Lee on the Three Types of Mark-up Prices

A price that is set by a firm on the basis of average unit costs of production plus a profit mark-up is an “administered price.” These prices are also sometimes called “mark-up prices,” “average cost prices,” “full cost prices,” “normal cost prices,” or “cost-plus prices.”

However, these are all essentially the same type of price, but differences exist mainly in mere accounting conventions used to calculate them.

Lee clarifies these differences and identifies three fundamental types of such prices, as follows:

(1) standard mark-up pricing
This takes average direct/variable costs at actual or estimated output, and then adds to this a mark-up which covers both (1) average “shop expenses” and average “enterprise expenses” (overhead/fixed costs) and (2) an allowance for profit;

(2) normal cost pricing
This begins by calculating average direct/variable costs at a target or expected output level, and adds to this average “shop expenses” and average “enterprise expenses” (overhead/fixed costs). Finally, a mark-up for profit is added to this;

(3) target rate of return pricing
This is calculated by taking normal average total costs (including overhead/fixed costs) and marking this up by a certain percentage to achieve a specific rate of return or profit at projected sales in relation to the firm’s capital assets. (Lee 1998: 204–205).

Now, as has been noted, both “shop expenses” and “enterprise expenses” constitute overhead costs (Lee 1998: 201–202), so that for most businesses it is ultimately total average unit costs – including both (1) direct/variable costs and (2) overhead/fixed costs – that matter and are the basis of the mark-up price. Fundamentally, all involve a mark-up for profit over total average costs, and types (2) and (3) are the most prevalent (Lee 1998: 206).

Why does this matter? First, if you are doing a price setting survey and ask businesses if they set prices based on direct/variable costs, then many will no doubt answer “yes.” However, standard mark-up pricing firms, as in (1) above, are adding a mark-up to this that includes overhead/fixed costs and an allowance for profit. Therefore it is highly misleading and wrong to conclude that firms are generally only using direct/variable costs as their cost base.

For instance, in a recent study of price setting behaviour in the Eurozone, Gaspar et al. (2007: 238) report that about half of Eurozone firms set their prices as a mark-up over average variable costs, but they fail to understand that the mark-ups of many, and probably most, of these firms will include average overhead/fixed costs as well, so that it is total average unit costs that should be the fundamental cost base of interest to economists.

Secondly, while some administered prices can be based only on direct/variable costs, this practice appears to be far less important than the use of total average unit costs. For example, Govindarajan and Anthony (1986: 31) found that 85% of the US companies they surveyed used full cost pricing, and Shim and Sudit (1995: 37) conducted a survey in 1993 of US industrial companies, and found that 69.5% were using full cost pricing.

So, in contrast to conventional marginalist theory, most businesses certainly do take account of fixed/overhead costs. “Sunk costs” can be important in determining the administered price.

As I noted in the last post, the failure to understand these facts causes deep confusion, and the wrong idea that firms generally use average variable/direct unit costs only, and that they are therefore doing this as a good general proxy for marginal cost.

That is why dynamic stochastic general equilibrium (DSGE) models that assume prices are set as a markup over marginal costs are also mistaken, and almost wholly irrelevant models for real world pricing.

And, finally, it appears to be “now well established in the industrial economics literature that the average variable cost data … may be a poor proxy for the theoretical concept of marginal cost,” and it is not irrational for firms to use overhead/fixed costs in calculating price.

All in all, the marginalist theory of prices has severe problems: it simply does not reflect reality.

Addendum
As noted in the comment below, Godley and Lavoie (2007: 263–276) have a good discussion of mark-up pricing, and they note that overhead/fixed costs are the important average unit cost basis (Godley and Lavoie 2007: 266–267, 272). They also argue that costing margins are generally set to include any increase in interest rate costs (Godley and Lavoie 2007: 265).

Godley, Wynne and Marc Lavoie. 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. Palgrave Macmillan, New York, N.Y.

BIBLIOGRAPHY
Fabiani, Silvia, Suzanne Loupias, Claire, Monteiro Martins, Fernando Manuel and Roberto Sabbatini. 2007. Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York.

