Seductive supermodels of supply and demand

One of the many schisms in economics is between economists – new and old – who believe that prices are set by supply and demand, and economists – also new and old – who believe they are set by a mark-up on the cost of production.

The former argument is the overwhelming favourite today, but two centuries ago, it was the minority view. Though modern ‘neoclassical’ economists are wont to claim Adam Smith as one of their own, he disowned their preferred ‘supply and demand’ pricing model to argue that products exchange at prices that are related to their relative costs of production.

“If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer. It is natural that what is usually the produce of two days or two hours labour, should be worth double of what is usually the produce of one day's or one hour's labour,” he said.

Smith allowed for deviations above and below this “natural price” of a product based on differences between supply and “effectual demand”, but the centre of gravity that the natural price represented was the core of his theory. The same applied to David Ricardo, while the alternative argument that eschewed any centre of gravity, and saw prices as set by an equal interplay of demand along with supply, inhabited the underworld of economics in the hands of such minor figures as Jean-Baptiste Say and Augustin Cournot. The classical economists, as Smith and Ricardo are rightly called, dismissed the daily movements of supply and demand as of secondary importance to the determination of natural prices by the relative costs of production.

All this changed when the mantle of classical economics shifted from the pro-capitalist Smith and Ricardo to the many ‘Ricardian socialists’, and ultimately, to Karl Marx.

Marx solidified (some would say ossified) the classical school’s focus on labour as the ultimate decider of prices, elevating it from simply determining the relative price of beavers and deers as in Smith’s example, to explaining the source of profit. Marx rejected explanations of profit that relied upon “buying cheap and selling dear”, and instead argued that profit resulted from inputs being bought at their value, and sold at their value:

“To explain, therefore, the general nature of profits, you must start from the theorem that, on the average, commodities are sold at their real values, and that profits are derived by selling them at their values, that is, in proportion to the quantity of labour realized in them. If you cannot explain profit upon this supposition, you cannot explain it at all,” Marx said.

His explanation of this apparent paradox was that the value of labour was equivalent to a subsistence wage – and it might take say six hours per day to produce those subsistence commodities – but the worker could then be set to work for, say, 12 hours a day. The gap between the two was the source of profit.

Marx argued that this was entirely fair, given the nature of capitalism:

“The circumstance, that on the one hand the daily sustenance of labour-power costs only half a day’s labour, while on the other hand the very same labour-power can work during a whole day, that consequently the value which its use during one day creates, is double what he pays for that use, this circumstance is, without doubt, a piece of good luck for the buyer, but by no means an injury to the seller,” he said.

But of course this sense that profit was taken from the worker was a major part of the radical appeal of Marx during a genuinely revolutionary period in Europe – and polite economists rapidly turned away from the classical school (aided by various technical conundrums with Marx’s logic that I’ll discuss some other time). The Neoclassical School, in which price was set by the interplay of supply and demand, rose to the fore in the hands of Leon Walras, William Stanley Jevons and Alfred Marshall. Marshall in particular undermined the classical school in popular thought, with is evocative image of supply and demand as “blades of a pair of scissors”, both of which were needed to determine price:

“We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production.”

Today, the neoclassical school is so dominant – (even after the financial crisis that it didn’t foresee) that its members don’t even know that other schools of thought exist –note this rant from John Cochrane, for example, complaining that ‘freshwater’ economists like “Lucas, Sargent, Sims, Prescott and all their many descendants” weren’t invited to IMF conference on "Rethinking Macro Policy". Neither were Post Keynesian economists like myself, Stephanie Kelton, Randall Wray, Michael Hudson and so on (even though we did foresee the crisis). Neoclassicals from Cochrane to Paul Krugman aren’t at all amazed that outsiders like us are excluded, because to them neoclassical economics is economics:  they wouldn’t even know that non-neoclassical economists exist (well, except that I tend to annoy them from time to time).

Equally, the neoclassical view that “supply and demand set prices” is so ingrained in society that, as Paul Keating once said, even the pet shop galah spouts it. But the Classical view that a mark-up on costs sets price is still alive and well in the Post Keynesian School – and their views are based on sound empirical research. It turns out that when you ask businesses how they actually set prices, the vast majority will tell you that they set them via a mark-up on costs – and that one of the key conditions for the ‘supply and demand set prices’ theory simply doesn’t hold in reality.

A key aspect of Marshall’s scissors was that, as demand rose, so would price. The cause of the rise wasn’t an increase in the profit margin, but an increase in cost: each additional unit produced cost more to make than the one before to what economists – with their brilliant fluency with language – called “diminishing marginal productivity”. The argument was that getting more output from a factory involved adding more “variable factors of production” (read ‘workers’) to the same amount of “fixed factors of production” (read ‘machinery’). After some ideal worker to machinery ratio was reached, the productivity of each additional worker would be less than earlier ones, resulting in less output per worker and – given a constant wage – rising cost per unit of output.

It’s a nice theory, but if reality had its way, it would experience what Thomas Huxley called “The great tragedy of science – the slaying of a beautiful hypothesis by an ugly fact”. Over 150 empirical studies since the early 1930s have found that at least 90 per cent of firms don’t face rising costs as output rises – and in fact for the majority of firms, unit costs fall as production increases.

The most recent person to rediscover this particular wheel was none other than Alan Blinder, a one-time vice chairman of the Federal Reserve. He undertook a huge survey of American business to find out why prices might be ‘sticky’, which is an essential part of the “New Keynesian” explanation for unemployment. As part of that he instructed his PhD student interviewers to find out what costs were like for the average American business – and he fully expected to confirm the standard “upward sloping” supply curve.

In fact, his empirical research contradicted it. Much to his amazement, he found that almost 90 per cent of his sample reported that their unit costs either remained constant or fell as output rose.

“The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 per cent of GDP is produced under conditions of rising marginal cost…” Blinder wrote in 1998.

“Firms report having very high fixed costs – roughly 40 per cent of total costs on average. And many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks.”

The reason that reality refuses to follow theory is that most goods are produced in factories which engineers designed to work at maximum efficiency when they are close to full capacity. So rather than efficiency falling as output rises, it tends instead to rise: it’s cheaper to produce each unit of output in a busy factory than in a relatively idle one.

This empirical fact hasn’t interfered with economic theory at all – as any current or past victim of an economics degree can attest. But it does seem to decide the case in favour of the classicals for the real world: prices must be set by a mark-up on costs, rather than by the ‘twin blades’ supply and demand.

That’s the opinion I held, until a crucial step in generalising my model of Minsky’s Financial Instability Hypothesis implied that, at a macro level, the two models are identical. I’ll get on to that – and the role of prices in economic instability – in the next post in this series.

Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch.
His Minsky Kickstarter page is here.