Posted by: Dirk | April 29, 2019

The problem with the supply curve

In his book Debunking Economics: The Naked Emperor of the Social Sciences (link) Steve Keen uses a 1952 paper to make a very important point about neoclassical economics: There is a problem with the supply curve. In the paper, the authors asked business people what they thought their supply curve looked like. In neoclassical economics, the theory is quite clear what it should look like:

supply

The supply curve slopes upwards, as a rise in supply can only be effected through an increase in price. The logic is that if you want to sell more of something, you will have to charge a higher price as it marginally gets more expensive to increase production. This is a central “insight” of neoclassical economics: resources are not limited, but rather they can be provided, given that the buyers are willing to pay a higher price.

Interestingly, it should not be too hard to see whether this theoretical supply curve is a realistic description of reality. So, Eiteman and Guthrie in their AER paper presented some supply curves to businesspeople and asked them which ones would represent best the situation of their respective business. Here are four proposals (the other four received an insignificant amount of approval, so I did not bother to reproduce them):

AER 1952.png

All these curves are “far away” from the supply curve presented in neoclassical economics. Maybe number 5 is kind of close, at least at a significant scale of output. The table that the authors present is a nasty surprise for any neoclassical economist:

TABLE II.-CHOICE OF COST CURVE BY COMPANIES WiTHOUT REFERENCE TO NUMDBER OF PRODUCTS

Curve Indicated – Number of Companies

1 – 0

2 – 0

3 – 1

4 – 3

5 – 14

6 – 113

7 – 203

8 – 0

Total – 334

Have a look at curves 6 and 7 above. Number 7 received almost twice as much support as number 6, and that is a DOWNWARD SLOPING supply curve! The authors conclude: “The replies demonstrate a clear preference of businessmen for curves which do not offer great support to the argument of marginal theorists.” To non-economists this is perhaps not that much of a surprise. If you produce more of something, you can use more machines and hence you will be more efficient. Prices would then be expected to fall. Industrial mass production typically features falling prices, as the expansion of output allows firms to operate at a larger scale, using more resources.

Eiteman and Guthrie conclude their paper with this statement: “If the beliefs of businessmen in general coincide with those included in this sample, it is obvious that short-run marginal price theory should be revised in the light of reality.” That was in 1952, and microeconomics is still presented to young economists as an insight to build on. Never mind that later on increasing returns to scale are introduced – the whole foundation of modern micro has collapsed decades ago. What would companies like Amazon, Google or facebook say about their supply curves? If you would add another account at facebook, have another user using Google’s search engine or another user buying books at Amazon – would marginal costs increase? Obviously not.

Microeconomics, the behavior of firms and households, is very important. Starting the subject by repeating theories that should have long been discarded blocks more relevant approaches from being taught. These new approaches could provide proper foundations of the behavior of firms and households if they are not based on “economic laws” that are refuted by reality.

In the face of climate change and the fight against it economics needs to be reformed from bottom up. A microeconomic theory that basically says that resources are unlimited – if only buyers accept a rising price – is not a good way to start thinking about our economy. The supply curve should not slope upwards by default. It should be presented as something that is conditional on technology and regulation.

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Responses

  1. Exactly. This is THE foundational error of traditional economics. Whereas the correct cost and supply curve is the foundation for Post-Keynesian and rent-based economics.

  2. Econ 101: supply-demand-equilibrium is dead for 140+ years
    Comment on Dirk Ehnts on ‘The problem with the supply curve’

    Dirk Ehnts reports: “Steve Keen uses a 1952 paper to make a very important point about neoclassical economics: There is a problem with the supply curve.” and concludes: “Microeconomics, the behavior of firms and households, is very important. Starting the subject by repeating theories that should have long been discarded blocks more relevant approaches from being taught. These new approaches could provide proper foundations of the behavior of firms and households if they are not based on ‘economic laws’ that are refuted by reality.”