Gaspar, Vítor, Levin, Andrew, Martins, Fernando and Frank Smets. 2007. “Policy Lessons and Directions for Ongoing Research,” in S. Fabiani, C. Suzanne Loupias, F. M. Monteiro Martins and Roberto Sabbatini (eds.), Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York. 235–249.

Govindarajan, V. and R. Anthony. 1986. “How Firms use Cost Data in Price Decisions,” Management Accounting 65: 30–34.

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

Pittman, Russell. 2009. “Who Are You Calling Irrational? Marginal Costs, Variable Costs, and the Pricing Practices of Firms,” Economic Analysis Group Discussion Paper 09-3
http://www.justice.gov/atr/public/eag/248394.htm

Shim, Eunsup, and Ephraim Sudit. 1995. “How Manufacturers Price Products,” Management Accounting 76.8: 37–39.

Downward and Lee on Blinder’s Asking about Prices

Downward and Lee (2001) provide a critical review of Blinder’s now classic Asking about Prices: A New Approach to Understanding Price Stickiness (New York, 1998).

Downward and Lee show that Blinder’s findings are better explained by Post Keynesian price theory, as opposed to New Keynesian theory.

Except for the most irrelevant types of general equilibrium theory, the existence of sticky prices is a widespread “stylised fact” even in mainstream economics (Downward and Lee 2001: 466).

Downward and Lee note that the merit of Blinder’s Asking about Prices is that it rejects questionable econometric methods for a direct well sampled survey of 200 US businesses and managers in interviews and questionnaires (Downward and Lee 2001: 466–467).

Blinder found that about 72% of firms changed product prices less than four times a year, with 45% reviewing their prices only once a year (Downward and Lee 2001: 468):

“Although there is a small ‘auction-market’ sector in the U.S. economy, there certainly appears to be enough price rigidity in most sectors to matter for macroeconomic purposes. According to the survey results, the typical commodity is repriced roughly once a year: and more than 75 percent of GDP is repriced quarterly or less frequently. The mean lag between shifts in supply or demand and the eventual response of prices is about three months; but there is huge variability across firms.

Prices appear to be most sticky in the service sector (which is, of course, the majority of the economy) and least sticky in wholesale and retail trade.” (Blinder et al. 1998: 105).

About 85% of business sales were from repeat customers (Downward and Lee 2001: 469). Moreover, 89% of firms reported that marginal costs either declined or were constant as output changed (Downward and Lee 2001: 469) and over 50% of firms said that they would not increase their prices when demand increased (Downward and Lee 2001: 476).

More importantly, Blinder et al. found the causes of price stickiness that received the most support – as reported by business-people themselves – were cost-based pricing, coordination failure, nonprice competition, and implicit contracts (Downward and Lee 2001: 469; Blinder et al. 1998: 304). Cost-based pricing received an acceptance rate of over 50% (Downward and Lee 2001: 469).

Downward and Lee point out that Blinder et al.’s findings discredit their own assumption that most firms seek to maximise profits in the neoclassical sense (Downward and Lee 2001: 476).

Despite Blinder’s misgivings about how representative Hall and Hitch’s earlier sample was in their research into pricing behaviour in the UK (Hall and Hitch 1939), Downward and Lee (2001: 478) argue that Blinder et al. have actually confirmed Hall and Hitch’s conclusions that most firms base pricing decisions on mark-up and full cost pricing systems, and that firms are so greatly concerned with customer goodwill that they feel frequent price changes will betray this and alienate their client base – an insight also made long ago by Nicholas Kaldor (1985: 26, 19–21).


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

Downward, Paul and Frederic Lee. 2001. “Post Keynesian Pricing Theory ‘Reconfirmed’? A Critical Review of Asking about Prices,” Journal of Post Keynesian Economics 23.3: 465–483.

Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.

Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.

Lee’s Post Keynesian Price Theory: Chapter by Chapter Summaries

My chapter by chapter summaries of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) can be found in these posts:

(1) “Lee’s Post Keynesian Price Theory: Chapter 1,” July 6, 2013.

(2) “Lee’s Post Keynesian Price Theory: Chapter 2,” August 15, 2013.

(3) “Lee’s Post Keynesian Price Theory: Chapter 3,” August 16, 2013.

