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
Number of Price Changes in a Typical
Year
Frequency
Less than 1
Per cent
of Firms
Cumulative
Percentage
10.20%
10.20%
1
39.2%
49.4%
1.01 to 2
15.6%
65%
2.01 to 4
12.9%
77.9%
4.01 to 12
7.5%
85.4%
12.01 to 52
4.3%
89.7%
52.01 to 365
8.6%
98.6%
More than
365
1.6%
100%
Median = 1.4 price adjustments per
year
Economic facts of the firm
Why Don't You Change Prices More Frequently Than That?
Response
It would antagonize or cause difficulties for our customers
Competitive pressures
Costs of changing prices
Our costs do not change more often
Coordination failure, price followership
Explicit contracts fix prices
Custom or habit
Regulations
Implicit contracts with regular customers
Miscellaneous other reasons
Total
Number of Firms
41
28
28
27
15
14
11
7
5
20
196
Per cent
21%
14%
14%
14%
8%
7%
6%
4%
3%
10%
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
Range
50% or less
50.1 to 90%
90.1 to 99.9%
100%
Mean share
Share of Sales Made to Regular Customers, by Sector
Percentage of Sales
All
Manufacturing
Wholesale
Services
Trade
10.7%
34.5%
24.4%
30.5%
85.2%
4.3%
28.6%
25.7%
41.4%
91.6%
15.1%
43.4%
20.8%
20.8%
80.4%
0.0%
25.0%
40.0%
35.0%
93.9%
Retail
Trade
23.5%
52.9%
11.8%
11.8%
71.2%
• 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)
• 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
Economic facts of the firm
Estimated Price Elasticity of Demand
Elasticity
Percentage of firms
0
0.1 to 0.5
0.51 to 1
1.01 to 2
2 to 5
Above 5
40.6%
28.8%
14.4%
8.8%
5.0%
2.5%
Small fall in
price, large
rise in
revenue
Small fall in
price, large
fall in
revenue
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…
Table 13. 2 THE VARIOUS MEASURES OF COST: THIRSTY THELMA'S LEMONADE SHOP
QUANTITY
TOTAL FIXED VARIABLE AVERAGE AVERAGE AVERAGE MARGINAL
OF LEMONADE
COST COST
COST
FIXED
VARIABLE
TOTAL
COST
BOTTLES PER HOUR)
COST
COST
COST
0
$3.00
$3.00
$0.00
1
3.3
3
0.3
$3.00
$0.30
$3.30
2
3.8
3
0.8
1.5
0.4
1.9
3
4.5
3
1.5
1
0.5
1.5
4
5.4
3
2.4
0.75
0.6
1.35
5
6.5
3
3.5
0.6
0.7
1.3
6
7.8
3
4.8
0.5
0.8
1.3
7
9.3
3
6.3
0.43
0.9
1.33
8
11
3
8
0.38
1
1.38
9
12.9
3
9.9
0.33
1.1
1.43
10
15
3
12
0.3
1.2
1.5
$0.30
0.5
0.7
0.9
1.1
1.3
1.5
1.7
1.9
2.1
Economic facts of the firm
Percentage Fixed
Percentage of Firms
20 or less
20.1 to 40
40.1 to 60
60.1 to 80
Above 80
Mean = 43.9% (std. dev. = 25.4%)
Median = 40.0%
24.7%
27.5%
22.5%
17.0%
8.2%
• 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)
Economic facts of the firm
Price
• 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
Pe consumers but bad for
economic theory…
Qe
Quantity
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
Percentage
to Stock
Zero
0.1 to 25
25.1 to 50
50.1 to 75
75.1 to 99.9
100
Median
Percentage of Output Produced to Stock
Percentage of Firms in
All
Durable
Nondurable
Industries
Manufacturing
Manufacturing
15.6%
21.1%
11.0%
8.3%
26.6%
17.4%
60.0%
22.5%
27.5%
17.5%
5.0%
20.0%
7.5%
27.5%
13.0%
21.7%
8.7%
4.3%
17.4%
34.8%
80.0%
Trade
5.9%
5.9%
8.8%
14.7%
41.2%
23.5%
90.0%
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…
Summary of Selected Factual Results
Price Policy
Median number of price changes in a year
Mean lag before adjusting price months following
Demand Increase
Demand Decrease
Cost Increase
Cost Decrease
Percent of firms which
Report annual price reviews
Change prices all at once
Change prices in small steps
Have nontrivial costs of adjusting prices of
which related primarily to
the frequency of price changes
the size of price changes
Sales
Estimated percent of GDP sold under contracts
which fix prices
Percent of firms which report implicit contracts
Percent of sales which are made to
Consumers
Businesses
Other (principally government)
Regular customers
Percent of firms whose sales are
Relatively sensitive to the state of the economy
Relatively Insensitive to the state of the economy
Costs
Percent of firms which can estimate costs at least
moderately well
Mean percentage of costs which are fixed
Percentage of firms for which marginal costs are
Increasing
Constant
Decreasing
1.4
2.9
2.9
2.8
3.3
45
74
16
43
69
14
28
65
21
70
9
85
43
39
87
44
11
48
41
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:
200
200
Marginal Cost
Average Cost
Price
150
Marginal Revenue
MC ( Q )
AC ( Q )
P (Q)
100
MR ( Q )
“Monopoly
profit”
“Competitive loss”
50
0
0
0
0
4
5  10
5
1  10
Q
5
5
1.5  10
2  10
5
210
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:
Constant marginal productivity
• Constant or falling marginal
cost as point of maximum
capacity & efficiency reached
• Steeply rising marginal cost
once at full capacity
• But this rising segment never
reached in practice, as
explained later
Price
• If factories plotted marginal cost, this is how it would
look for 89-95% of them:
“Marginal cost”
Quantity
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:
• 3-5 “neoclassical”:
• 3 most like
textbook drawing
• “5… high at minimum
output, … decline
gradually to a leastcost point near
capacity, after
which they rise
sharply.”
