Whichever Way You Paint It, The Supply Curve Is Flat

The conventional ‘upward sloping’ supply curve is known by everyone from an econ101 student to a professional economist. The curve posits a positive relationship between price and quantity supplied – in order to increase the quantity supplied, a higher price must be offered. What is less commonly known, however, is that an upward sloping supply curve is actually incredibly hard to justify, both in theory and in practice.

Behind the curve lies the proposition that production costs per unit increase as output increases. This makes the ‘upward slope’ a necessity: since an item costs more to produce, a higher price must be charged as production increases. Microeconomic theory posits that this relationship holds in both the short and long run. However, all signs say this can’t be true.

The Short Run

The neoclassical idea is that firms can only increase one factor in the short run, which gives birth to the increasing marginal cost argument – returns to production diminish as more and more is ‘squeezed’ out of the fixed input. Is this how production behaves?

I have previously commented on Piero Sraffa’s excellent critique of the idea of increasing marginal costs in the short run. Sraffa’s argument was two pronged, depending on how we define a ‘firm’ or ‘industry.’

Sraffa argued If we define an industry narrowly, such as a single firm, it turns out firms generally have a lot of spare capacity and can quickly employ previously idle resources to expand all inputs at once. This belies the traditional justification for decreasing returns – if we expand inputs simultaneously, we should expect roughly constant increases in output as a result.

Sraffa went on to argue that we could define an industry broadly enough that it’s reasonable to say a factor is fixed in the short run. This would be because, for a large industry, a new factor would have to be converted from other uses before it could be employed. Hence, diminishing returns may be possible. However, at this point it is no longer possible to neglect the collateral effects caused by changes in firm’s expenditure and output: the partial equilibrium method becomes contradictory, and the various curves – demand, supply, average cost – cannot move independently, which is a key assumption of the theory. So the theory as a whole is no longer appropriate.

So the idea doesn’t hold up in the short run, except in the extremely small number of cases that lie between the ‘narrow’ and ‘broad’ definitions. But what about the long run?

The Long Run

If you learn producer theory from the bottom up, one of the assumptions you start with is that inputs and outputs are infinitely divisible; in other words, they are like clay. They are also homogeneous, and available at a set price. Based on these assumptions, it is reasonable to assume that in a short run – when one factor is fixed – there may be increasing marginal costs. At this point I would defer to Sraffa’s above critique.

However, when we move to the long run, it’s incredibly hard to justify increasing MC even within the confines of the theory. Textbooks will generally assume the standard production function, which looks like this:

The downward sloping portion – for which costs fall as output rises – will generally be justified by ‘Economies of Scale (EoS).’ But what causes EoS? Bulk buying is one example, but this can’t apply because prices are taken as a given. Another is indivisibilities – if you buy a big machine it takes a while before you fully utilise it – but this quite clearly contradicts the assumption of perfectly divisible inputs. Yet another, the increasing returns to the division of labour, contradicts the assumption of homogeneous inputs.

Similarly, the upward sloping portion is then justified by ‘Diseconomies of Scale (DoS).’ Examples of this are generally few and far between – DoS is, after all, the strange proposition that firms simply become incompetent at some level – but again they tend to contradict our assumptions. One example is managerial difficulties – who is the manager if labour is homogeneous?

In fact, it turns out that few, if any, of the explanations for either EoS or DoS hold up under the available assumptions. If you increase a homogeneous  perfectly divisible mass of inputs a certain amount, there is no reason to expect anything other than a constant, proportional increase in put: in other words, constant returns to scale.

The Evidence

Unsurprisingly, it is true that the overwhelming majority of firms report constant or falling returns to scale. Walking down a high street in a capitalist country, it’s hard to deny that firms have the available goods to accommodate an increase in demand without a rise in cost; factories are designed in a similar fashion. Furthermore, in the long run a firm is likely to respond to an increase in demand by opening up more branches, rather than simply increasing prices.

So what’s the problem? The proposition that demand determines outputs and supply determines price is logically, intuitively and empirically reasonable in any time period and for most industries. Why can’t economists just tilt their supply curve 45 degrees to the right?

Well, at this point a few things become apparent. The theory of the firm becomes indeterminant: one of economist’s beloved negative feedback loops that allows the economy to self-equilibrate is gone, as firm size is not limited by production costs. Hence, the marginal theory of the firm goes from explaining everything – from firm size to income distribution – to explaining very little. This also makes explicit the idea that output in the economy is driven by demand, both in the short and long run, which contradicts conventional macro theory, where demand only matters because prices are sticky.

Overall, a flat supply curve turns the conventional story told in neoclassical economics, where the economy is self-equilibrating, bar a few frictions, to one where many key variables – wages, output, firm size – go from being at the equilibrium or ‘natural’ level, into one where they are largely arbitrary. It’s easy to see why economists would resist this.

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  1. #1 by Jon Finegold on December 11, 2012 - 4:34 pm

    One thing that bothers me in Keen’s book is the lack of reference to models of imperfect competition. These were developed after Sraffa’s 1926 article, but describe conditions that don’t fit the perfect competition model. Some of them also make use of game theory, and these are taught to undergrads (or, if not, undergrad textbooks do include chapters on them).

      • #3 by Jon Finegold on December 11, 2012 - 7:27 pm

        Right, I’m not saying that the supply curve is necessarily upward sloping in cases of imperfect competition. I’m just saying that there are more price models in Neoclassical economics than the perfectly competitive one.

    • #4 by Dallas on December 12, 2012 - 4:22 am

      “Right, I’m not saying that the supply curve is necessarily upward sloping in cases of imperfect competition.”

      If you are using a model of imperfect competition (monopoly, cournot oligopoly, etc), then there is no supply curve.

    • #5 by Unlearningecon on December 12, 2012 - 12:27 pm

      Yeah, well Keen takes on the momentous task of ‘debunking economics’ (duh) so I think he decided to stick to the core of what is taught on UG and PG courses.

      Having said that, even the more realistic models tend to carry over concepts and ideas that Keen talks about.

  2. #6 by john77 on December 11, 2012 - 5:40 pm

    Let us suppose, for just a minute, that the greedy capitalist has an IQ greater than his shoe size. Also that we are not talking about cornflakes so there is more than one machine making the product in question. Then the capitalist will buy from the factory with the lowest sale price/use the machine with the lowest marginal cost first. If that is not sufficient to meet demand he will buy from the next cheapest factory/use the next most efficient machine next and so on until demand is fully satisfied or he cannot make a profit from carrying on. If demand is still unmet then in order to call the next factory/machine into production the price has to rise because selling stuff at below cost of purchase/production is a one-way ticket to insolvency.
    You seem to assume that all factories and machines are identical. This just ain’t so in the real world. There is something called technological progress which periodically results in a new machine being more efficient than those currently in use and expected to remain in use for another twenty (or ten, or five, depending on how old they are) years. There are also wages which are higher in the UK and USA than in China or India.

    • #7 by Unlearningecon on December 12, 2012 - 2:17 am

      There are a couple of things worth noting about your example. The first is that there are other effects on the mechanics of production than the price of inputs. Even if it were rising, other EoS could offset this. More generally, however, your example simply contains the assumption that input prices must rise as demand rises – an upward sloping supply curve. But this is the same as your conclusion! So the logic is circular. In any case, there’s no reason to believe firms face increasing costs for their inputs- in fact, due to bulk buying, many face falling costs.