(4) “Lee’s Post Keynesian Price Theory: Chapter 4,” August 17, 2013.

(5) “Lee’s Post Keynesian Price Theory: Chapter 5,” August 19, 2013.

(6) “Lee’s Post Keynesian Price Theory: Chapter 6,” October 6, 2013.

(7) “Lee’s Post Keynesian Price Theory: Chapters 7, 8 and 9,” October 24, 2013.

(8) “Lee’s Post Keynesian Price Theory: Chapter 10,” October 25, 2013.

(9) “Lee’s Post Keynesian Price Theory: Chapter 11,” October 26, 2013.

(10) “Lee’s Post Keynesian Price Theory: Chapter 12,” October 27, 2013.

Lee’s Post Keynesian Price Theory: Chapter 12

Chapter 12 of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) is the final chapter and conclusion of Lee’s book.

A capitalist economy has a productive structure of input and output. In any given capitalist economy, 24% to 50% of output is itself used as input intermediate goods (Lee 1998: 220). This circular production model includes all primary sector, industrial, wholesale, and retail markets. Administered prices can occur in any one of these types of markets.

The calculation of costs of production for a product depends on the accounting procedure used and with the degree of mark-up will determine the administered price (Lee 1998: 228).

Administered prices are neither market-clearing nor profit-maximising prices in the neoclassical sense (Lee 1998: 228).

Above all, economic coordination in modern capitalist economies is not a straightforward function of the price system, in view of the prevalence of administered pricing (Lee 1998: 230) – a fundamental conclusion which cannot be emphasised enough.

The profit mark-up is mostly determined by custom, convention, reasonableness, fairness and short and long-term competitive pressures (Lee 1998: 226).

Finally, the administrative procedure of setting prices by means of a profit mark-up undermines the Marxist, classical and Sraffian view that there exists a tendency towards a uniform rate of profit throughout a competitive capitalist economy (Lee 1998: 226, n. 17).

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

Lee’s Post Keynesian Price Theory: Chapter 11

Chapter 11 of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) begins Lee’s summing up and overview of the doctrine of administered prices in Post Keynesian economics. Lee draws on over 100 empirical studies to draw together the elements of this theory (Lee 1998: 201).

First, a misunderstanding should be dispelled. Post Keynesian price theory does not deny the existence of flexprice markets (Lee 1998: 203, n. 7). In any given capitalist economy, commodity markets (defined as those for goods and services) and asset markets are divided into (1) flexprice and (2) fixprice markets. Administered prices constitute the major form of the latter.

Flexprice markets are prevalent in primary commodities and asset markets, while newly produced goods and services tend to be fixprices. A “flexprice” market – as the name suggests – indicates that prices are generally flexible and are determined by the dynamics of supply and demand, either in (1) competitive auction-like markets or (2) markets where a buyer and seller haggle and negotiate an individual price for an individual exchange (as in the oriental bazaar). Of course, destructive price wars can also lead to flexible prices that deviate from costs of production (Lee 1998: 203, n. 7), but it is notable how frequently businesses shun such price wars.

Administered prices generally seem to represent the majority of prices in most advanced market economies. Empirical studies conducted since the publication of Lee’s book confirm this.

For example, in the Eurozone, the percentage of administered prices in a given nation ranges from about 50% to 65%. The average for the Eurozone as a whole is 54% (Fabiani et al. 2006: 18, Table 4). Once other fixprices caused by government regulation are added to this, the percentage for fixprices generally appears to rise to about 60% to 70% of prices – which is the overwhelming majority (I conservatively assume about 10% of the third category of prices called “other” in Fabiani et al. [2006: 18, Table 4] represent prices fixed by government regulation, but the Eurozone average is actually 18%, so that 68% to 83% might actually be a more realistic estimate).

Enterprises that adopt administered prices employ a cost accounting system that calculates direct factor input costs (the direct costs) plus overhead costs (Lee 1998: 201–202).

The cost of a product is then calculated at standard, estimated or budgeted output or capacity utilisation (Lee 1998: 202–203). The mark-up is then added to the cost to create a price.

