Independent of Sraffa’ theoretical critique, a number of academics challenged the economic theory of marginal cost pricing by simply asking firms what they do. As Lee (1998) documents, between 1930 and 1950 a number of researchers (Means, Tucker, Andrews, Eiteman and Guthrie, Downie, the ‘Oxford Economic Research Group’) independently and consistently found that, for the vast majority of manufacturing firms:
• their average costs of production declined as output rose;
• their marginal costs were always well below their average costs, and substantially smaller than ‘marginal revenue’, and
• the concept of a ‘demand curve’ (and therefore its derivative ‘marginal revenue’) was simply irrelevant.
These firms set price, not by passively reacting to the market, but by setting a price prior to sales, based on a markup on costs at a target rate of output. Means described these as ‘administered’ prices, with an essential feature of this system being that prices were set to maintain the long-term viability of the firm. This, and the underlying reality that per-unit costs fell as output levels rose, resulted in far more stable prices than were predicted by traditional economic theory (since if price was set by intersecting supply and demand curves, the ‘jiggling of the market’ as demand and supply curves ‘shifted’ should result in frequent price fluctuations). Means concluded that administered prices “differ so sharply from the behaviour to be expected from [neo]classical theory as to challenge the basic conclusions of that theory” (Means 1972).
One intriguing study (Eiteman and Guthrie 1952) actually showed firms a range of hypothetical cost curves, and asked firms which ones most closely approximated their own costs. Table 1 summarises the results of their survey according to whether the firm’s reply supported or rejected the ideas that marginal costs rose, and price was set where marginal cost equalled marginal revenue.
Their empirical findings support Sraffa’s arguments (and Kornai’s; see later this chapter). Over 90% of firms chose a graph like that shown in Figure 12, rather than the conventional economic diagram showing rising marginal costs. As Sraffa surmised, these firms faced declining average cost, and their marginal revenues were much greater than marginal cost at all levels of output.
|
|
By Firms |
By Products |
|
Supports MC=MR |
18 |
62 |
|
Contradicts MC=MR |
316 |
1,020 |
|
Per Cent supporting MC=MR |
5.4 |
5.7 |
Table 1: Empirical support for firms setting price where MC=MR (Eiteman and Guthrie 1952)
Eiteman’s explanation of this failure of reality to confirm to economic theory was simple: modern production occurs in factories, where the relationships between various inputs has been carefully planned by engineers. According to Eiteman, engineers design factories
so as to cause the variable factor to be used most efficiently when the plant is operated close to capacity. Under such conditions an average variable cost curve declines steadily until the point of capacity output is reached. A marginal cost curve derived from such an average cost curve lies below the average cost curve at all scales of operation short of capacity, a fact that makes it physically impossible for an enterprise to determine a scale of operations by equating marginal cost and marginal revenues. (Eiteman 1947)
Lee has since argued, again on the basis of empirical research into prices, that firms use a blend of three approaches to determine prices. An industrial firm will:
• set a markup over direct production costs, where the markup is constrained to some degree by competitive pressures;
• set prices in a three-stage process where stage one covers production costs, stage two the firm’s management expenses, and stage three sets a profit margin;
• set a target rate of return compared to the market or book value of the firm's assets; or they will use a combination of all three approaches across a range of products (Lee 1998).
These researchers concluded that actual price setting has nothing to do with clearing the market by equating market supply to market demand–which economic theory sees as the role of prices. Instead, prices are set to enable the firm to continue as a going concern. Equating supply and demand in any arbitrary period of time is irrelevant to a firm which hopes to exist for the indefinite future. As Lee put it:
market prices are not market-clearing or profit-maximising prices, but rather are enterprise-, and hence transaction-reproducing prices (Lee 1998)
At the very least, these empirically-based analyses of price setting call into question the generality of the economic vision of price being determined by the intersection of a rising marginal cost and a falling marginal revenue, and therefore provide empirical support for Sraffa’s theoretical critique. Most of these researchers were rather more damning in their judgment about the value of the conventional economic theory of markets and price setting, however. My favourite dismissal of supply and demand analysis was that given by Tucker, whom Lee says
viewed the economists’ concepts of perfect competition and monopoly as virtual nonsense and “the product of the itching imaginations of uninformed and inexperienced armchair theorizers”. (Lee 1998, citing Tucker)