Managerial Economics

Managerial Economics Lecture Two: How economic theory stacks up against reality What’s wrong with diminishing marginal productivity?

Last week • Economic theory: • Output & price set by falling marginal revenue on one hand, rising marginal cost on the other • Economic reality: Blinder’s survey • Results contradict most of economic theory • Most sales to other businesses, not end consumers • Most sales to repeat customers, not “impersonal” • Marginal costs fall for most firms, not rise • Most firms face inelastic demand (E<1), not elastic • Fixed costs more important than variable costs • Summary? • From an economist’s point of view, the real world is a strange place…

Economic facts of the firm: overview • “First, about 85 percent of all the goods and services in the U.S. nonfarm business sector are sold to "regular customers" with whom sellers have an ongoing relationship … And about 70 percent of sales are business to business rather than from businesses to consumers… • Second, and related, contractual rigidities … are extremely common … about one-quarter of output is sold under contracts that fix nominal prices for a nontrivial period of time. And it appears that discounts from contract prices are rare. Roughly another 60 percent of output is covered by Okun-style implicit contracts which slow down price adjustments. • Third, firms typically report fixed costs that are quite high relative to variable costs. And they rarely report the upward-sloping marginal cost curves that are ubiquitous in economic theory. Indeed, downward-sloping marginal cost curves are more common… If these answers are to be believed … then [a good deal of microeconomic theory] is called into question… For example, price cannot approximate marginal cost in a competitive market if fixed costs are very high.” (p. 302)

Economic facts of the firm: detail • How fast do prices adjust? • Economic theory: quickly • Prices adjust to bring demand and supply into equilibrium • Adjustment process so fast that non-equilibrium sales (where demand is greater than supply or vice versa) can be ignored • Blinder’s results: slowly • 23% of firms adjust prices instantly after a shock to demand • 20% adjust within a month • 26% take 1-3 months to adjust prices • 21% take 4-6 months • 11% take more than six months

Economic facts of the firm • Frequency of price adjustments a factor in speed of adjustment • Less than 2% of firms adjusted price daily • 50% of firms changed prices only once a year • Extremely sluggish compared to economic model of instantaneous movement from one equilibrium price to another • If supply/demand analysis accurate, most sales occur out of equilibrium

Economic facts of the firm

Economic facts of the firm • To whom do firms sell? • Economic theory: Utility maximising consumers • No buyer/seller relationship; only interest lowest price • Blinder’s results: 85% of sales to repeat customers • “Thus, in the aggregate, sales to nonrepeat customers are almost small enough to be ignored.” (96-97) • But conventional economic theory based on this minority! • 38% of GDP sold under written contracts • At least 75% of these fix price for over a year with no discounts • 70% of sales to other businesses; only 21% to consumers (other 9% mainly government) • Type of customers explain infrequent price changes: • wish not to disturb continuing customer relations

Economic facts of the firm • Regular up/down price movements would • Antogonise consumers in planning budgets • Disturb cost/revenue calculations of other businesses who make up 70% of all sales (and large proportion of repeat business)

Economic facts of the firm • Are firms concerned with nominal or real prices/profits? • Economic theory: only real values matter • Prices should be adjusted to achieve real rather than nominal returns • Blinder’s results: 50% of firms never consider expected price inflation when setting own prices • Less than 1/3rd do consider expected inflation • “The responses hold bad news for any theory based on the idea that firms seek to set their real price.” (98)

Economic facts of the firm • Is demand elasticity high or low? • Economic theory: Elasticity of demand an important concept • Most industries competitive & elasticity should be high • Blinder’s results: “most firms … not only do not have an elasticity estimate handy but [also] are unaccustomed to thinking in such terms.” (99) • 40% of firms said elasticity zero: no change in demand for 10% cut in price • 70% elasticity below 1; only 2.5% of firms high elasticity (E>5) • “only about one-sixth of GDP is sold under conditions of elastic demand” (E>1) • “the numbers … may offer a simple key to understanding price stickiness because, as even beginning students of economics are taught, only firms with price elasticity of demand greater than unity can increase total revenue by cutting prices.” (99)

