Gillies’ Philosophical Theories of Probability, Chapter 5

Chapter 5 of Donald Gillies’ Philosophical Theories of Probability (2000) deals with the relative frequency theory of probability.

The relative frequency theory was originally developed in the 19th century by John Venn (1834–1923) and Robert Leslie Ellis (1817–1859), and then by the early 20th century empiricists Hans Reichenbach and Richard von Mises (1919 and 1961), who were influenced by the Vienna circle (Gillies 2000: 88).

Richard von Mises saw probability theory as an empirical science dealing with repeated events of the same type, such as in games of chance, biological statistics, and natural phenomena (Gillies 2000: 89). Such repeatable events or mass phenomena were called “collectives” by von Mises (which could be “empirical collectives” or “mathematical collectives”), and a “sample space” is a set of possible outcomes in such a collective.

To establish objective probabilities by means of the relative frequency approach the phenomenon in question must yield stable relative frequencies for the outcomes it exhibits in the long run, and von Mises called this the “law of stability of statistical frequencies” (Gillies 2000: 92).

Richard von Mises thus believed that real numeric probabilities are confined to processes where stable relative frequencies can be obtained, and indeed “probability” in the scientific sense is limited to this (Gillies 2000: 97–98).

Critics of von Mises countered that his frequency theory approach does not explain the qualitative probabilities obtained in inductive arguments (Gillies 2000: 99), and thus seems to be a highly restricted definition of probability.

External Links
“Interpretations of Probability,” Stanford Encyclopedia of Philosophy, 2002 (rev. 2011)
http://plato.stanford.edu/entries/probability-interpret/

BIBLIOGRAPHY
Gillies, D. A. 2000. Philosophical Theories of Probability. Routledge, London.

Mises, Richard von. 1919. “Grundlagen der Wahrscheinlichkeitsrechnung,” Mathematische Zeitschrift 5: 52–99.

Mises, Richard von. 1961. Probability, Statistics and Truth (2nd edn.). Allen and Unwin, London.

Steve Keen, Debunking Economics, Chapter 5: Theory of the Firm

I review Chapter 5 of Steve Keen’s Debunking Economics (the rev. and expanded 2011 edn.) below, which is a discussion of the Post Keynesian theory of the firm.

Neoclassical theory assumes that in the short run as output rises productivity falls: that is, increasing levels of output will result in higher prices, and the marginal cost curve of a firm slopes upwards (Keen 2011: 103).

That is, a typical neoclassical firm will face diminishing marginal productivity and rising marginal cost, so that the “profit maximising” firm will stop producing when marginal cost of production equals the marginal revenue from sales (Keen 2011: 107–108).

Therefore the level of output is determined by the point where marginal revenue equals marginal cost (Keen 2011: 108), and the average firm cost curve is U-shaped.

The trouble with this theory is that, for most firms, it is untrue and the empirical evidence blatantly contradicts it:

“Economic theory also doesn’t apply in the ‘real world’ because engineers purposely design factories to avoid the problems that economists believe force production costs to rise. Factories are built with significant excess capacity, and are also designed to work at high efficiency right from low to full capacity. Only products that can’t be produced in factories (such as oil) are likely to have costs of production that behave the way economists expect.

The outcome is that costs of production are normally either constant or falling for the vast majority of manufactured goods, so that average and even marginal cost curves are normally either flat or downward sloping.” (Keen 2011: 104).

As Keen notes, Piero Sraffa’s article “The Laws of Returns under Competitive Conditions” (Economic Journal 36.144 [1926]: 535–550) argued long ago that this “law of diminishing marginal returns” does not, generally speaking, apply to modern industrial economies (Keen 2011: 108). Instead, the general tendency would be constant marginal costs and horizontal cost curves.

Secondly, firms do not make full use of their resources and operate with unused excess capacity. This can be seen in the graph below of total US capacity utilisation since 1967 as a percentage of resources used by corporations and factories in their production of goods in manufacturing, mining, and electric and gas utilities.

Even during the strong boom in the late 1960s US capacity utilisation was below 90%, and in the boom of the late 1980s only climbed to about 85%.

Spare capacity is the normal state of affairs, and indeed often essential for firm survival in a market economy, because the best way to deal with an uncertain future with sudden, unexpected changes in demand is to vary capacity utilisation (with use of inventories) (Keen 2011: 125).

One can even note how with the abandonment of Keynesian full employment policies of the 1945 to mid-1970s era (the so-called golden age of capitalism) there has been a persistent falling trend in average capacity utilization. Modern market economies since the late 1970s have had a plague of unused or underused resources from unemployed labour to underutilised factories.