      You seem to assume that all factories and machines are identical. This just ain’t so in the real world.

      Here you are making your routine mistake of identifying an assumption of neoclassical economics- which I assume for the sake of argument – and mistaking it for my own assumption, then criticising it as part of a defence of the neoclassical approach. In no way do constant returns require inputs are homogeneous, and technological progress implies production costs may be falling.

    • #8 by john77 on December 12, 2012 - 7:30 pm

      You misread me. I am NOT assuming that input prices rise as demand increases – I am, as I state, assuming that the greedy capitalist has an IQ greater than his shoe size and explaining *why* input prices rise when demand does.
      I did not intend to insult you – it was fairly obvious that the assumption was an academic’s oversimplification *but* your argument relies upon it.In real life costs/prices vary so any rational individual will choose that giving the best value/cost ratio first. I am *including* economies of scale in the decision process.
      Technological progress means that when all the machines that were in use before the advance was made have been replaced the cost per unit is decreased *but* while they are in use the marginal cost is that of an old machine. if you want to argue that progress means that my son’s computer costs less than mine, I can only agree but that is not what the supply curve is all about.a

      • #9 by Unlearningecon on December 13, 2012 - 1:41 pm

        Right but what you are assuming is that the capitalist exhausts his first source. If this is true, then you are possibly right. But if the capitalist can continue buying from their existing supplier, I don’t think price will rise and in fact it will probably fall.

      • #10 by john77 on December 13, 2012 - 2:39 pm

        If the cheapest source can supply the whole market ….
        BUT I have stated that the greedy capitalist’s IQ is greater than his shoe size. If you already have N different machines then building a new machine that can supply the whole market at its cyclical peak is an appalling waste of capital

  3. #11 by JW Mason on December 11, 2012 - 6:45 pm

    This post is right, I think. In the short run, it is very hard to substitute between inputs, so the kinds of mechanisms john77 talks about, while plausible in the abstract, don’t really exist in practice, at least until short-run output rises well above its usual levels. It probably is possible to find rising short-run supply curves in wartime and the like, but not under normal conditions.

    I’m not sure this should be framed as a critique of the mainstream, though. A flat aggregate supply curve (with a monopoly-based markup over marginal cost) is a pretty standard part of New Keynesian economics, I think, and can be found in widely used textbooks.

    • #12 by john77 on December 11, 2012 - 11:34 pm

      J W Mason seems ignorant of what happens in the real world. Let me quote an easily checked example. There is something in the UK called an electricity supply grid and a large number of power generating plants and each day the different plants offer to sell electricity to the grid which buys the cheapest it can get so the price is higher when there is most demand.
      This pattern was very visible in the brick industry for generations until Hanson Trust bought London Brick and starting stockpiling bricks in cyclical downturns – until then brickmakers competed on price during downturns and sold fewer bricks at lower prices.
      In the steel industry it is the highest-cost plants that get shut down first by private sector owners (but not if it is state-owned in Nye Bevan’s constituency).
      In the oil industry, the cheapest production is controlled by OPEC politics but for a given political stance and level of world-wide the US price is set by the marginal cost of some “nodding donkey” well in Oklahoma – if price is less than its marginal cost it won’t reopen after it is next closed down for maintenance so you do get the Econ 101 supply-demand curve.
      There are markets in all sorts of food and other commodities all over the world and and Unilever or Nestle or Danone or Archer Daniels will fill their boots with produce from the cheapest supplier first.

      • #13 by Unlearningecon on December 12, 2012 - 2:33 am

        There are examples of increasing costs – if quantity is fixed; if the good is positional; various other examples such as the electricity grid. However, as I said above, costs aren’t the only factor influencing production, and the evidence seems to suggest that these cases are few and far between.

    • #14 by Unlearningecon on December 12, 2012 - 2:19 am

      There are a few conditions where we might observe demand increasing price: positional goods; goods with a fixed quantity; in wartime where production really is pushed to the limit; and that small amount of cases that lie between Sraffa’s two examples.

      I’m not sure this should be framed as a critique of the mainstream, though. A flat aggregate supply curve (with a monopoly-based markup over marginal cost) is a pretty standard part of New Keynesian economics, I think, and can be found in widely used textbooks.

      Really? Which books? I’ve certainly never seen it.

  4. #15 by Ramanan on December 11, 2012 - 7:14 pm

    I like your post very much. Except that your headline is a bit extreme – not saying that in a negative way.

    It leaves you to being attacked with questions such as, “if what you are saying is true, one can put up fiscal policy and double output in six months”.

    I understand output is demand driven/led both in the short run and in the long run, but output is also supply constrained – although not in the neoclassical sense.

    • #16 by Unlearningecon on December 12, 2012 - 2:36 am

      Yeah, of course there are supply constraints. But we are incredibly far away from them.

  5. #17 by Matías Vernengo on December 11, 2012 - 9:31 pm

    Sraffa suggested that there is a tendency in economics to create functions where none exist. There is a complex function that transforms commodities into commodities (represented by his prices equations in PCMC). The flat supply curve (which would mean constant returns) is just a very simplistic assumption, which is reasonabel for certain circumstances. In fact, in real economies increasing returns are very common. Downward sloping supply functions would mean a tendency for monopolies, as noted in his 1926 paper. He abandoned such notions by 1927, to deal with the more general case of price determination under conditions of a given quantities, the method of the old classical authors.

    • #18 by Unlearningecon on December 12, 2012 - 2:28 am

      I was just assuming the flat curve for the sake of the argument, but downward sloping is probably more reasonable than flat.

  6. #19 by Dallas on December 11, 2012 - 10:08 pm

    Unlearningecon,

    Even if you believed Eiteman’s survey results from 60 years ago and assumed that all firms utilized production processes with constant returns to scale, that doesn’t have to imply that the industry supply curve will be flat.

    This would only be true if, as you are assuming that, the price of inputs is constant regardless of how much input is purchased. That is a fine assumption for a single firm, but for this assumption to hold true when an entire industry increases demand for an input, you essentially have to assume the supply of that input is perfectly elastic. That seems like a REALLY strong assumption. Especially for inputs whose supply is relatively fixed like land.

    In Milton Friedman’s Price Theory textbook, this is the primary reason why he stresses that an industry supply function is not simply the summation of marginal costs across firms.

    • #20 by Unlearningecon on December 12, 2012 - 2:23 am

      That is a fine assumption for a single firm, but for this assumption to hold true when an entire industry increases demand for an input, you essentially have to assume the supply of that input is perfectly elastic. That seems like a REALLY strong assumption.

      Honestly I don’t think it is. Due to bulk buying, many firms experience decreasing average costs as their inputs increase.

      Especially for inputs whose supply is relatively fixed like land.

      It is worth noting that when I say ‘the’ supply curve, I am playing devil’s advocate. I do not believe one ‘theory of the market’ can be applied to all situations. Where land is a major factor, we are more likely to observe these effects – for example Ricardo’s law of diminishing rents on land was based on this. Olive oil also apparently exhibits increasing MC. However, for everyday commodities which are produced and consumed regularly, a flat or downward sloping supply curve seems to be a good first approximation.

      • #21 by Dallas on December 12, 2012 - 4:10 am

        Unlearningecon,

        “Honestly I don’t think it is. Due to bulk buying, many firms experience decreasing average costs as their inputs increase.”