Lee distinguishes three types of administered prices which differ owing to the type of cost accounting systems that underlie the calculation of average costs:

(1) standard mark-up pricing;

(2) normal cost pricing, and

(3) target rate of return pricing. (Lee 1998: 204–205).

However, all involve a mark-up for profit over average costs, and types (2) and (3) are the most prevalent (Lee 1998: 206).

Administered pricing is not restricted to monopolies, oligopolies, or cartels: it also occurs in competitive markets. But even here businesses tend to establish a similar administered price, and shun price wars, as Lee points out:

“Consequently, co-ordination is required among the enterprises if destructive price competition is to be avoided and an acceptable, single market price established. Business enterprises have therefore utilized a range of private market institutions, such as cartels and price leadership arrangements, buttressed by an array of ancillary conventions, traditions, and restrictive trade agreements to establish an orderly market with a single market price. When the private market institutions have failed to control price competition, enterprises have turned to quasi-government or purely government organizations, legal decrees, and laws in order to establish an orderly market with a single market price.” (Lee 1998: 207).

Within private administered price markets with competition, often the most powerful business acts as a “price leader” by setting a price that competitors follow: when average costs differ, other businesses adjust their profit mark-up to set roughly the same price (Lee 1998: 207–208).

When governments offer goods and services for sale, they too often adopt the very same administered price procedures to set the price of their products (Lee 1998: 207). In this respect, there is nothing “unnatural” about such government price “fixing”: governments simply follow the same practice as the private sector.

For the private sector, administered pricing provides security and stability of profits, to allow businesses to survive over time and grow (Lee 1998: 208–209).

A consequence of administered pricing is that many such prices generally remain stable and fixed from periods varying from three months to a year (Lee 1998: 209). Administered prices consequently do not normally change when demand changes, which violates a fundamental tenet of neoclassical price theory. Moreover, administered prices are not market clearing prices and are not even intended to be.

A fixed and predictable price allows businesses to build “goodwill” relationships with their customers, a practice which is very important to businesses (Lee 1998: 212).

Most astonishing of all is that empirical studies show that many products do not have well behaved demand curves:

“Where reported … business enterprises stated that variations in their prices within practical limits, given the prices of their competitors, produced virtually no change in their sales, and that variations in the market price, especially downward, produced little if any changes in market sales in the short term. Moreover, when the price change is significant enough to result in a non-insignificant change in sales, the impact on profits has been sufficiently negative to persuade enterprises not to try the experiment again.” (Lee 1998: 207).

The significance of this is that, if many administered price businesses tried to clear their product markets by price reductions (as one fundamental step in a convergence to a general equilibrium), then it would simply not work or would result in massive losses and most likely mass bankruptcy of many businesses.

When administered prices are changed, the change tends to be driven by (1) labour and materials costs or (2) changes in the profit mark-up (Lee 1998: 213).


BIBLIOGRAPHY
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.

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

Lee’s Post Keynesian Price Theory: Chapter 10

Chapter 10 of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) looks at the Josef Steindl and the later development of his “stagnation thesis.” Again, this chapter is only of marginal interest for me, given that I prefer to concentrate on the central idea of administered prices.

I merely provide a brief sketch below.

Steindl used the theory of mark-up pricing in his “stagnation thesis”: the idea that over time oligopolies and large corporations would tend to dominate advanced capitalist economies, and that, because their profit margins would exceed new investment, over time the aggregate level of economic activity would tend to be dampened (Lee 1998: 192).

This thesis was taken up by certain Marxists such as Paul Baran and Paul Sweezy (Lee 1998: 193–194). Their book Monopoly Capital (1966) developed the “stagnation thesis” and argued that the tendency to stagnation was checked by (1) business advertising and sales promotions to create new demand for products and (2) government expenditure (Lee 1998: 196). Whatever the merits of this thesis, it did at least understand that many markets are dominated by firms that actively set prices to stabilise profits.

Another novel and interesting elaboration of the theory by Harry Magdoff and Sweezy himself was the idea that the financial sector provides another important element of the process: consumer credit from financial institutions promotes more demand but corporate spending on financial assets tends to reduce real capital investment and re-enforce the stagnation tendencies.