Economic facts of the firm • Firm with elastic demand can increase revenue by reducing cost • Fairly likely to compete on price • Inelastic demand means cut in price will reduce revenue • Unlikely to compete on price Price Elastic Demand Small fall in price, large rise in revenue Small fall in price, large fall in revenue Inelastic Demand Quantity

Economic facts of the firm • Are fixed costs important? • Economic theory: No. • Fixed costs are “sunk” costs • Variable costs determine scale of output • Firm should operate as long as revenue exceeds variable costs • Blinder’s results: Fixed costs important • “in a fair number of cases—and this was the big surprise—we found that the ‘fixed’ versus ‘variable’ distinction was just not a natural one for the firm to make.” (101) • 44% of costs fixed and 56% variable • “fixed costs appear to be more important in the real world than in economic theory.” (101)

Economic facts of the firm • Economic “examples” • Always “made up”—e.g., Mankiw Microeconomics 2003—rather than real • Have low fixed costs • Fixed costs low percentage of average cost • Why made up examples? • Because can’t find real ones that fit the theory…

Economic facts of the firm • Theory makes fixed costs irrelevant anyway • But they’re not “irrelevant” in real world • Fixed costs much higher in absolute terms than theory’s models • Fixed cost of new semiconductor plant well over US$1 billion • & much larger proportion of average total costs • “While we lack a good metric against which to judge these numbers, fixed costs appear to be more important in the real world than in economic theory.” (101)

Economic facts of the firm • Does marginal cost rise? • Economic theory: Yes! Marginal cost must rise otherwise • Firms in competitive industries would produce infinite amounts • Firms in other industries couldn’t work out a profit maximising level of output • Blinder’s results: only minority have rising marginal cost • 41% of firms have falling marginal costs • 48% of firms have constant marginal costs • Only 11% of firms have rising marginal costs • “The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost.” (102)

Price Quantity Economic facts of the firm • Rising MC needed for “MC=MR rule” to identify maximum profit point • Needed for price theory • Downward sloping marginal cost curves  downward sloping supply curve • Increase in demand causes price to fall; good for consumers but bad for economic theory… Pe Supply Demand Qe

Economic facts of the firm • Why are falling marginal costs “bad for theory”? • Because theory sees price as reflecting relative scarcity • If demand rises, relative scarcity rises  price should rise • With falling marginal costs, rise in demand  fall in price • “price signals” don’t function as economists expect • Maybe prices don’t reflect relative scarcity • Maybe other factors (e.g., rate of growth of demand) play role economists assume played by prices • Think computer, MP3 players • Rising demand & falling price • Falling relative price obviously doesn’t make products less profitable to produce

Economic facts of the firm • Will shifting supply and demand cause fluctuating prices? • Economic theory: Yes • If demand increases then price will rise because supply curve slopes upwards because of rising marginal cost • Blinder’s results: No • “one basic reason for expecting prices to rise in booms and fall in slumps is the presumption that demand curves are shifting in and out along upward-sloping supply curves… If the supply prices of cyclically sensitive goods are more commonly downward-sloping, then we would expect their relative prices to move counter-cyclically instead. Then, if nominal marginal costs rise in booms, nominal prices might not show much cyclicality at all.” (102-104)

Economic facts of the firm • Do stocks matter? • Economic theory: No. Markets are “spot” markets; sales occur at equilibrium prices that precisely equate supply and demand • Blinder’s results: Yes • “On average, 54 per cent of output is produced to stock.” (104) • “Wholesale and retail firms report that they sell primarily from stock” • Fluctuations in stock levels play buffer role between supply and demand that economists assumed performed by prices

Economic facts of the firm • Is economic theory relevant to management/business? • Economic theory: of course! • Blinder’s results: No—not conventional theory anyway! • “Firms report having very high fixed costs-roughly 40 percent 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.” (105)