        Why would an input seller offer lower prices the more that it sells? I can think of two reasons.

        First, if the input seller was a monopolist, they might offer quantity discounts to individual companies that purchase more of the input (second degree price discrimination).

        Second, if the production of the input was characterized by increasing returns to scale, the input seller could sell the input for less as more was produced.

        Unfortunately, neither of these explanations make sense for major inputs like labor or lands.

        First, neither labor or land are monopolies. So I don’t see how price discrimination could be driving quantity discounts. Of course, even if it were, this explanation only explains why individual companies might receive quantity discounts as they purchase more of an input. As an entire industry buys more of an input, even a price discriminating monopolist would raise its price.

        Second, neither the production of labor or land are characterized by increasing returns to scale.

      • #22 by Unlearningecon on December 12, 2012 - 3:08 pm

        First, if the input seller was a monopolist, they might offer quantity discounts to individual companies that purchase more of the input (second degree price discrimination).

        I think this is the major factor. Any business will tell you that they get cheaper prices per unit if they buy substantially more. I mean, you can find this form of discrimination pretty much every day.

        Unfortunately, neither of these explanations make sense for major inputs like labor or lands.

        No, wages for the overwhelming majority of workers will be the same for a given job in an organisation. Land prices may increase (I’m not sure if this is true empirically?) but as I said, this only translates into an increasing production function as a whole if land is a major factor, like in agriculture.

      • #23 by Dallas on December 12, 2012 - 3:56 pm

        “I think this is the major factor. Any business will tell you that they get cheaper prices per unit if they buy substantially more. I mean, you can find this form of discrimination pretty much every day.”

        But as I said, the same logic that applies to a single firm does not apply to an entire industry. If an input seller has monopoly power, then he might be able to earn additional profits by giving quantity discounts to individual companies.

        But that isn’t what we’re talking about when we’re deriving a supply function for an entire industry. If you increase the price of an output, that will increase the marginal revenue product for each input for each firm. This means “demand” for the input will increase. So if the marginal cost of producing the input is increasing, then this increase in demand for the input will HAVE to be met by an increase in the price for the input. That is true even if the input seller is a price discriminating monopolist.

        “No, wages for the overwhelming majority of workers will be the same for a given job in an organisation.”

        So? Again, you can’t assume reasoning that will work when an individual firm increases demand for an input will also work when an entire industry increases demand for an input.

        If a single firm hires more workers, then chances are they will be able to hire more workers at a constant wage. But that is because their demand for workers represents a very very very small fraction of the total demand for workers.

        But if an entire industry increases demand for workers, I don’t see how they will not bid up the wage.

      • #24 by john77 on December 12, 2012 - 10:32 pm

        Even if a single firm is trying to hire away workers from a rival it *does* have to bid up wages in order to do so.

      • #25 by Unlearningecon on December 13, 2012 - 12:56 pm

        First of all, let me note that we have completely abandoned the standard textbook justification for upward MC, which seems to me to be untenable.

        Second, if we are taking about an entire industry, remember Sraffa’s point that partial equilibrium analysis is actually invalid here. We can’t talk about these slopes moving independently as you seem to be; there are multiple feedback loops.

        Third, as I keep saying, input costs are not the only factor affecting production functions. There are many competing effects, and even if the price of inputs goes up we still have geometric relationships, the division of labour, indivisibilities and so forth working in the opposite direction.

        Fourth, capitalism is generally characterised by unemployed resources. If we were at full employment, perhaps the effects you speak of would take place. But historically we very rarely are.

        Fifth, if you are talking about an entire industry, are you making the claim that the firm’s curve is often downward or flat, but the industry curve slopes upward? Because this still makes the theory of the individual firm indeterminant.

        But that isn’t what we’re talking about when we’re deriving a supply function for an entire industry. If you increase the price of an output, that will increase the marginal revenue product for each input for each firm. This means “demand” for the input will increase. So if the marginal cost of producing the input is increasing, then this increase in demand for the input will HAVE to be met by an increase in the price for the input. That is true even if the input seller is a price discriminating monopolist.

        As I said, you are assuming an upward sloping supply curve in your argument. For me this just seems to be assuming your conclusion.

      • #26 by Dallas on December 13, 2012 - 1:48 pm

        “First of all, let me note that we have completely abandoned the standard textbook justification for upward MC, which seems to me to be untenable.”

        Actually, I think this is all standard textbook. You will find it in Milton Friedman’s Price Theory, George Stigler’s Theory of Price, and more recently Hirshleifer’s Price Theory and Applications.

        “Fourth, capitalism is generally characterised by unemployed resources.”

        It is?

        “As I said, you are assuming an upward sloping supply curve in your argument. For me this just seems to be assuming your conclusion.”

        Actually, my point all along has been that for your initial argument to work, the price of inputs must be constant. And this really only makes sense if the supply of inputs is perfectly elastic (as Nick Rowe also notes in his excellent comment to your post below).

        In other words, your argument that the output supply curve is flat hinges on your assumption that the input supply curves is flat (for which you have offered no empirical evidence). For me, this sounds like you are assuming your conclusion.

        I would recommend reading Nick Rowe’s comment (and his recent blog post). He makes the same points I am making much more simply and articulately.

      • #27 by Unlearningecon on December 14, 2012 - 1:46 pm

        I have read Nick Rowe and I worry we are all talking past each other.

        Actually, I think this is all standard textbook. You will find it in Milton Friedman’s Price Theory, George Stigler’s Theory of Price, and more recently Hirshleifer’s Price Theory and Applications.

        Well I haven’t read those but my textbook assumes perfectly divisible homogeneous inputs and outputs at fixed prices, among other things.

        Actually, my point all along has been that for your initial argument to work, the price of inputs must be constant.

        There is empirical evidence that inputs are flat or falling: firms report it. However, my argument doesn’t hinge on this. Some can be falling, some flat, some increasing. And as I keep emphasising, a firm’s production function is not defined merely by the price of inputs. Even if their costs are rising, EoS can offset this.

        As for when we jump to the macro level:

        (a) Partial equilibrium analysis becomes invalid anyway.

        (b) Macroeconomics as a whole can and do experience economies of scale rather than the opposite. For example recall Allyn Young’s “Increasing Returns and Economic Progress.”

        I’m not denying a firm can experience increasing MC. All I’m saying is that for frequently produced and consumed goods, expansion seems to mean falling prices. This is fairly intuitive if you speak to business owners/look around a supermarket.

        Oh and I think it is fair to say capitalism’s history has been one of unemployment and idle resources. See unemployment rates throughout history, as well as the spare capacity graph I linked to in my post. But this is besides the point.

      • #28 by Dallas on December 15, 2012 - 6:17 am

        “I have read Nick Rowe and I worry we are all talking past each other.”

        You could be right. It may be my fault we are talking past each other as I don’t think I am doing a good job of saying where I disagree with your post. Here’s a final attempt to make my complaints more clear. However, I will say that if we still don’t understand each other, I think this has been an interesting conversation. So I’m glad you made the post. :)

        “There is empirical evidence that inputs are flat or falling: firms report it.”

        I didn’t see a question on input prices reported in the Eiteman and Gutherie paper you posted. But even if we did do a survey and found that businesses report constant or falling input prices I don’t think that would prove anything.