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

Lee’s Post Keynesian Price Theory: Chapters 7, 8 and 9

Chapters 7, 8 and 9 of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) deal with the work of Michał Kalecki (1899–1970). Unfortunately, these chapters are more useful for the history of Kalecki’s work and his influence on some Post Keynesians, rather than administered prices per se. I provide only a brief summary of interesting points below.

Kalecki’s initial work focussed on the price rigidity, monopoly and oligopolistic tendencies in market economies, and was imbued with explicit marginalist ideas (Lee 1998: 147–149).

But Kalecki’s early work, as it had emerged by the 1940s, was subsequently developed in two ways:

(1) from 1952 to the 1980s, by Sraffa, Geoffrey Harcourt, Peter Riach, Joan Robinson, Kaldor, Athanasios Asimakopulos, Adrian Wood, Aldred Eichner, and Kalecki himself, and

(2) from 1945 to the early 1980s by Josef Steindl, Sylos-Labibi, Paul Baran, Paul Sweezy, Harry Braverman, and David Levine in the “stagnation thesis” (Lee 1998: 152).

During WWII, Kalecki worked at Oxford with Steindl, Fritz Burchardt and G. D. N. Worswick, and came to develop his theories (Lee 1998: 153).

Burchardt and Worswick soon became interested in markup pricing, and by 1944 Kalecki himself seems to have been aware of the idea (Lee 1998: 154, n. 2). Strangely, however, Kalecki, in a revised version of his economic ideas, in the Theory of Economic Dynamics (1954) did not explicitly adopt markup, cost-based pricing, and it was not until the 1960s that he adopted it in his analysis (Lee 1998: 167).

All in all, Kalecki’s early work contained a number of marginalist elements, though arguably he abandoned marginalism by 1954 (Lee 1998: 172–173), and a non-marginalist interpretation of Kalecki’s work inspired Post Keynesians to develop some of his theories on monopoly power, administered prices and the causes of the profit markup.


BIBLIOGRAPHY

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

Kalecki, Michał. 1954. Theory of Economic Dynamics: An Essay on Cyclical and Long-Run Changes in Capitalist Economy. Allen and Unwin, London.

Lee on Post Keynesian Price Theory in The Oxford Handbook of Post-Keynesian Economics

Frederic S. Lee has a useful and up-to-date chapter on Post Keynesian price theory in The Oxford Handbook of Post-Keynesian Economics. Volume 1: Theory and Origins (Oxford, 2013). I summarise the main points below.

The crucial conclusions from empirical investigation of real world capitalist price systems are as follows:

(1) administered prices make up somewhere between about 50–70% of prices in modern market economies (for direct evidence for these percentages in, for example, the Eurozone, see Fabiani et al. 2006: 18, Table 4).

(2) in these widespread administered, fixprice markets, prices are not primarily a mechanism for economic coordination in the neoclassical sense, but a method by which a business obtains and stabilises its income and profits, in order to support the survival of the business (Lee 2013: 467–468). Administered prices are not market clearing prices, nor are they set in order to equate marginal costs to marginal revenue. Administered prices are set before the sale or exchange takes place and sometimes even before production (Lee 2013: 470). They are not the product of competitive bidding in a Walrasian auction-like market or a haggling process familiar from bazaars (Lee 2013: 474).

Rather, intense price competition is often shunned by businesses because competition via flexible prices and price wars will drive many enterprises toward bankruptcy. Hence administered prices provide a way by which private businesses control and avoid the uncertainty attached to intense and destructive price competition (Lee 2013: 476).

(3) administered price businesses are not concerned with maximisation of profits in the neoclassical sense. Rather, they wish to create a steady flow of income and stable profit to maintain and grow their business, increase market share, engage in new investment and/or produce new products, and so pursuit of profit can be conceived of as an “intermediate objective” (Lee 2013: 468). When possible, profits are generally increased by increasing the profit markup and reducing costs, rather than adjusting prices in response to demand changes.

(4) an administered price is calculated from average total costs (ATC) at a given capacity utilisation or output plus profit markup. Average total costs (ATC) are broken down into product average direct costs (ADC) and average overhead costs (AOHC) (Lee 2013: 469). In an industry where competition exists, the outcome is normally that a “price leader” – the largest and most successful producer or producers – set a profit markup and price for the product that strongly influences other businesses (Lee 2013: 473).

