Testing the Orthodox Theory of the Firm
By the end of this section, you will be able to:
- Construct testable hypotheses from the orthodox theory of the firm
- Test these hypotheses against the given data
Let’s review the basic properties of the orthodox theory of the firm as given in previous chapters (“Cost and Industry Structure,” “Perfect Competition,” and “Monopoly”). To keep things simple, we’ll focus on the short run behavior of a single firm, and we’ll look to the similarities of this behavior regardless of whether the market is competitive or monopolistic. First, the firm is portrayed as a functional relationship between inputs (factors) and outputs (products). Because we’re considering the short run, there are variable and fixed inputs, and therefore variable and fixed costs.
Second, the firm accepts the demand for its product as given and determines how much it should produce–its quantity of output (Q)–so that its profits are maximized where the cost of producing the last unit equals the revenue from selling it–that is, where marginal cost (MC) equals marginal revenue (MR). We assume that the firm is subject to diminishing marginal returns. Therefore marginal costs will always eventually rise to meet marginal revenue and will cause average total cost (ATC) to eventually rise (giving it its ‘U’ shape). Hence, the very simple Hypothesis 1: over some short-run period, managers are aware of their firms’ marginal costs associated with increasing (or decreasing) their production, and they generally find that marginal cost increases over a relevant range of production.
Now, consider the conditions presented in the chapters “Cost and Industry Structure” and “Perfect Competition”:
- If MC < ATC, then ATC is decreasing (marginal cost is ‘dragging down’ average total cost the same way a low test score would drag down your course grade). Therefore, if ATC is decreasing, it must be the case that MC < ATC.
- Profits = Q(P-ATC), where P represents price. Therefore, firms make losses when P < ATC, break even when P = ATC, and make profits when P > ATC.
- Profit maximizing firms under perfect competition produce where MC = MR = P.
We can read these three conditions in reverse to establish a necessary condition for firms to avoid making a loss. Plugging (3) into (2), it should be clear that, since the firm will produce where P = MC, the profit equation can be restated as Profits = Q(MC – ATC) under perfect competition. Hence, if the firm is going to break even or make a profit then MC must be ≥ ATC. Taking this back to (1), then, for MC to be equal to or greater than ATC, ATC must either be constant or increasing at some reasonable level of output.
Hence, Hypothesis 2: if firms maximize profits by producing a quantity where marginal cost equals marginal revenue, then under competitive conditions firms must normally be producing in a situation in which average total cost is either constant or increasing. Really, this is just an extension of hypothesis one which allows us to test our theory by looking at average total costs rather than marginal costs.
Testing the Theory
It is generally held that a developed science should be capable of expressing ideas about how the world works in hypotheses, and that these hypotheses should be compared with actual observations to determine how well the theory explains what we see in the real world. Fortunately (and perhaps surprisingly), a considerable number of studies on both costs and prices have been produced going back over 100 years. Saving the reader a laborious trek through all of them, we’ll just look at a couple to test the validity of our hypotheses.
In 1998 Alan Blinder and colleagues published a book, Asking About Prices, which was not actually concerned with microeconomics (it was concerned with testing theories of macroeconomic price ‘stickiness’), but just the same can help us test our hypotheses . Their approach was somewhat uncommon to orthodox economics at the end of the 20th century: they simply asked business people about how they did things. For our purposes, their work marginal costs (see p. 103) sheds light on hypothesis 1. Asking business executives about the shape of their marginal cost curve was apparently a bit tricky. Evidently, most do not normally consider the concept of marginal cost, so the surveyors had to repeat, rephrase, and further explain the question before a response could be given.
And the responses were not encouraging for the orthodox theory of the firm. Firms representing only 11% of GDP were believed to have upward sloping marginal cost curves. Nearly half reported constant marginal costs, and, almost shockingly, 41% reported decreasing marginal costs (suggesting increasing returns). Evidently, the ‘law’ of diminishing marginal returns is more like a local custom, appropriate to only a small part (about 11%) of the US economy.
In fact, similar findings had been reported over 50 years ago. In an article published in the American Economic Review in 1952, Wilford Eitemen and Glenn Guthrie reported their findings from a survey of manufacturing companies across the US. Specifically, they found that only 5% of the goods produced conformed to the standard ‘U’-shaped depiction of average total costs. The majority (60%) of products were reported as having average total cost curves which simply declined as output increased up to maximum capacity. (Almost all remaining products were reported as similar but with a slight rise in average total costs just before capacity was reached.)
Designing the Average Total Cost Curve
Eitemen offered a simple, intuitive reason why we should expect that most average total cost curves would always decline with increased output. One way to look at the matter is in terms of the percentage of designed maximum capacity output at which you would want your production process to operate most efficiently. To give an example, imagine you’re an engineer and you have been tasked with designing a machine (or a factory, or the layout of an office) that can produce some maximum number of units in a given day. In designing the machine, you find that it will have to operate more or less efficiently depending on how heavily it’s being used. Would you design it to operate most efficiently when it’s only running at 20% capacity? Maybe 60%? Perhaps 99%?