        As I keep stressing, you can’t assume that what makes sense for an individual company will make sense for an entire industry. Think about it this way. If you asked me about the price of Oreos per cookie I might say that it is constant. I might even say that the price decreases the more cookies I buy (especially if I shop at CostCo). However, that doesn’t mean that if everyone in America tripled the amount of Oreos they buy, the price of oreos would stay the same or fall.

        “And as I keep emphasising, a firm’s production function is not defined merely by the price of inputs. Even if their costs are rising, EoS can offset this.”

        Agreed. Internal economies of scale could offset the rising input prices. But, if internal economies of scale were that extensive, we would wind up with only a few firms supplying the entire market (an oligopoly). So we wouldn’t have a supply curve at all (let alone a flat one). So I don’t think that supports the conclusion of your initial post.

        Let me be more clear about what I’m trying to say. I’m not saying you theoretically couldn’t have a flat or even a downward sloping supply curve. But I don’t think your arguments illustrate why such a phenomena is a possibility. Your initial post focused on INTERNAL returns to scale. Specifically, if we imagine an industry where all the firms have identical constant returns to scale technologies purchasing inputs at a constant price, then we would have a flat supply curve. I agree with that.

        BUT I think you are ignoring an important piece of the story. Namely, what happens in the input market as industry output expands. In other words, you are ignoring EXTERNAL economies/diseconomies of scale. If input prices rise as industry output expands, that will give rise to an upward sloping supply curve even if all firms have constant returns to scale technologies (this is an example of external DISeconomies to scale).

        Alternatively, you could have a situation where input prices fell as industry output increases. This would be a case of external economies of scale. But I could imagine a case of this happening. For example, if firms in industry are geographically concentrated, then as an industry grew bigger, input supplies may locate closer to those firms bringing down transportation costs and therefore input prices.

        Milton Friedman explicitly talks about the possibility of a “forward falling” supply curve and external economies of scale in his price theory textbook (see link). However, the idea apparently goes back to Alfred Marshall.

        My bottom line is that if you want to talk about supply curves you need to be talking about a competitive industry (that means no internal economies of scale). And the only way I can see a competitive industry having a downward sloping supply curve is if there external economies of scale present. Which your initial post didn’t mention and the empirical studies you link do not address.

        http://books.google.com/books?id=BxaSUfPV2WkC&pg=PA87&dq=forward+falling+supply+curve&hl=en&sa=X&ei=ig_MULH6DISK8QTt9IG4Bg&ved=0CDoQ6AEwAQ#v=onepage&q=forward%20falling%20supply%20curve&f=false

  7. #29 by Metatone on December 11, 2012 - 10:12 pm

    The most important bit of evidence – which may or may not support your exact critique, but supports some kind of critique is that we can see from the historical record that economies are not self-equibrilating. There is no single natural equilibrium. Historically we have evidence for at least 5 or 6 rough possibilities, which basically suggests there are a large number of possible equilibria.

    • #30 by Unlearningecon on December 14, 2012 - 3:10 pm

      Yeah, exactly. There’s no empirical evidence to support a single, stable equilibrium solution.

  8. #31 by JW Mason on December 11, 2012 - 10:48 pm

    Also, the existence of different vintages of capital only implies an upward sloping supply curve if demand shifts are assumed to be very short term, so there’s no adjustment of the capital stock. As soon as we allow investment to respond to demand, it points the other way, toward downward sloping supply curves. In general, if a business responds to increasing demand by reproducing an existing facility, the new one will produce at a lower cost than existing ones. Of course it’s an empirical question which effect dominates in practice; but Verdoorn’s law, which says that labor productivity moves in the same direction as output, is one of the stronger empirical regularities in macroeconomics.

    Okun’s law, also very well supported empirically, similarly points to increasing rather than decreasing returns. Since employment almost always changes less than proportionately with output — whether at the firm, industry or economy-wide level — it would seem that marginal labor costs are normally decreasing in output.

    • #32 by john77 on December 11, 2012 - 11:47 pm

      No. You are assuming a constant growth in demand which justifies building larger production units which benefit from economies of scale. Cyclical swings in demand are actually the norm. Also there are engineering and other limitations which determine the optimal size of a production unit so it does not necessarily follow that you can reduce unit cost by increasing the size.
      ” In general, if a business responds to increasing demand by reproducing an existing facility, the new one will produce at a lower cost than existing ones.” That does not make sense! If it reproduces an existing facility it produce at *the same* cost. If it makes technological improvements it will produce at lower cost. BUT that has a capital cost and a fairly long time-scale ,

      • #33 by Unlearningecon on December 13, 2012 - 1:39 pm

        A brief note on branch reproduction is that a new branch may well benefit from state of the art technologies and expertise and know how the firm didn’t have when it set up its existing branch. You alluded to the technology point John and I think it’s actually a fair assumption.

  9. #34 by Dallas on December 12, 2012 - 4:52 am

    Unlearningecon,

    I am a little sad your post does not mention or directly address a recent post by Nick Rowe on this same topic:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/11/four-mc-curves-and-two-ppfs.html#more

    He seems to directly address your concerns.

    • #35 by Unlearningecon on December 12, 2012 - 12:24 pm

      I’ve been so lax in the blogosphere recently, I wasn’t aware of that post. I’ll look at it.

    • #36 by Nick Rowe on December 13, 2012 - 11:48 am

      Thanks Dallas. But I think my much earlier post, that I link to in my comment below, is much closer to the sort of model Unlearning has in mind.

      Unlearning thinks macro, not micro. That’s OK.

      Like Unlearning, I used to suffer from cognitive dissonance when trying to think macro with perfect competition. Then i figured out how to do macro with monopolistic competition, and that resolved all my worries. (Well, not *all*, but a helluva lot of them.)

  10. #37 by Roman P. on December 12, 2012 - 7:59 am

    I think it is safe to say that supply and demand curves don’t even exist. They are just a metaphor for the forces that drive prices and quantities up and down. In the single moment of time, there is nothing besides a point in (P,Q) space – a quantity and a price for a single good on a single market. The curves take the hypothetical changes in prices and quantity and compress them into a static picture – useful when the markets are small and ceteris paribus applies but breaking down when you consider more and more factors. Because of that, there is not much sense in talking about industry supply curves and even less sense in talking about economy supply curve – as per Sraffa 1925. I think that to make a useful economy-wide model of production the first step would be to solve something like a dQ/dt=f(P,Q,t), but I won’t even guess what the f looks like.

    • #38 by Unlearningecon on December 12, 2012 - 12:23 pm

      Yeah, absolutely, this post is phrased narrowly for the sake of argument.

      Insofar as there is ‘a’ supply curve, it will vary depending on the market. The relationship will be different for (financial) capital, labour, assets, positional goods etc. But for commodities that are produced and consumed regularly, and whose nature it is easy to discern, constant or decreasing costs is a good starting approximation.

    • #39 by john77 on December 12, 2012 - 10:40 pm

      These curves do not have any physical existence: they merely describe the change in demand and supply as prices change if all other factors are kept static or the change in price if demand or supply changes while other factors remain static.