(5) depending on the market, administered prices are reviewed and possibly changed from 3 month periods to a year (Lee 2013: 474), and even then changes in price will generally be driven by costs of factor inputs.

(6) the most recent empirical evidence suggests that many modern administered price businesses often do not reduce their prices when factor input prices decrease, if they can avoid it. Instead, the business will increase its profit markup and maintain prices – a factor that tends to re-enforce the downward rigidity of prices in modern market economies (Lee 2013: 475; Álvarez et al. 2006).

BIBLIOGRAPHY
Álvarez, L. J., Dhyne, E., Hoeberichts, M., Kwapil, C., Le Bihan, H., Lünnemann, P., Martins, F., Sabbatini, R., Stahl, H., Vermeulen, P. and J. Vilmunen. 2006. “Sticky Prices in the Euro Area: A Summary of New Micro-Evidence,” Journal of the European Economic Association 4.2–3: 575–584.

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.

Lee, Frederic S. 2013. “Post-Keynesian Price Theory: From Pricing to Market Governance to the Economy as a Whole,” in G. C. Harcourt and Peter Kriesler (eds.), The Oxford Handbook of Post-Keynesian Economics. Volume 1: Theory and Origins. Oxford University Press, Oxford and New York. 467–484.

Lee’s Post Keynesian Price Theory: Chapter 6

Chapter 6 of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) examines developments in the doctrine of administered prices.

Lee looks at the work of Harry Edwards, Paolo Sylos-Labini, Wilford John Eiteman (1949), and John Williams (1967), Jack Downie, George Richardson, and Romney Robinson on the idea of the costing margin and sequential production (Lee 1998: 120–125).

I will merely focus below on Wilford Eiteman and George Richardson, since there are some interesting points to be noted.

The experience of Wilford Eiteman is worth quoting:

“Around 1940, Eiteman was teaching marginalism in principles of economics classes at Duke University when it occurred to him that as treasurer of a construction company he had set prices and talked with others who set prices and yet had never heard of any price-setter mentioning marginal costs. He quickly came to the conclusion that a price-setting based on equating marginal costs to marginal revenue was nonsense. Eiteman then began to piece together a critique of marginalism aimed at its production and cost foundations.” (Lee 1998: 125).

Thus Eiteman’s book Price Determination: Business Practice versus Economic Theory (1949) was born. In this, Eiteman argued that a firm that wishes to survive and engage in continued production will aim at generating revenue that covers their cost of production. This is generally achieved by creating a price based on costs of production and a markup for profit (Lee 1998: 126–127).

George Richardson produced a critique of Hayek’s paper “Economics and Knowledge” (1937). Richardson argued that flexible prices, as in neoclassical and Hayekian theory, convey considerably less information than conventional theory thinks precisely because the continually changing nature of such prices severely impairs long-term business investment decisions (Lee 1998: 135). By contrast, a relatively stable administered price in the medium term allows business to calculate better estimates of future profits and sales trends, which allows far better planning in investment decisions (Lee 1998: 136; Richardson 1960 and 1965). Thus administered prices are very much part of business and corporate planning that actively gives stability to markets: in this sense, administered prices are a private sector way to reduce the degree of uncertainty they face in the market economy.

Finally, an important point made by Sylos-Labini is that variations in normal cost prices through an economy require careful empirical investigation of each particular market (Lee 1998: 139), since many factors are involved.

BIBLIOGRAPHY
Eiteman, Wilford John. 1949. Price Determination: Business Practice versus Economic Theory. Bureau of Business Research, Ann Arbor.

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

Richardson, G. B. 1960. Information and Investment: A Study in the Working of the Competitive Economy. Oxford University Press, London and New York.

Richardson, G. B. 1965. “The Theory of Restrictive Trade Practices,” Oxford Economic Papers 17: 432–449.

Williams, John Burr. 1967. “The Path to Equilibrium,” The Quarterly Journal of Economics 81.2: 241–255.

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.