    All this is true, of course, but ultimately not very helpful: “The moral of the story is simply this: it takes a new theory, and not just the destructive exposure of assumptions or the collection of new facts, to beat an old theory.” (Blaug)

    Because traditional Heterodoxy consistently failed at this methodological barrier economics students are still taught the ‘Totem of the Micro’, i.e. supply-demand-equilibrium.#1

    The lethal blunder of microeconomics, though, does not start with the supply curve but with the neo-Walrasian axiom set: “HC1 There exist economic agents. HC2 Agents have preferences over outcomes. HC3 Agents independently optimize subject to constraints. HC4 Choices are made in interrelated markets. HC5 Agents have full relevant knowledge. HC6 Observable economic outcomes are coordinated, so they must be discussed with reference to equilibrium states.” (Weintraub, 1985)

    The pivotal propositions are HC3 and HC6. Methodologically, they are NONENTITIES like the Easter Bunny and Spiderman. The behavioral axiom HC3 makes economics marginalistic.#2, #3 In order to make constrained optimization work, a well-behaved production function is required. The production function is NOT the result of real-world observations but implicated by HC3.#4, #5, #6 The supply curve, in turn, follows from the assumed production function. So HC3 is the ultimate reason why there “is a problem with the supply curve”.

    From this follows that the microfoundations HC1/HC6 have to be discarded. And this is the end of Econ 101 as we know it. Economics textbooks are worthless since Samuelson’s firstling of 1948.#7

    The end of proto-scientific economics, though, is the beginning of scientific economics which is no longer based on false microfoundations but on true macrofoundations.#8, #9, #10

    From the devastating critique of supply-demand-equilibrium follows the necessity of a Paradigm Shift. Traditional Heterodoxy never performed the Paradigm Shift but was content with the endless repetition of how “unrealistic” Orthodoxy is.

    Because of this, both Orthodoxy and traditional Heterodoxy go down the scientific drain.

    Egmont Kakarot-Handtke

    References
    https://axecorg.blogspot.com/2019/04/econ-101-supply-demand-equilibrium-is.html

  3. @Egmont: Not quite true. Post-Keynesians, MMT and Rent-based Economists have developed a whole new theoretical framework and written comprehensive textbooks about it. Also the Walrasian axioms are mostly a consequence of the false cost/supply curve. With a correct downward-sloping cost curve, there is no traditional market equilibrium and all else collapses. You end up in a Post-Keynesian cost-plus reality.

  4. @Egmont: Very interesting site of yours. I will study it carefully. At first glance I agree with most of what you write. The key scientific questions of price and profit have not yet been answered by anybody.

  5. The graphs are a bit misleading, because they actually don’t show supply curves but cost curves of suppliers. But the costs define merely the minimal price you need to charge to survive, not the price you ask for at the market.

    Business economics teaches you to make your product not interchangeable in some way with your competitoners product. Michael Porters theory of competition (and other peoples theories as well) is mostly about how to avoid direct competition on price. Check your favorite supermarket and check the prices of spring water which you would assume has the same or similiar price for every brand.

    Hence a cost-plus supply curve is equally questionable.

    What you have are single price points on the demand curves for each uninterchangeble product which the producer sets, most likely at his monopolistic price point. With his marketing activities the producer tires to manipulate the demand curve, while in the same time by lowering his costs to increase his profits. You need to understand that he is NOT moving his price point when changing the costs or changing the quantity on the market.

    When changing prices the producer moves directly the demand curve of the substitute goods, and only indirectly of his own goods, because the new price might attract consumers substitute goods.

    Possibly you can try to model the price determination as a game like in game theory. When one participant raises the price it is not completely clear if for the competitioner is taking your market share is the best strategy to respond. It can be that raising his prices as well will pay of higher profits compared to not raising, because the delta in price increases the profit more then the delta in qty when keeping the price.

    Summary: It is highly unlikely that a continuous supply curve can be constructed at all.


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