      • #40 by Roman P. on December 13, 2012 - 6:08 am

        john77,
        The thing is: they describe the -hypothetical- change. The change that we -think- will happen in a thought experiment where we omit time and other circumstances from consideration. The resulting devices, supply and demand curves, sort of work in a context like Menger’s horse trading or, if you want, Varian’s flat renting, but as you move to the more relevant problems of economic theory those curves lose all of their predictive power. AD/AS curves are especially bad. Does AD slope down? Why? Maybe income effects dominate and it slopes up? Maybe it all depends on a point of time? The correct answer should be that the AD curve does not exist in any sense useful to us (though it might exist as an incorrect theoretical concept).

      • #41 by john77 on December 13, 2012 - 8:55 am

        Quite!

      • #42 by Unlearningecon on December 13, 2012 - 1:37 pm

        Yeah, I feel like a should have prefaced this post with warning: angels dancing on a pinhead to follow. Really all I’m trying to say is that it’s difficult to suggest prices will rise for a firm as it increases output, except in some special cases.

  11. #43 by Nick Rowe on December 13, 2012 - 12:01 am

    Hi Unlearning.

    Let’s take a simplified version of your model.

    Assume one unit of labour produces 1 unit of output. The individual firm’s production function is y=l, and the aggregate production function is Y=L. Let W be the money wage. So Marginal Cost = Wage.

    Assume monopolistic competition, so the firm sets P as a markup (depending on elasticity of demand) over MC.

    The individual firm has a flat MC curve, but all firms in aggregate have an MC curve that is the same as the labour supply curve.

    Unless workers have a perfectly elastic labour supply curve, that aggregate MC curve will slope up.

    Here’s your macromodel in pictures: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/01/macroeconomics-with-monopolistic-competition-in-pictures.html

    (Just make the MC curve in the top picture horizontal, and remember that the MC curve in the second picture is the labour supply curve.)

  12. #44 by Unlearningecon on December 13, 2012 - 1:21 pm

    Nick,

    On this post, which is similar to what Dallas was saying:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/11/four-mc-curves-and-two-ppfs.html#more

    I’m surprised you didn’t reference Sraffa in that post as his critique seems to apply to it directly.

    In the short run, firms have excess capacity and generally vary all inputs at once. Sure, if they couldn’t you might experience diminishing returns (although this assumes a smoothness of inputs that is perhaps questionable), but the fact is – to paraphrase Keen – engineers design factories to avoid the problems economists think make their costs increase.

    When jumping to the level of industry, note Sraffa’s observation that static ‘curves’ and partial equilibrium methodology aren’t really appropriate, because the feedback effects from, say, doubling inputs like land are too large to ignore. Nevertheless, maybe there is something to be said for the mechanics you identify. But they seem only to apply to your example – agriculture – where land is a significant cost. For other industries, it is rare that an input is completely fixed (and there are other factor sin the production function than input costs).

    Furthermore, bear in mind that even in your example, the long run theory of the individual firm is indeterminant because it is not constrained by rising MC. As I said, your standard textbook gets around this with an arbitrary assumption about the production function, but I see no way to justify it given perfectly divisible inputs and outputs (and if we don’t have those, well, the theory becomes a very different beast).

    Perhaps I’m being dense, but I don’t see the relevance of the monopolistic competition post? Having said that, I don’t see a justification for why the micro MC curve must slope upwards, and you again jump to the macro level without considering Sraffa’s critique (for example, where do the inputs come from? Can we really define the macroeconomy without considering the interaction between firms? How do we invoke game theory if there is only one firm?)

    EDIT: it is also worth noting that the standard theory assumes prices as exogenous, so your rationale for increasing MC does not work within the assumptions.

  13. #45 by Jamie on December 13, 2012 - 5:57 pm

    As an outsider looking in on the debates of economists, it often seems that economists have decided that they should aspire to being Isaac Newton. The answer is a single formula. The only question is the composition of the formula.

    In many aspects of economics, the result of this approach is endless factional infighting, lots of heat and virtually no light. Economists seem to have abolished the concept of “progress” and risk being viewed as irrelevant by outsiders.

    How about thinking differently about the problem?

    Economists could aspire to be Charles Darwin. They could explore the real world and catalogue the different species of market they find. They could then try to look for common patterns, group the market species in different ways, and develop insights into how markets really work. They might recognise that markets are not all the same and that they evolve all the time. Customers and suppliers continually develop new and better strategies to optimise markets from their own perspectives. Price may be simply an emergent property which results from these strategies.

    Here are a few example markets to illustrate my point.

    Digital products e.g. software, music: The costs of producing these products for an additional customer are virtually zero, so how are prices set?

    Newspapers: Who are the customers? Readers or advertisers? This is a huge issue at the moment e.g. do pay walls work?

    Sea fishing: Fisherman often try to take their trawlers out to sea as often as possible. This can lead to over-fishing which threatens the very existence of the market. Solutions have evolved to cope with this. They tend to involve regulatory intervention and the imposition of supply quotas.

    Wheat: Farmers can determine how much wheat they plant but not how much they take to market. The latter depends on outside factors such as the weather during the growing period. In order to work out total supply, a farmer would have to take a view on weather not just at this own farm but at all other farms across the world. This is impractical. Commodity markets have evolved to solve this problem. These markets take a view on weather and the consequences for supply. Markets can also share the risk of adverse weather in some regions and provide farmers with insurance.

    Professional services e.g. lawyers, consultants. The costs in these markets are mostly labour costs. Basic pricing is based mostly on labour rates. Do labour costs dictate prices, or do prices dictate labour costs? Should firms price each lawyer or consultant based on the specific costs of that person, or should they adopt a more general approach?

    • #46 by Unlearningecon on December 14, 2012 - 1:49 pm

      Yeah this is absolutely true. There is no ‘theory of the market.’ I think a flat or falling supply curve is OK for what people have in mind when they think of a standard, mass produced ‘commodity,’ but the analysis doesn’t apply to labour, financial assets, agriculture, energy, asymmetric information or whatever else.

  14. #47 by Grant McD on December 13, 2012 - 6:03 pm

    A couple points:

    1) Pedantic one first: “belies”, not “bellies” :)

    2) I see someone already sort of mentioned it, but the electricity market is a good example of a short-run supply curve that is upward sloping (due to sequential coming on stream of increasing marginal cost inputs: wind, hydro, gas, coal, oil, etc). As for a decreasing long-run supply curve in the electricity market (i.e. permanent increasing returns to scale which constitute a natural monopoly), this is really limited to the actual grid… which must necessarily be kept distinct from production. See here.

    3) Since people are talking about Joan Robinson, it’s only fair to mention Edward Chamberlin — who actually coined the concept “monopolistic competition”. Robinson’s theory of “imperfect competition” very closely parallels it and originated around the same time. That, combined with the fact that Robinson is the more famous economist, probably explains why people credit her with the term rather than Chamberlin. Nonetheless, both were trying to improve upon Marshall’s explanation for why industries under perfect competition would be characterised by long-run declining costs even as this observation didn’t hold at the level of the individual firm. (Marshal himself attempted to “save” the theory by describing the presence of “external economies” whereby firms would have positive effects on those surrounding it. Interestingly enough, this is here the concept of externalities originates from…)

    4) Your post reminded me of a Krugman column that I read a while back. Thanks to Google, I see he too was writing about the role of monopolistic competition and the limitations of standard models:

    I would not have said that [the standard economic model is] backed by lots of evidence. We do know that demand curves generally slope down; it’s a lot harder to give good examples of supply curves that slope up (as a textbook author, believe me, I’ve looked)…

    • #48 by Unlearningecon on December 14, 2012 - 2:01 pm

      (1) Whoops, have corrected.