Economic facts of the firm • Economic facts of the firm conflict strongly with assumptions of (neoclassical) economics • Infrequent price adjustments • Fixed price contracts common • Most sales to other businesses, not “utility maximizing” consumers • Fixed costs very important, large percentage of product costs • Marginal costs fall for most businesses, not rise • So what’s gone wrong with theory? • Basis of theory is diminishing marginal productivity…

Diminishing marginal productivity • Basic concept sounds sensible • One (or more) fixed resources • One variable resource • To increase output in short run, have to add additional variable inputs to fixed input • Exceed ideal variable:fixed ratio, output still rises but at diminishing rate • Diminishing marginal productivity means rising marginal cost • BUT… • Remember “jackhammer” example • Low variable:fixed ratio… one person operating six jackhammers? • High variable:fixed ratio… more than one person per jackhammer?

Diminishing marginal productivity • Both are nonsense • Less workers than jackhammers? • One worker per jackhammer: get best possible “holes per worker” outcome by leaving other jackhammers idle • More workers than jackhammers? • No, just hire more jackhammers • Not really true to say input of jackhammers “fixed” • Easy to hire extra jackhammers when needed • Concept of a “fixed” resource artificial • Sounds OK in theory, but in “real world” can often readily hire additional machinery, etc. • Real world result: marginal cost constant (or falling)…

Diminishing marginal productivity • In real world, if: • firms always operating within capacity; or • machinery inputs can be expanded as easily as labour • Then: • constant marginal productivity • constant marginal cost • With high fixed costs, per unit cost of production falls as output rises • Marginal cost would always be below average cost:

Constant marginal productivity • Couldn’t have “competitive” industries as economists define them • Price equal to marginal cost • Because then firms could only make losses: “Monopolyprofit” “Competitive loss”

Constant marginal productivity • So two conditions needed in real world for constant marginal cost: • (1) All inputs employed in ideal ratio up to capacity • (2) Firm always operates within capacity • 1st condition easy! • Economic textbooks almost always draw falling segment of marginal cost… e.g., Mankiw 2003 Ch 13: • But this is “one worker operating six jackhammers” • Real firms employ workers & machines at engineering ideal ratio up to capacity • Therefore productivity constant right out to capacity:

Price Quantity Constant marginal productivity • If factories plotted marginal cost, this is how it would look for 89-95% of them: • Constant or falling marginal cost as point of maximum capacity & efficiency reached • Steeply rising marginal cost once at full capacity “Marginal cost” • But this rising segment never reached in practice, as explained later

Constant marginal productivity • Blinder’s findings echoed Eiteman’s half a century earlier: most real firms have constant or falling marginal costs • Factories are designed by engineers “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) • Roughly 140 academic studies found the same thing: marginal cost & marginal revenue irrelevant to real firms

Constant marginal productivity • E.g., Eiteman & Guthrie 1952 showed managers 8 hypothetical average cost curves: • 6-8 constant or falling MC: • “6… high at minimum output, … decline gradually to a least-cost point near capacity, after which they rise slightly; 7… high at minimum output, … decline gradually to capacity at which point they are lowest.” (Eiteman & Guthrie 1952: 835) • 3-5 “neoclassical”: • 3 most like textbook drawing • “5… high at minimum output, … decline gradually to a least-cost point near capacity, after which they rise sharply.”

Constant marginal productivity Only 18 out of 336 fit neoclassical vision of diminishing marginal productivity, rising marginal cost Almost 2/3rds have lowest unit costs at maximum output

Constant marginal productivity • Rising MC cost curves fits just 5% of companies & products • Other 95% experience constant or falling marginal cost • Don’t even get to first base on “MR=MC” • MC has to rise for MR=MC to be any guide to profit maximisation (even with modified formula shown later) • Otherwise average costs above marginal cost • So “diminishing marginal productivity” doesn’t apply out to capacity: instead, constant MP until capacity • Second issue: do firms operate within capacity?