Most would say that a production process should work best when it’s operating somewhere near the level of output it was designed to be capable of producing–otherwise, why should it be made to produce so much output in the first place? Translate ‘work best’ into ‘operate at lowest average total cost’ and the implication should be clear: a ‘U’-shaped average total cost curve indicates a production process that was designed to be capable of producing up to some maximum amount inefficiently. In contrast, a declining average total cost curve indicates that the production process was made to work best when it’s producing as much as it was designed to be capable of producing–the most efficient, lowest average total cost point being at or near 100% of maximum capacity output.
Returning to the three postulates we used to develop hypothesis 2, Eitemen and Guthrie’s findings indicate a clear departure from the standard model of firm behavior. If most firms believe their average total costs decline as output increases, then mathematically their marginal cost curves must be below (‘dragging down’) their average total costs. (This would be the case if the firm’s marginal costs are constant or declining with increased output, as Blinder et al. indicate is common throughout the economy.) Now, if marginal costs are always less than average total costs, then there are only two possible conclusions to be drawn:
- Firms produce a quantity where MC = MR. But, since MC is always < ATC, and under perfect competition profits = Q(MC-ATC), then firms in perfectly competitive markets will always make a loss. This doesn’t seem like an attractive conclusion–surely we can find firms in competitive markets that manage to make a profit. So it’s worth considering the alternative:
- Firms do not produce a quantity where MC = MR. That is, under the cost structure that most firms report, the standard profit maximization behavior postulated in the orthodox theory of the firm is not only unrealistic, it’s impossible.
Clearly, the implications of these findings do not bode well for the orthodox theory of the firm presented in earlier chapters. The preponderance of evidence may not wholly refute the orthodox model, but it does expose severe limitations. In the breakout box below, two additional hypotheses are examined, giving greater reason to abandon the orthodox theory of the firm. The section that follows then introduces a few basic concepts from an alternative, heterodox viewpoint.
Two More Hypotheses
From the orthodox perspective, we can imagine a firm incrementally increasing its, say, weekly output, and continuing to do so as long as its marginal revenue is greater than its marginal cost. Once the additional revenue of one additional unit of output just covers the cost of that unit’s production, the firm settles on that level of output–profit maximizing equilibrium has been reached where MC = MR. Assuming that marginal cost must be positive (most workers won’t pay their boss to let them work more hours, but perhaps there are exceptions), then marginal revenue must also be positive.
Now, refer back to chapter “Elasticity,” specifically the section asking “Does Raising Price Bring in More Revenue.” There you learned that a firm that is able to set its own price can increase revenues by cutting prices if demand is elastic. If on the other hand demand is inelastic, cutting your price will increase your sales (that’s the law of demand after all), but the lower price will weigh heavier on your revenues than the gained sales, and your revenues will actually decline. Mathematically, this works out to a simple rule: if demand is elastic then selling more will increase revenues–which is to say that marginal revenue is positive when the elasticity of demand > 1 (and MR is zero when the elasticity of demand = 1, and negative when elasticity of demand is < 1). Hence, hypothesis 3: If firms produce where MC = MR, then MR must be positive, and therefore demand must be elastic.
Blinder et al. (1998 p. 99) found some support for this–but not much. While noting many businesses do not actually calculate or even think along these lines, the authors found that, among those that could give an answer, 84% believed demand to be inelastic (and, by implication, negative marginal revenue). In fact, 41% believed that the elasticity of demand was zero–that is, a price cut would not increase sales at all.
Now consider a more general issue. In chapter “Supply and Demand” you were introduced to the centerpiece of orthodox economics: the market model. The chief argument of that model is that prices in the market will adjust to bring supply and demand into an equilibrium in which the quantity people wish to sell is equal to the quantity people wish to purchase–that is, the price mechanism acts to clear markets. This model fits into the broader narrative of orthodox thought which holds that capitalist economies are organized by price adjustments in the complex network of markets that make up these economies. Therefore, Hypothesis 4: unless the world changes very seldom or very slowly, leaving most markets in their previously established equilibria for long stretches of time, prices should be changing rapidly with frequent bidding, as in an auction market.
By now you could probably predict what the evidence was going to tell us about this important part of standard orthodox theory: throughout most of the modern US economy, prices change relatively infrequently. Blinder et al. (1998, p. 84) find that 49% of responding firms change their prices no more than once in a year or even longer. Indeed, only 22% reprice daily, weekly, or monthly. The auction market model at the core of orthodox economics exists, indeed; but, it would appear that it lies somewhere between minor and insignificant in today’s economy.
Blinder, Alan, et al. Asking about prices: a new approach to understanding price stickiness. Russell Sage Foundation. 1998.