      (2) Yeah the energy market is an interesting case. What I find conspicuous is the way economists will almost always use agriculture or energy as an example, rather than the far more obvious case of a supermarket or manufacturing plant, where the economies of scale and excess capacity are so visible that it’s hard to conclude a firm could face anything but decreasing returns to scale. As I’ve said repeatedly, I don’t think there is one ‘theory of the market’- increasing MC will exist in some markets, and energy is probably one of them. But given 95% of firms report falling or constant returns to scale, I don’t think increasing MC is a good starting point.

      (3) Interesting.

      (4) Good that Krugman acknowledges that. Also interesting that he is forced to write it in his textbooks anyway. You’ll see the comments here seem to ignore the empirical evidence I have presented, while presenting none of their own.

      • #49 by john77 on December 14, 2012 - 2:48 pm

        ” manufacturing plant, where the economies of scale and excess capacity are so visible that it’s hard to conclude a firm could face anything but decreasing returns to scale”
        Overtime is traditionally time-and-a-half; shift-work gets a premium
        Nobody (except the Fire Service) plans for excess capacity on the scale you describe – if they did they would go out of business
        Have you ever worked in (private) manufacturing industry?

      • #50 by Unlearningecon on December 14, 2012 - 3:08 pm

        I didn’t describe a scale. However I have linked to evidence suggesting anywhere from 10-25% capacity utilisation overall.

        I have worked as a T shirt printer, yes, but anecdotal evidence isn’t the same as data. Just because overtime is paid more doesn’t mean MC is increasing overall.

      • #51 by john77 on December 14, 2012 - 4:38 pm

        ” Just because overtime is paid more doesn’t mean MC is increasing overall.”
        Have you changed the definition of Marginal Cost? Otherwise it does.
        I am beginning to wonder whether you are confusing marginal cost with average cost.
        Average cost goes down for various slices of the supply curve because fixed overheads get diluted but that does not impact on marginal costs. If you up the labour cost of a product by 50% that is going to wipe out any economies of scale on purchasing with masses to spare.
        “10-25% capacity utilisation” means that three out of four workers/machines are redundant. Someone is taking the mickey! Even if that is a typo and you mean 75-90%,you will find that a lot of the 25% is mothballed machinery that is less efficient and is held as a reserve. With low interest rates it is more economic to run production at 90+% of capacity and build up stocks in seasonally slack periods than to buy one-third more machines than you need.
        My limited experience of dealing with T-Shirt printing is that is *not* representative of manufacturing industry: it is a service industry with comparably (i.e.appallingly low) levels of efficiency of use of factors of production – my wife occasionally orders one T-shirt and a club of which I used to be an active member orders a score or couple of score (divided between T-shirts, sweatshirts, hoodies, jackets in two genders, three lengths and more than half-a-dozen chest sizes) each year so more time is spent changing the setting on the machine than actually printing. Not quite the same as traditional engineering where batch sizes are measured in the thousands.

      • #52 by Unlearningecon on December 14, 2012 - 5:28 pm

        Have you changed the definition of Marginal Cost? Otherwise it does.

        No, MC is a product of more than labour. In the very short run a firm may employ workers overtime. However, under any extended period they simply employ more. Overtime is a very special case and does not correspond to uniform increasing MC.

        “10-25% capacity utilisation” means that three out of four workers/machines are redundant. Someone is taking the mickey!

        It’s just the evidence. It’s not arguable, unless you want to go into the methods used to determine it.

        Even if that is a typo and you mean 75-90%,you will find that a lot of the 25% is mothballed machinery that is less efficient and is held as a reserve. With low interest rates it is more economic to run production at 90+% of capacity and build up stocks in seasonally slack periods than to buy one-third more machines than you need.

        Please, present some evidence.

        Does the fact that 95% of firms report constant or falling returns to scale not enter into your arguments? Or, taking another source, it’s 89%?

      • #53 by john77 on December 14, 2012 - 6:24 pm

        Your link demonstrates that you are arguing about AVERAGE cost, NOT marginal cost.
        PLEASE read it
        Of course average cost is a downward-sloping curve because fixed costs are a large %age of the total for any company with 500 or more employees. That does NOT mean that marginal cost is a downward-sloping curve. Even for me, fixed costs mean that my average costs are downward-sloping while marginal cost are upward-sloping.
        Incidentally it specifies *excluding overtime pay* and is researching businessmen’s opinions rather than facts.
        The Electricity supply industry is *not* just an anecdote. Read it in Hansard or look at any of the websites. Go to your local florist and ask why flowers are more expensive for Mothering Sunday and she will tell you that it’s not *just* gouging the public but because they have to import most of them by air

      • #54 by Unlearningecon on December 14, 2012 - 6:35 pm

        Well the main problem here is that marginal cost for any input isn’t something that businessmen consider, as they generally have to have a certain amount of capital per labourer. So for them the ‘marginal’ cost is that of increasing both inputs at one, and therefore the same as their average cost, excluding initial fixed costs.

        Incidentally it specifies *excluding overtime pay* and is researching businessmen’s opinions rather than facts.
        The Electricity supply industry is *not* just an anecdote. Read it in Hansard or look at any of the websites. Go to your local florist and ask why flowers are more expensive for Mothering Sunday and she will tell you that it’s not *just* gouging the public but because they have to import most of them by air

        Businessmen’s opinions are useless so we’ll just go with yours? And florists throw away a substantial amount of flowers, even on mother’s day. So I am forced to conclude it is gouging.

        And as I am emphasising: increasing MC is possible. It is probably observed in areas of agriculture and utilities/power. But for standard commodities that are produced and consumed regularly, constant or falling costs seem to be the rule.

      • #55 by john77 on December 14, 2012 - 9:03 pm

        Average cost is NOT the same as Marginal cost.
        Prices are NOT the sames as cost.
        I agree that the florists are gouging, but they do that every day, not just on Mothering Sunday,
        IFF you are talking about AVERAGE cost, then we do often (I should expect that to be usually) get a downward-sloping curve until we reach diseconomies of scale. All or most of the comments you make are valid for a discussion on *average* costs but *not* for marginal costs. Of course bulk buying helps reduce average cost and if you look at the cost of holding stock you will get a small additional benefit since that tends to be proportional to the square root of weekly sales. Central overheads can dwarf marginal costs so if you want to rewrite this blog to demonstrate that *average* cost is a downward-sloping curve I should support that.
        I do not know which businessmen you have been talking to but marginal cost pricing spread from the oil companies into business mainstream in the ’60s and ’70s. The guys to whom I have been talking for the last forty years look(ed)at marginal cost and return on marginal capital invested. De-bottlenecking is all about marginal cost of capital (I remember sitting in on a discussion about analysis of the return on marginal capital investment as a teenager – I’m not sure why: I think I was just in the room and wasn’t told to get out because I was assumed to be trustworthy). Nobody would ever be made redundant until the company went bust if businessmen did not look at marginal cost. There are a million guys on the dole who will tell you that businessmen DO look at marginal cost
        Marginal cost pricing is why ASLEF was able to hold British Rail to ransom every year because the cost of a strike exceeded the cost of giving them what they asked for. As far as I can tell, train drivers get paid more than the average Economics graduate.
        Businessmen’s opinions are not useless and my opinion is not more important unless I know a lot more about the subject. It just happens that their opinions are about average cost and your post is about marginal cost so the opinions that you reference are irrelevant.
        You claimed that you were citing facts about Marginal cost when you quoting opinions about *Average* costs. It appears from your reference to a book review that Stephen Keen does not know the difference – I hope that is a typo by the editor because otherwise it would be deeply worrying.