Lee’s Post Keynesian Price Theory: Chapter 4

The fourth chapter of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) turns to the work of the Oxford Economists’ Research Group (OERG), an empirical and research group that was instituted at Oxford University in 1936, and involved economists such as Hubert Henderson, James Meade, and George L. S. Shackle.

The research conducted by this group involved direct interviews with UK businessmen, and one of the many topics of interest was price setting.

One of the findings of the research was that often business people were ignorant of the standard marginalist neoclassical price theory (Lee 1998: 87):

“… the problem was that businessmen were seeing common phenomena in a different light than the members of the OERG. The most important example of this, according to Robert Hall …, was that businessmen saw prices as non-market-clearing and not even designed to clear the market, while the members of the OERG saw prices as a market-clearing (Lee 1998: 88; emphasis in original).

The members of the OERG quickly realised that they had uncovered novel and important facts about price setting in the private sector:

“In fact severe questioning by the Group failed to uncover any evidence that the businessmen paid any attention to marginal revenue or costs in the sense defined by economic theory, and that they had only the vaguest ideas about anything remotely resembling their price elasticities of demand. The Oxford economists were shocked, to say the least. But what caught their attention even more was the relative stability of prices over the trade cycle, and this became the phenomenon which really needed to be explained.” (Lee 1998: 89).

Yet another finding was that the interest rate had considerably less influence on investment than standard economic theory held, and that uncertainty was an overriding factor in the investment decision – an insight which was of particular interest to Shackle (Lee 1998: 88).

The economists R. L. Hall and Charles J. Hitch found themselves much concerned by the findings of the OERG on price setting, and after further research published their now classic paper “Price Theory and Business Behaviour” (Oxford Economic Papers 2 [1939]: 12–45) to explain the evidence they found. Hall and Hitch concluded that businessmen did not generally estimate the elasticity of the demand curves for their products or equate marginal revenue with marginal cost, but instead set prices by means of “full cost pricing” (Lee 1998: 90), which was their terminology for what are now called “administered prices.”

Hall and Hitch found that full cost pricing was determined by the following factors:

(1) direct material and labour costs per unit of output;

(2) indirect costs at an expected level of output, and

(3) a markup for profit. (Lee 1998: 90).

However, given either the competition in a particular industry or the presence of a “price leader,” the profit margin and hence the price of products would tend to be similar in many markets even with full cost pricing (Lee 1998: 90–91). Thus the profit markup and profit margin tended to be a stable and conventional one (Lee 1998: 92), so that full cost prices are not profit maximising prices and are set before the many transactions in a given period.

Furthermore, businesses found that frequent price changes were unpopular with customers, that often price reductions would not induce significant additional market sales, and that they feared price wars (Lee 1998: 91). The business expectation that (1) price reductions would be followed by competitors but that (2) price increases would not be followed therefore tended to cause a price stability in full cost pricing markets.

Lee concludes by noting that Hall and Hitch’s full cost pricing research was developed by Philip Andrews in his own theory of competitive oligopoly.

UPDATE
Philip Pilkington has some related discussion of neoclassical price theory here:

Philip Pilkington, “Teleology and Market Equilibrium: Manifesto for a General Theory of Prices,” Fixing the Economists, August 16, 2013.

Philip Pilkington, “Quantity Rationing as Business Strategy: Furthering the Case for a General Theory of Pricing,” Fixing the Economists, August 17, 2013.

BIBLIOGRAPHY
Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.

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

Lee’s Post Keynesian Price Theory: Chapter 3

The third chapter of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) deals with the further history of the doctrine of administered prices.

Gardiner C. Means had a great influence, but his work was developed over a period of 40 years by Rufus Tucker, Edwin Nourse, Abraham Kaplan, and Alfred Chandler (Lee 1998: 69).

When the Great Depression struck the US, there was increasing criticism of oligopolistic corporations and a feeling that the reduction in competition brought about by big business and the rigidity in corporate prices were the major cause of the depression (Lee 1998: 69). Some saw the solution as breaking up big business and regulating corporations.

Paradoxically, big business responded to this unpopularity by funding studies in research foundations and institutions to defend themselves, but these studies produced important empirical work on the role of administered prices (Lee 1998: 70).

Rufus Tucker’s research indicated that administered prices were far more important historically than others thought, were not just confined to big business, and had existed to some degree since the 1830s (Lee 1998: 71).