Keen notes the paradox pointed out by Janos Kornai: that the old communist economies had persistent problems of scarce resources that limited production, whereas capitalist economies normally have relative abundance and a significant volume of unused resources, so that production is limited mainly by demand for output (Keen 2011: 115).

Finally, Keen points to the empirical evidence of Eiteman and Guthrie (1952) and Blinder (1998).

Eiteman and Guthrie (1952) was a survey in which 334 companies were shown a number of different cost curves, and asked to specify which one best represented the company’s cost curve.

A stunning 95% of managers chose cost curves with constant or falling costs, which is contrary to marginalist theory (Keen 2011: 125).

Blinder (1998) conducted much the same type of survey, which involved 200 US firms in a sample that should be representative of the US economy at large.

Blinder found that about 40% of firms reported falling variable or marginal cost, and 48.4% reported constant marginal/variable cost (Blinder 1998: 102).

BIBLIOGRAPHY
Blinder, A. S. et al. (eds.). 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York.

Eiteman, Wilford J. and Glenn E. Guthrie. 1952. “The Shape of the Average Cost Curve,” American Economic Review 42.5: 832–838.

Keen, Steve. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn.). Zed Books, London and New York.

Sraffa, P. 1926. “The Laws of Returns under Competitive Conditions,” Economic Journal 36.144: 535–550.

Downward’s Pricing Theory in Post-Keynesian Economics: Chapter 5

Chapter 5 of Paul Downward’s Pricing Theory in Post-Keynesian Economics: A Realist Approach (Cheltenham, UK, 1999) deals with a new “synthetic” econometric study on pricing.

Downward takes UK manufacturing prices and prices of industrial factor inputs in the period from 1984 to 1991 in his own econometric study (Downward 1999: 106, with results Table 5.1, Downward 1999: 107).

He finds that costs are the more important factor in influencing the UK manufacturing prices he examined, even if some lesser influence from demand was seen, probably given the bad recession of the early 1990s (Downward 1999: 108).

Downward finds that prices display “considerable inertia” (Downward 1999: 110), and that the last period’s prices are generally carried over into the current period by businesses (Downward 1999: 108).

BIBLIOGRAPHY
Downward, Paul. 1999. Pricing Theory in Post-Keynesian Economics: A Realist Approach. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Lee’s Post Keynesian Price Theory: Chapter 5

Chapter 5 of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) looks at the work of the economist Philip Andrews, who served as secretary of the Oxford Economists’ Research Group (OERG), chief statistician of the Nuffield College Social Reconstruction Survey, a participant in the Courtauld Inquiry on business enterprises, and was developer of the theory of “competitive oligopoly.”

Philip Andrews’s research led him to conclude that many businesses’ average direct cost curves were horizontal, and that even the notion of downward-sloping enterprise demand curves were problematic in manufacturing markets (Lee 1998: 101–102).

Moreover, many industrial markets were oligopolistic, used administered pricing, and engaged in competition not necessarily involving price adjustment (Lee 1998: 102).

Andrews held that both average direct costs and indirect costs will decline as a business increases its flow rate of output (Lee 1998: 105).

The setting of prices, though based on cost of production plus profit markup, was called by Andrews “normal cost price” (Lee 1998: 109). This involves the following concepts:

(1) a normal flow rate of output, determined by past experience and future expectations about sales;

(2) normal average direct costs and normal average indirect costs to calculate normal average total costs;

(3) the addition to normal average direct costs of a “costing margin” to cover normal average indirect costs and a profit margin (Lee 1998: 109).

But the profit margin is also constrained by the behaviour of competitors, and by “goodwill” relationships with suppliers and consumers (Lee 1998: 107–108). Some markets have a “price leader” that sets the market price because it is the business with the largest scale of production (Lee 1998: 112). Alternatively, trade associations allow businesses to share information about average normal costs and determine a common profit markup (Lee 1998: 112). The result of either of these is a stable administered price in many markets.

A particularly interesting finding of Andrews relates to the prices of factor inputs: he found that reductions by suppliers in the prices of factor inputs do not necessarily induce more purchases of a factor by a producer if its sales are stagnant or falling (Lee 1998: 108).

As previous researchers had found, changes in normal cost pricing tend generally to be caused by changes in factor input costs.

BIBLIOGRAPHY
Andrews, Philip Walter Sawford. 1949. Manufacturing Business. Macmillan, London.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.