      • #56 by Unlearningecon on December 14, 2012 - 9:23 pm

        Again, you are not presenting actual facts, just anecdotes that are not supported by any evidence I am aware of.

        Steve Keen is merely reviewing a book by Blinder, and no, neither he nor Blinder confuse average and marginal cost. The two are obviously related, but my point is that the economist’s conception of MC – cost of a unit increase in one factor of production – often does not make sense to a businessman, as they have to increase factors of production together (e.g. an office worker needs a computer). For this reason, average variable cost would functionally mean the same thing to a businessman as marginal cost.

      • #57 by john77 on December 14, 2012 - 10:14 pm

        Average cost = (fixed overheads + labour + materials + variable production costs)/output
        Marginal cost = (marginal labour + marginal materials + marginal production cost)/marginal output
        How can you be unaware of this?
        Marginal cost does NOT equal average cost except in *very* exceptional circumstances
        Buying/hiring a computer for one additional office worker does not amount to the average capital/cost per worker. Last week I was talking to a medium-sized firm that was spending £30 million on upgrading its computer software and paying its staff about £40k per head plus profit-share. Average cost is wildly different from marginal cost of an extra worker. Profit-share is based on the team’s profit minus its cost of capital. It isn’t just the directors but every team leader who looks at marginal revenue against marginal cost.
        Can you name a single solvent businessman who ignores marginal cost when making an investment decision? I’ll advise people to sell all their shares.

      • #58 by john77 on December 14, 2012 - 3:18 pm

        Krugman’s article is a political not an economic one and he descends into political propaganda (excusably, only a little of the fault for the recession is Obama’s). He is talking bullshit when he says it is difficult to find examples/evidence of upward-sloping supply curves. Start with the USA’s biggest export industry – agriculture, then oil, gas, automobile production, renewable energy, construction, engineering ….
        The time when you get reducing costs is when there is technological innovation
        or a quantum change in demand that justifies a larger manufacturing unit generating economies of scale.
        “You’ll see the comments here seem to ignore the empirical evidence I have presented, while presenting none of their own.” In reality *I* have produced empirical evidence and I have seen none from you apart from dubious anecdata ” Any business will tell you that they get cheaper prices per unit if they buy substantially more” – which is far from universally true
        Bulk buying can only reduce unit costs in the long by the admin costs of the transaction (although in the short run it can give the bulk buyer an advantage over a rival paying a higher price)

      • #59 by Unlearningecon on December 14, 2012 - 5:24 pm

        John, I have linked to actual studies. All you have given are anecdotes and assertions!

  15. #60 by Dallas on December 15, 2012 - 6:31 am

    One last thing. This maybe the third time you quoted the Eiteman study from 1952. However, it doesn’t strike me as very strong evidence for a lot of reasons. Primarily, I am not sure that businessmen would be able to accurately answer the questions they were asked and Eiteman doesn’t mention doing any pre-testing to ensure that they could. Of course, there are many other problems with the study as well. The survey response rate is pretty low (36%). The authors don’t consider problems associated with non-response bias. The results are aggregated across all industries. The list goes on.

    If this study really impressed you, maybe you should do a post explaining why? I think that would be really interesting.

    • #61 by Unlearningecon on December 15, 2012 - 1:00 pm

      I don’t really understand why businessmen wouldn’t understand how their costs develop as they expand?

      You are right that the response is low. However, I don’t see any systemic bias this may have had (their costs are increasing so fast they didn’t have time to respond? :)). And I linked to that one only because it is readily available online. There is a fair amount of work done by post-Keynesians, and of course Alan Blinder’s book, which concludes 11% of industry MC curves are upward sloping.

      • #62 by Dallas on December 16, 2012 - 3:41 am

        “I don’t really understand why businessmen wouldn’t understand how their costs develop as they expand?”

        Maybe you take the neoclassical theory of the firm more seriously than I do. :P

        My skepticism comes from my own very limited personal experience. I once worked in a very very minor capacity as a contractor for a company that was considering opening a new production facility. They hired literally dozens of people from a variety of fields to figure out how much a new facility would cost to build, how much output it would produce, how many people it would employee, what economic impact it would have on the surrounding area, etc. DOZENS. Just to figure out the details for opening a single new facility.

        Yet, Eiteman and Gutherie think that a single manager has the entire cost structure for any production their firm would care to produce across all their facilities IN THEIR HEAD??

        To me it sounds crazy. I could be wrong. But Eiteman and Gutherie apparently did absolutely no pre-testing to see if their questions made sense. That is a very bad sign.

        “However, I don’t see any systemic bias this may have had (their costs are increasing so fast they didn’t have time to respond? ).”

        Well Eiteman gives almost no descriptive statistics about his sample (another weak feature of the paper) so I can only guess. But I could easily imagine that larger public firms would be more willing to answer a survey about their costs than smaller private firms since public firms already have release data on costs in their 10ks. That would certainly bias the results since I would imagine larger firms to benefit from greater economies of scale than smaller firms (that’s why they’re large).

        Of course, maybe that didn’t happen. Like I said its only a guess. But the fact that the authors don’t even discuss these issues (or provide you much real data about their sample) is a serious weak point in the paper.

        “And I linked to that one only because it is readily available online.”

        Fair enough. But I still wouldn’t expect anyone to be convinced by such a poorly conducted study. Just my two cents.

  16. #64 by Dallas on December 15, 2012 - 6:49 am

    Okay, one last last thing. :) Several times you have said that you have posted evidence supporting the notion that supply curves are flat (perfectly elastic), but that no one has posted evidence to the contrary. One reason that might be is that the elasticity of the supply curve will obviously differ across industries, so I don’t think you will find a single study that addresses your question.

    But, I will say that there have been many studies looking at the elasticity of supply in specific industries. These studies are typically done because agencies like the EPA use them to estimate the welfare consequences of policies they consider. Now, you probably won’t find a review of this literature as a whole anywhere. But you will find that the EPA has a database where they report many of the elasticity estimates they have used in economic impact analyses (some come from the peer-reviewed literature and some are estimated by EPA’s own economists).

    http://www.epa.gov/ttnecas1/Elasticity.htm

    As you will see, all of the supply elasticity measurements are positive. And many of them are relatively inelastic (less than 1).

    • #65 by Unlearningecon on December 15, 2012 - 1:03 pm

      I don’t think elasticity is quite the same thing as what I’m saying. Elasticity measures the change in quantity in response to a change in price. If price goes down, ceteris paribus, I would indeed expect a firm to supply less.

      HOWEVER what I am really talking about is the effect of an increase in demand on price and quantity. I would conjecture that generally, demand just increases quantity due to excess capacity, and over time as new stores/branches are open costs decrease due to EoS.

  17. #66 by Unlearningecon on December 16, 2012 - 9:16 pm

    Dallas, I will post one last comment and leave you to have the final word if you so wish.