Operation within capacity • At macro level, USA clearly operates below capacity • Capacity utilisation below 90% even during booming ’60s:

Operation within capacity • At firm level: operation within capacity makes sense • Firm operates in growing economy • Must plan for growth • Say expects 5% growth p.a.; • Expects factory to last ten years; takes 2 years to build • Factory starts operation at 60% capacity • Efficiency rises over time • After 8 years, factory at 90% capacity • New factory commissioned • When old factory at 100% capacity, new factory starts… • Firm never reaches capacity where marginal costs rise

Operation within capacity • Hypothetical example consistent with Blinder’s findings • Output & efficiency rise towards capacity; • At 90% capacity, new factory commissioned • When old factory approaches 100% capacity • new factory starts at >60% capacity • Old factory refurbished, etc.

Price Quantity/Time Operation within capacity • Pattern over time series of overlaps of constant/falling marginal cost “Marginal cost” 1990 plant “Marginal cost” 2000 plant • At any time, output well within current capacity • Increasing output normally reduces unit costs Because…

Operation within capacity • “Even with the low efficiency and premium pay of overtime work, our unit costs would still decline with increased production since the absorption of fixed expenses would more than offset the added direct expenses incurred.” (Manager response to Eiteman survey 1947) • So marginal cost curves slope down in reality… • What does this mean for “supply & demand” analysis? • It can’t work! • Market supply curve = sum of marginal cost curves if all firms produce where price equals marginal cost

Price Price Quantity quantity What price “supply & demand”? • “Works” for rising marginal cost since firms can make a profit: Marginal Cost Supply Pe Pe Demand Qe qe

Price quantity What price “supply & demand”? • Area beneath price line is total revenue • Area beneath marginal cost curve is variable cost • Total costs include fixed costs as well Marginal Cost Pe Revenue>Variable cost • With rising MC, firm covers variable costs and at least some of fixed costs • Theory says should operate • Can make profit qe But if marginal cost slopes down…

Price quantity What price “supply & demand”? • Firm can’t even cover variable costs • According to theory, it should shut down • So • Market can’t be “competitive” if this means Price = Marginal Cost • Price must exceed marginal cost in 89% (Blinder) to 95% (Eiteman) of real industries Revenue where P>MC Revenue>Variable cost Loss Price Pe Marginal Cost Revenue Variable cost • Can’t have quantity determined by “horizontal demand curve” (P=MR) and marginal cost because profit rises as output rises qe

Price Quantity What price “supply & demand”? • Whatever shape of demand curve, price must be above “supply curve” if marginal cost constant or falling • Price can’t be below here, otherwise firms won’t cover costs • Conventional theory might make some sense with analysis of “monopoly” behavior • Price set where marginal revenue equals marginal cost… • Must be above here for profit; but where? • “Supply & demand” can’t tell… Demand AFC+MC AFC “Supply” (sum MC curves)

Deadweight loss Monopoly price Marginal revenue Monopoly quantity Efficient quantity What price “supply & demand”? • Conventional economics anti-monopoly because of perceived exploitation of consumer • E.g. from Mankiw 2001 Ch. 15 “The Inefficiency of Monopoly...” Price Marginal cost • But anti-monopoly argument irrelevant anyway if MC constant or falling for vast majority of firms • And it has other problems… Demand 0 Quantity

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve Price Price Demand Demand 0 Quantity of Output Quantity of Output 0 What price “supply & demand”? • Conventional textbook view monopoly versus competition (Mankiw 2001 Ch. 15) • Whole basis of alleged difference in behavior is shape of demand curve: horizontal for competitive firm, downward sloping for monopoly

Price Quantity What price “supply & demand”? • “Horizontal demand curve” mathematically false: • Slope of competitive market demand curve negative • Slope of individual firm demand curve the same: • First published in 1957 by George Stigler • Ignored by economics textbooks & most economists…

What price “supply & demand”? • Worse still, “profit-maximising” advice of conventional theory wrong • Equating marginal revenue and marginal cost doesn’t maximise profits for firm in a multi-firm industry • Profit maximising formula is not • MR=MC but • where n is number of firms in industry • Technical details complicated (click here for the hard stuff), but end result: no difference in economic theory between monopoly & competition • Discussed further when we consider game theory, but • Bottom line: accepted theory of little help to managers wanting to know how to set price!

Managerial Economics