Chapter 5 of Steve Keen’s Debunking Economics explores the marginalist theory of the firm. Keen first channels Piero Sraffa’s 1926 criticisms, then catalogues the neoclassical theory’s complete lack of real world corroboration – as noted in my title, a businessperson once referred to it as “the product of the itching imaginations of uninformed and inexperienced arm-chair theorisers.”
The neoclassical theory of the firm supposes that, in the short run, firms face increasing marginal costs – their costs per unit (average cost) increase as they produce more. This occurs because in the short run, the ‘amount’ of capital (and land) employed is fixed, so producing more involves squeezing more and more out of machines with more labour. The intersection of these increasing costs with how much they can gain from selling more, or their ‘marginal revenue’, constrains their size.
This homogeneous treatment of capital should strike many as silly. The neoclassical theory effectively supposes that, if we employ 9 people to dig a ditch with 9 spades, employment of the tenth will split the 9 spades into 10 slightly smaller, worse spades. However, if new labour is employed, new capital is – must be – employed simultaneously, whether it is bought or if it is taken from previously idle capacity. A taxi driver cannot do anything without his taxi; an office worker without a computer is also fairly useless.
So increasing marginal costs are unlikely to be the case with individual firms or narrowly defined industries. As Keen puts it, “engineers purposely design factories to avoid the problems economists believe force production costs to rise.” In reality, firms have excess inventories and tend to vary capital, labour and land all at once, even in the short run. They therefore face roughly constant, or falling, returns to scale.
Sraffa pointed out that it’s only really valid to treat some factor inputs as fixed if we define an industry so broadly that the factors would have to be converted from other uses. For example, if we take agriculture, and assume the country is well populated and at or close to full employment, then it’s reasonable to treat land and machinery as fixed in the short term. However, since the theory of the firm assumes that supply and demand are independent and that one ‘industry’ can be studied apart from all others, another problem appears: this situation does not lend itself well to ceteris paribus analysis. Changing wages, supply costs, and the displacement of labour from other areas will have notable impacts on the rest of the economy, such that tinkering with our curves individually cannot be deemed a proper representation of what will happen.
There are a few cases where firms or industries might fall between these two categories, but really they are the exception.
Keen cites 150 empirical surveys that found firms reporting constant or falling average costs of production. In particular he cites Eiteman and Guthrie, who found that 95% of firms out of 334 did this, whilst only 1 chose the curve that looks like the one found in textbooks. Most firms also use cost-plus pricing, rather than taking marginal considerations into account, and adopt a form of trial and error when pricing.
A flat(ish) supply curve leads us to the incredibly interesting proposition, supported by the classical economists, that supply determines price while demand determines quantity. This is, of course, a simplification ,but appears to corroborate far better with the real world than neoclassical ‘simplifications.’
In my opinion this is the strongest case against neoclassical micro as taught. Jonathan Catalan can find no objections to this section, either, and gives the story an Austrian slant. Keen says that this problem has never really been addressed by economists, but ignored, despite the clear superiority of Sraffa’s logic and the corroboration of the empirical evidence with his approach. I find it hard to believe neoclassical economists can wiggle their way out of this problem, should they ever address it.