    First, thanks for a lot of constructive engagement. I think you last post nailed it – we’ve been dancing back and forth between the real world and theory, when the nature of our disagreement becomes much clearer once we separate the two.

    Second, you are correct to note that a rigorous supply ‘curve’ only applies under perfect competition. I do not believe a supply ‘curve’ exists in the sense found in textbooks; it will be discontinuous and lumpy. However, what I wanted to show in this post was that:

    (a) Generally speaking, there is good reason to believe that firms have at least constant, probably decreasing, returns to scale.

    (b) The standard textbook justification for upward sloping supply curves is questionable.

    Personally, I’d say neither you have not really disputed that for an individual firm, the costs may be constant or decreasing – you have focused on the fallacy of composition.

    However, as I said, whether or not the industry ‘supply curve’ slopes upwards or downwards depends on whether other curves in the industry slope upwards or downwards. In the cases you identify, there may well be a positive feedback loop between increasing costs – for example, a wage price spiral, or the knock on effects of an agricultural disaster. The reason I think this rarely exists in the real world is precisely because of this: it creates big problems, rather than simply quelling firm size.

    I’m inclined to think most industries experience the opposite, though – a positive feedback loop between decreasing costs, where as firms expand, their suppliers expand, and they all experience falling costs. I do this based partially on real world experience and partially on evidence (not specific to Eiteman, e.g. Blinder).

    In terms of the long run theory of the individual firm, I stand by my criticism. The only way you can have continuous MC curves is if inputs and outputs are infinitely divisible, even if not every exposition notes this. From there it’s difficult to find justification for EoS, and even moreso for DoS.

    However, I think you are right that, within the confines of the theory, there would be reason to expect an industry MC curve to slope upwards.

  18. #67 by Jordan on December 19, 2012 - 4:23 pm

    I would say that at the level of a single firm, MC line should be a wave, which depending on level of financing by debt determines it’s flatness. There is exchange in EoS and DoS on individual firm level even in deflation when other firms go out of production. Financing expansions by debt puts less preassure on price change due to time derived repayment schedulle.
    At the level of an industry, due to interchanges of vaves of different firms and availability of credit MC line becomes flat.
    If an industry is dependent on a single firm that holds a huge share of a market and have a monoply on price setting then the line should be a prety flat wave

    • #68 by Unlearningecon on December 20, 2012 - 9:48 pm

      I would say that at the level of a single firm, MC line should be a wave, which depending on level of financing by debt determines it’s flatness.

      That’s an interesting observation. It fits in with Keynes’ view that rates should be permanently low, which reduces the uncertainty for businesses that are expanding or largely dependent on debt. Low long term rates would ‘flatten’ the MC curve somewhat.

      • #69 by john77 on December 20, 2012 - 10:35 pm

        Interesting as in a”n idea detached from reality” (pardon me for sounding like an old curmudgeon, but…) Except to the extent where debt finances work-in-progress, the cost of debt-financed capital has *no* bearing on marginal cost – it *does* have an impact on average cost. Many firms finance w-i-p by overdraft but that is a virtually negligible %age of cost at current interest rates.

      • #70 by john77 on December 20, 2012 - 10:41 pm

        In case you had not noticed Keynes was writing in a disinflationary environment. Low positive real interest rates are generally viewed as a beneficial environment but Keynes had only witnessed negative real interest rates in wartime and was not thinking about, let alone advocating them, so you cannot cite him in defence of David Blanchflower

      • #71 by Unlearningecon on December 20, 2012 - 10:46 pm

        I didn’t say Keynes advocated negative real rates. I can guarantee 100% that he advocated low long term nominal rates (Keynesians see the RoI as a nominal phenomenon btw). I am unaware of who David Blanchflower is.

      • #72 by john77 on December 21, 2012 - 12:13 am

        David Blanchflower, is a former member of the BoE Monetary Policy Committee and now a professor at Dartmouth College, from where, with a secure high income he is able to advocate impoverishing UK citizens dependent upon a pension fixed in nominal money.
        Anyone who ignores inflation when calculating RoI is ignoring the purpose of investment. Have you forgotten that British Leyland was reporting record profits, using historical cost accounting, when it went bust?
        Keynes did not adjust for inflation because it had not been significant in the UK except during wars and post-war periods had been disinflationary, offsetting wartime inflation, for more than a thousand years. Chronic inflation is post-WWII phenomenon caused by so-called “Keynesians” ignoring the bits of Keynes that didn’t suit them.
        A low nominal interest rate during inflationary periods hands over vast profits to property developers at the expense of working-class savers. Although Trinity College has vast wealth due to its property investments, I cannot believe that Keynes was trying to boost that on the backs of the working man.

  19. #73 by rumplestatskinn on December 20, 2012 - 11:45 pm

    The main problem with the whole market model that implies the existence of supply and demand curves is that assumptions about time and fixed factors of production. In the magical place we call the ‘short run’, some factor of production is fixed – say capital. We only have one machine, and after a point it becomes more expensive to get a little more production out of it.

    However, if one factor of production is fixed, because it’s the short run, how come we can seem to add labour to these machines an increase output? Why isn’t labour already optimally allocated to machines? Which I guess is the important but not quite common enough criticism that the curves don’t really exist, only the point of price and quantity.

    But if we take a ‘medium run’ approach, all factors can vary a little, but not too much, and then basically anything goes. How long is the medium run? Enter rabbit and hat stage left.

    However, the concept of an upward sloping supply curve in the medium run is important in a few crucial industries – mining and agriculture. The land area available for agriculture is essentially fixed, so we at least have one of the theoretical criteria in place. However, one has to ask exactly how big the supply curve can be. Maybe there are some minute incremental gains in output by increasing some factors of production, but there will be close technical limits. So maybe not that useful.

    But in mining we have the classic case. Each new mineral deposit is typically more remote, deeper, harder to extract, and more expensive. So we have a situation where supply will increase only when price increases. And where supply will contract when prices contract (marginal mines shut down). This is happening right now across Australia and I assume Canada, Mongolia etc.

    So I don’t think we ned to throw away the idea. We need to teach that this upward sloping supply curve applies to one special case of production. We also need to teach that supply curves can be many shapes, and that there existence is more of a tool for thinking, because under the assumptions only the intersection point can exist.

    I would like a better theory of markets. I really would. And there are many out there. Monopolistic competition has much more realistic prediction than perfect competition.

    My big gripe is that the economically educated public – politicians, think tanks, and even many academics and government departments, simply assume perfect markets when they analyse policy impacts. If we could get over this, and not that the real world is more complex and that we must consider general equilibrium effects, wealth effects, etc. then we might raise the standard of debate.

    In any case, yes, most of the time the supply curve is flat for all intents and purposes. However there are special cases where it can be upwards sloping in the medium term, and downward sloping. And we must be careful about what we mean by medium term. Economists could do well to have a theory of time, including returns on costs rather than profits on fixed capital, in a new theory of markets.

    • #74 by Unlearningecon on December 21, 2012 - 11:46 pm

      Yeah, you’re spot on with this post. Supply ‘curves’ – insofar as they exist – will differ in different markets. The labour market curve will be incredibly chaotic, as will that for financial assets. Most mass produced commodities will probably have a downward sloping curve; many services will likely have a constant curve; land-heavy industries will have an upward sloping curve.

      I think economics as a whole needs to progress into an institutional perspective that acknowledges the differences between markets.

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