While farming was an important sector where flexprices did exist, industrial markets had long had a degree of relative price inflexibility. Moreover, Tucker also argued that the price elasticity of demand was quite small for many industrial products (Lee 1998: 72, n. 4), while employment and production in this sector were very sensitive to demand changes (Lee 1998: 72).

Industrial price reductions in recessions were more the result of the falls in factor input costs rather than price changes in response to demand (Lee 1998: 72).

Another study was conducted by Edwin Nourse and funded through the Falk Foundation. Nourse confirmed that administered pricing was a fundamental activity of corporate management, and was based on cost accounting and calculation of average total costs at a given capacity utilisation rate plus the profit markup (Lee 1998: 76). The constraints on this price setting behaviour included the often poor responsiveness of demand to price changes and the reactions of competitors (Lee 1998: 77). The emergence of business and trade associations and basing-point pricing systems allowed businesses to avoid unwanted price wars and fix the market prices of goods in a particular market around a certain level (Lee 1998: 77).

Still further empirical work after 1945 was done by Abraham Kaplan and Alfred Chandler in interviews of management from 28 major corporations (Lee 1998: 78). Their findings were that normal cost and target rate of return pricing was used by virtually all firms surveyed (Lee 1998: 78).

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

Lee’s Post Keynesian Price Theory: Chapter 2

The second chapter of Frederic S. Lee’s Post Keynesian Price Theory (Cambridge, 1998) continues to study the career and work of Gardiner C. Means, an American Institutional economist and researcher.

Means came to see “administrative coordination” as a fundamental concept for the internal operations of corporations (Lee 1998: 48).

Means identified three ways to conceptually categorise market economies as follows:

(1) the atomistic market economy or the competitive economy imagined by Marshall and in neoclassical theory, in which owner-worker enterprises pursing profit maximisation predominate and where these businesses produce one type of good for sale, and such sales were made by haggling and bargaining;

(2) the factory system, with significant market concentration and scale of production. In such a system, businesses can control wages and prices;

(3) the corporate economy, in which market concentration greatly increases with corporate businesses, with separate ownership and management, and “administrative coordination” of decisions and pricing within firms (Lee 1998: 50).

Means of course realised that markets in any real world economy are a mix of these three models, but (3) was especially important.

The business behaviour of large corporations where ownership and management are split came to be governed by the firm’s management and its increasing size and scale of production. Barriers to entry had become strong in many markets and firms were no longer as motivated by the idea of long-period maximisation of profits; instead, they were more concerned with not inducing new entries into their markets (Lee 1998: 54–55).

The most important type of “administrative coordination” was achieved by price administration: prices are set for a given period of transactions on the market and often held there (Lee 1998: 55).

An equally important practice was the “flow principle of production”: market activity and demand will cause the rate of production at a given administered price (Lee 1998: 55).

In determining the profit markup, the corporation calculated a target rate of return and then took account of market competition and the prices of competitors (Lee 1998: 56).

In addition, many corporations came to shun price wars or significant price competition since this would damage the corporation’s financial health (Lee 1998: 57). Instead, they preferred to focus on advertising and sales campaigns to attract more buyers (Lee 1998: 57).

Means also saw the ultimate source of the general procyclical nature of prices as lying in the flexprice markets, which, for example, would decline in a recession and cause factor input costs for administered price businesses to fall as well.

But in administered price markets demand falls would generally cause direct reductions of employment and output, and not price reductions (Lee 1998: 60–61). Thus Means saw that demand is the primary driver of business cycles (Lee 1998: 61).

Means also had a theory of inflation in the administered pricing sector, and identified three forms of inflation:

(1) demand side inflation (or monetary inflation) at full employment, which stemmed from the flexprice sector.

(2) reflation during an upswing in a business cycle whereby market flexprices rise and induce possible changes in administered prices, and

(3) administered inflation caused by corporate decisions to raise administered prices, caused by factors such as rising wages, or to increase the profit markup (Lee 1998: 61–63).

Means understood one of the most important trends in modern capitalism: the upwards rise in prices and general inflation that occurs because of the relative downwards rigidity in administered prices.


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