact that, of the three possible market outcomes—market-clearing, surplus, or shortage—only market-clearing outcomes validate the firm’s expectations and strengthen its confidence in its ability to judge market conditions.
In contrast, surpluses and shortages are truly disappointments—sources of regret and diminished confidence.” (Shapiro 1985: 208).
If Rothbard and Shapiro aren’t talking about the average real-world firm here, or the majority of real-world individual firms, then what the hell are they even talking about?

Furthermore, Austrian economics requires that the majority of individual real-world firms are engaging in flexible pricing to clear markets, because otherwise there would be no real-world tendency to market clearing, and towards shifting “final state of rest” equilibrium states (for Mises’ general equilibrium concept, see here).

Secondly, Academic Agent’s claim that equilibrium “does not take into account what is happening in the inventories of individual firms or at the producer-good level” is a bizarre statement.

Here is what Austrian economics has to say about inventories or buffer stocks:
(1) “Competitive prices are the outcome of a complete adjustment of the sellers to the demand of the consumers. Under the competitive price the whole supply available is sold, and the specific factors of production are employed to the extent permitted by the prices of the nonspecific complementary factors. No part of a supply available is permanently withheld from the market, and the marginal unit of specific factors of production employed does not yield any net proceed. The whole economic process is conducted for the benefit of the consumers.” (Mises 2008: 354).

(2) “We know from ‘microeconomic’ analysis that if there is a ‘surplus’ of something on the market, if something cannot be sold, the only reason is that its price is somehow being kept too high. The way to cure a surplus or unemployment of anything, is to lower the asking price, whether it be wage rates for labor, prices of machinery or plant, or of the inventory of a retailer.” (Rothbard 2006b: 44).

(3) “There is no reason why prices cannot fall low enough, in a free market, to clear the market and sell all the goods available. If businessmen choose to keep prices up, they are simply speculating on an imminent rise in market prices; they are, in short, voluntarily investing in inventory. If they wish to sell their ‘surplus’ stock, they need only cut their prices low enough to sell all of their product. But won’t they then suffer losses? Of course, but now the discussion has shifted to a different plane.” (Rothbard 2008: 56).
As we see, Austrian economics makes specific claims about buffer stocks and inventories, and they are contemptibly wrong. In real-world capitalism, firms set their mark-up price based on average unit costs of production, and then normally adjust production to match demand, while keeping inventories and significant unused capacity at factories and plants available to meet increases in demand. When demand falls, businesses fire workers and cut production.

It is absurd to say, as Austrians do, that firms aim to sell their whole supply, or that businesses only have inventory or stocks because they are “speculating on an imminent rise in market prices.”

Thirdly, the final devastating problem with this video is that, in the last few minutes, it unintentionally and rather comically sets out to refute me, but ends up confirming and vindicating my main points in Academic Agent’s points about his imaginary firm “Baker Bros.”

In essence, Academic Agent admits that his imaginary firm would cut production and employment (and hence change his variable capital and labour) to match production output to expected demand, and would not bother to cut prices to clear his supply every production cycle.

But this now raises the following issues:
(1) if the majority of real-world firms normally use relatively-inflexible cost-based mark-up prices and vary production to meet demand and shun highly flexible money prices to clear markets, then

(2) how can real-world capitalism have a strong tendency to market clearing (that is, equilibration of supply and demand by flexible prices) and a tendency to general equilibrium? (or, in Austrian terminology, Mises’ “final state of rest”).
Without a real-world tendency to market clearing and full employment general equilibrium, Austrian economics collapses: this is true because Mises’ idea of economic coordination and his idea of a real-world tendency to shifting “final state of rest” general equilibrium states are absolutely dependent on a flexible system of money wages and prices.

Libertarians like Academic Agent have no answers to these questions, and have nothing but evasions, lies and sophistry to offer in response to such critiques.

Further Reading
“Vulgar Austrians do not Understand Austrian Price Theory (Updated),” July 10, 2014.

“Price, Average Total Cost, Average Variable Cost and Marginal Cost,” November 28, 2013.

“Mises on Marginal Cost: A Critique,” December 3, 2013.

“Reality Refutes Mises on Costs and Prices,” December 9, 2013.

“Administered Prices Discredit the Austrian Economic Theories of Mises,” December 10, 2013.

Mises, Ludwig von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Mises Institute, Auburn, Ala.

Rothbard, Murray N. 2006a. For a New Liberty: The Libertarian Manifesto (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.

Rothbard, Murray N. 2006b. Making Economic Sense (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.

Rothbard, Murray N. 2008. America’s Great Depression (5th edn.). Ludwig von Mises Institute, Auburn, Ala.

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