GURWES PKE Tutorials – A Note On Constant Marginal Cost

At this week’s voluntary tutorial on Economics 2B run by GURWES, some points came up which may need further clarification.
It was asserted that firms generally (and particularly firms in manufacturing) produce with constant marginal/unit cost. This is in contrast with neoclassical microeconomic theory, which typically holds that firms will produce at rising MC.

The first thing to note is that this question is of highest importance when discussing perfect competition. In the first tutorial, the point was made that an independent supply curve can only be derived for perfect competition (an independent supply curve traces out a unique relationship between quantity and price, i.e. each quantity is only produced at one specific price and vice-versa). All mainstream micro textbooks make this point, and usually have a diagram to show why a supply curve which is independent from the demand curve cannot be derived for a monopoly, for instance (see e.g. Pindyck & Rubinfeld, 2012, p. 366 (still the 2A textbook?)). So, keep in mind that whenever you are shown a diagram (e.g. to analyse the welfare impact of a sales tax) where supply and demand are depicted as independent, it is implicitly assumed that the investigated industry is perfectly competitive, even if this is not mentioned explicitly. I know, in the first tutorial we showed how even under perfect competition, an independent supply curve cannot be derived, but let’s accept the neoclassical reasoning for the moment, i.e. assume that a perfectly competitive firm is facing a horizontal demand curve at the prevailing market price.

How does a perfectly competitive firm behave? It observes the prevailing market price and then produces output until its marginal cost has risen far enough to equal that price. What would happen if the marginal cost was constant? Well, the firm would produce an infinite amount of output, since MC would never equal P (Yes, even the Post Keynesian firm experiences rising unit cost beyond full capacity, but bear with me). So marginal cost can’t possibly be constant, right? Well, this is where the theory really runs into trouble because, unfortunately, studies conducted by Alan Blinder (not exactly a heterodox economist, incidentally), as cited by Keen (2011, p. 126) show that only around 11% of US GDP are produced under conditions of rising marginal cost. So 89% aren’t. The point here is that if marginal cost at the point of production is constant, the firm cannot possibly be a profit-maximising perfectly competitive firm as envisioned by neoclassical theory, see the diagrams below:

PCMC

(Note: the second diagram is not the Post Keynesian production diagram but just a tool for illustration! The appropriate diagram can be found in Lavioe (2006) and in your lecture slides)
From the presentation in most micro textbooks, you could get the impression that at least 90% of the economy was perfectly competitive, by the relative weight given to the examination and application of that theory. A prime example is Mankiw (2012) who, in his treatment of income distribution, thinks it’s okay to model the entire economy as perfectly competitive. This is not the case (quite apart from the fact that the theory is unsound in the first place).

Studies like Blinder’s are also a good point of departure for discussing the Post Keynesian/Kaleckian theory of the firm. There are other studies also cited in Keen (2011, Ch. 5) showing that constant or falling marginal cost is appropriate to describe the vast majority of firms’ cost-conditions in industrialised countries. Then there is the data on excess capacity, also cited in that chapter as well as in Lavoie (2006), which we mentioned in the tutorial.

Observing this evidence, which are the most appropriate premises on which to construct a theory of production? The Post Keynesian theory of the firm, as presented to you in lectures and this week’s tutorial, would suggest itself since Leontief production functions result in constant or, under economies of scale, falling unit direct cost. In this sense, it is in accordance with the real world.

Leontief production functions also imply constant factor proportions, that is, labour and capital are used in a fixed ratio to produce output. Whether this always holds in practice I do not know, but keep in mind that the labour included in this ratio is only the labour physically required to produce the output, i.e. supervisors, managers, accountants, marketing and so forth are part of the overhead, the fixed cost! The Post Keynesian reasoning is that an existing plant embodies the technology prevailing when it was built. It was planned and constructed to be operated at maximum efficiency from the start by a specific number of workers, so that adding or removing a few does not make sense (one could add an additional shift though, if capacity permits, keeping the ratio constant). Similarly, if the plant can be divided into several assembly lines, it wouldn’t make sense to employ its entire capital at less than full efficiency by spreading workers evenly (which is what the neoclassical firm would do) but rather to operate one segment at full efficiency, leaving the rest idle (A point made by Sraffa and illustrated by an example in Keen (2011, p. 113)). As Lavoie (2006: 40) notes: “each firm usually has a number of physical plants, which are generally divided into a number of segments or assembly lines. The level of practical capacity is defined as the production capacity of a plant or a plant segment, as measured by engineers, the so-called engineer-rated capacity. Each segment is designed to operate with a given number of workers for a given number of hours. (…) Even if some flexibility is possible, bureaucratic rules and regulations, such as collective bargaining agreements, as well as customs and habits, dictate the number of workers on each machine.”