• 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)
Constant marginal productivity
Curve Indicated
Number of companies
1
0
2
0
3
1
4
3
5
14
6
113
7
203
8
0
Total
334
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
By Firms
Supports MC=MR
Contradicts MC=MR
Per Cent supporting MC=MR
18
316
5.4
By Products
62
1020
5.7
• 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:
Capacity vs Employment USA 1967-1985
0.95
0.90
Employment Rate
Rate of Capacity Utilization
0.85
0.80
0.75
0.70
19671968196919701971197219731974197519761977197819791980198119821983198419851986
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
g  5%
g  ( t M)
M  10
C ( t)  e
Capacity Utilisation
1
Per cent of capacity reached
• 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.
0.9
C ( t) 0.8
0.7
0.6
0
2
4
6
t
Years of operation
8
10
Operation within capacity
Price
• Pattern over time series of overlaps of constant/falling
marginal cost
Quantity/Time
• At any time, output well within current capacity
• Increasing output normally reduces unit costs
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
What price “supply & demand”?
• “Works” for rising marginal cost since firms can make a
profit:
Marginal Cost
Price
Price
Supply
Pe
Pe
Demand
Qe
Quantity
qe
quantity
What price “supply & demand”?
• Area beneath price line is
total revenue
Price
• Area beneath marginal cost
curve is variable cost
• Total costs include fixed
costs as well
Pe
Revenue>
Variable cost
qe
quantity
• With rising MC, firm covers
variable costs and at least
some of fixed costs
– Theory says should operate
– Can make profit
What price “supply & demand”?
Price
• Firm can’t even cover variable costs
• According to theory, it should
shut down
• So
– Market can’t be “competitive”
if this means Price =
Revenue>Variable cost
Marginal Cost
Price
Pe
Loss
– Price must exceed marginal
Variable cost
cost in 89% (Blinder) to 95%
(Eiteman) of real industries
Revenue
• Can’t have quantity determined
by “horizontal demand curve”
Revenue where P>MC
(P=MR) and marginal cost
qe
quantity because profit rises as output
rises
What price “supply & demand”?
• Price can’t
be below
here,
otherwise
firms won’t
cover costs
• Must be
above here
for profit;
but where?
• “Supply &
demand”
can’t tell…
Price
• Whatever shape of demand curve, price must be above
“supply curve” if marginal cost constant or falling
• Conventional theory might
make some sense with
analysis of “monopoly”
behavior
– Price set where marginal
revenue equals marginal
cost…
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
Deadweight
• But antiloss
monopoly
argument Monopoly
price
irrelevant
anyway if MC
constant or
falling for vast
majority of
Marginal
revenue Demand
firms
• And it has other
problems…
Monopoly Efficient
0
Quantity
quantity quantity
What price “supply & demand”?
• Conventional textbook view monopoly versus competition
(Mankiw 2001 Ch. 15)
Price
(a) A Competitive Firm’s
Demand Curve
Price
(b) A Monopolist’s
Demand Curve
Demand
Demand
0
Quantity of
Output
0
Quantity of
Output
• Whole basis of alleged difference in behavior is shape of
demand curve: horizontal for competitive firm, downward
sloping for monopoly
What price “supply & demand”?
• “Horizontal demand curve” mathematically false:
– Slope of competitive market demand curve negative
Price
• Slope of individual firm
demand curve the same:
dP
 0, MR  P
dQ
Quantity
dP
dP dQ
dP


0
dq dQ dq
dQ
• 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
n 1
• MR=MC but MR  MC 
P  MC 
n
• 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!