The second chapter of Steve Keen’s Debunking Economics explores a number of arguments: the incoherence of perfect competition; that idea that equating Marginal Cost (MC) to Marginal Revenue (MR) does not maximise profit; and, eventually, that a supply curve cannot be derived. I will offer a brief summary of each of these arguments, but I encourage further reading (Keen’s book being the obvious candidate), as this is complicated stuff and a blog post can only serve as an introduction and overview.
Keen’s first point is that, under perfect competition, the demand curve for an individual firm is not horizontal, as taught in economics textbooks, but the same as the market demand curve. Analysis of perfect competition makes the basic mistake of confusing infinitesimally small firms with firms whose size is 0 – in other words, it says that a market demand curve can be split into an infinitely small amount of flat demand curves. However, if you add up any number of flat demand curves, the result will be a flat demand curve, not a sloped one. Therefore the demand curve for any individual firm must be sloped, however shallow the slope is.
Again, it was a neoclassical economist, George Stigler, who discovered this flaw in perfect competition. Stigler’s argument is that since, by assumption, firms do not react to each other’s strategies, any change in output by a firm will change market output by the same amount, and hence affect price. This means the demand curve for an individual firm cannot be horizontal (a change in output does not affect price), but must be the same as the market demand curve (a change in output changes industry output by the same amount).
Keen’s discussion of perfect competition also notes something obvious – the use of the word ‘perfect’ is obviously value laden, despite economist’s claims that their science is value free. I’d add that whilst ‘perfect’ may have a specific definition, the broader value judgement of ‘competition is good’ is undeniably present in economics.
Marginal Cost =/= Marginal Revenue
Keen goes on to argue that the basic neoclassical theory of the firm, that firms maximise profit where Marginal Cost (the cost of producing one extra unit) equals Marginal Revenue (the revenue received from selling one extra unit) is incorrect. This is because it is vulnerable to a fallacy of composition – whilst it is rational for individual firms (at least according to neoclassical principles), it is collectively irrational for an industry, and will result in firms losing money if they all pursue it as a strategy.
The neoclassical profit maximising formula only focuses on the effect of changes in a firm’s own output on revenue, ignoring the impact of changes in industry. Whilst perfect competition assumes firms do not change their output in response to one another, the above result shows that industry output will change by the same amount as a firm’s output. If I’ve interpreted Keen correctly, the reduction in price resulting from this industry change (assumed away by neoclassical theory) is missing from neoclassical formula, so revenue will be lower than predicted, and equating MC and MR will yield a loss.
Is there a supply curve?
It is well known that a supply curve can only be derived for a perfectly competitive market – if firms are price takers. However, once firms have some market power, price cannot be taken as a given, because if they produce more (less), the price will fall (rise), meaning MR and demand diverge. Once this happens, MC will equal MR and not price; a change in price will not cause a firm to move smoothly along its MC curve (which is the supply curve), but instead will depend on MC, MR and demand.
As Keen notes, this explains why economists have been so keen to cling to perfect competition, with its blatant lack of real world corroboration and its seeming incoherence. However, Keen’s own arguments suggest that even under perfect competition, firms have some impact on industry output, and MC cannot be equated to price without making a loss on some sales. Therefore, unless individual firms behave irrationally – something that is obviously contrary to core tenets of economic theory – a supply curve cannot be derived as taught in economics textbooks.
I had a hard time getting my head around this but eventually became convinced of Keen’s arguments. Once you take into account a perfectly competitive firm’s own impact on industry output, the standard analysis of MC = MR breaks down and all the problems with deriving a supply curve, previously assumed away by economic theory via perfect competition, return. This bears something of a resemblance to the problems with demand curves, which were well-known but assumed away by Hicksian demand functions, only to return once you introduced more than one consumer.
The general impression Keen has given me so far is that economic theory is disturbingly aware of its own flaws.