Is this a perfect description of reality? Probably not, but I would argue that it is a far more valid generalisation than neoclassical production functions given the empirical data.

Further (theoretical) underpinning comes from Piero Sraffa’s critique of diminishing returns, outlined in Keen (2011, Ch. 5). Sraffa observes that neoclassical economics makes two assumptions which are mutually contradictory:

–          Demand and supply curves are independent

–          There are factors of production which are fixed in the short run

Note that the “law” of diminishing returns has its origins in classical political economy. David Ricardo used it to derive a theory of aggregate rent on land. So it was originally conceived as a concept applying at the macro-level, connected to the distribution of income. Neoclassical economists picked up on the concept and applied it to the micro-level theory of production.

Sraffa goes on two make two critiques:

Sraffa’s broad arrow: If an industry is broadly defined (say, the agricultural sector), it is valid to treat one input as fixed. The industry utilises a large share (or, in extreme cases, all) of it and it will be costly and time-consuming to obtain additional doses of it. However, such a broadly defined industry can no longer be treated as a price-taker in input markets. If agriculture attempts to increase its output by employing more labour, the price of labour (the wage rate) will rise. This affects the distribution of income, and hence demand for the output of this broadly defined industry. Demand and supply are not independent, i.e. it is not possible to derive an independent supply curve. “Thus while diminishing returns do exist when industries are broadly defined, no industry can be considered in isolation from all others [which is what neoclassical theory of production does], as supply and demand curve analysis requires” (Keen, 2011, p. 111).

Sraffa’s narrow arrow: If an industry is narrowly defined, on the other hand, Sraffa argues that the assumption that some input is fixed is not reasonable. Sraffa argues that, if need be, such a narrowly defined industry will be able to draw marginal doses of this input from other industries, or to activate unutilised stocks of inputs, so that its unit-cost won’t increase appreciably. The former may, admittedly, not be the case with inputs such as specialised capital equipment, but the empirical observations on spare capital capacity in industry back up Sraffa’s point. This means that the ratio of inputs remains constant as output is increased.

The reasons firms have for keeping spare capacity were, I think, sufficiently discussed in the tutorial. An important point to note is that the output of a firm producing at constant marginal cost is constrained by demand. Sure, the firm would like to sell as much as it could possibly produce, but because in the real world firms aren’t perfectly competitive and products are differentiated, for a given demand there’s only so much output that can be sold. We could also add that a firm is constrained by available internal and external financing. Production takes time, and workers typically have to be paid before the output is sold.

I hope this makes the whole story a bit clearer, and if any questions remain please feel free to ask them next week! Also, I emphasise again that it’s really worth reading Keen’s book. If not all of it then at least those chapters with direct relevance to the course content. It covers not only the stuff you talk about in your tutorials, but also things you will be examined on (such as the Post Keynesian theory of the firm) and it really helped me get a better idea of the concepts, whilst at the same time it is quite entertaining.

Best,
Severin

References:

Keen, Steve (2011) Debunking Economics – The Naked Emperor Dethroned? Revised and Expanded Edition, London: Zed Books.

Lavoie, Marc (2009) Introduction to Post-Keynesian Economics, Basingstoke: Palgrave Macmillan.

Mankiw, Gregory (2012) Macroeconomics International Edition, 8th edition, Basingstoke: Worth Publishers/Palgrave Macmillan.

Pindyck, Robert and Rubinfeld, Daniel (2012) Microeconomics – International Edition, 8th edition, Boston: Pearson.

 

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