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Supply or Cost?

By James H. Nolt

Last week, we saw that microeconomics textbooks teach backwards, starting with demand rather than supply. This week, we explore another example of backwards logic: how supply curves are described before the source of supply—production—is introduced in the context of the theory of the firm and its cost curves. As I also mentioned last week, classical political economy was much more realistic and useful by starting with production. If microeconomics started with basic cost accounting and real production data, students would learn something practical, rather than mere propaganda about the supposed powerlessness of producers as the servants of sovereign consumer whims.

Economics puts the supply curve before production costs, even though the textbook will eventually argue that the supply curve derives from production costs. This is only because it is an ideological imperative that demand be as much divorced from production as possible, to make consumer sovereignty seem more absolute. Putting supply before production creates one more layer of insulation between production/supply and demand, when in fact they are closely related and not independent, as in the textbook story.

As I argued last week, people do not know what they might buy until they see what has been produced and brought to market at what prices. Furthermore, most people derive their incomes from their employment, so they must be employed producing things before they know how much they are willing to spend.

On the other hand, producers must make decisions on what to produce prior to knowing what might eventually be bought. They might be wrong, in which case markets are in disequilibrium, requiring either price or production to be adjusted to consumer demand that is not well known in advance. A celebrated genius of design and marketing, Steve Jobs, for example, made several horrendous misestimates of consumer demand for several personal computer models before he finally had a runaway hit with the iPhone. It is obvious to everyone except economists that the price of the Macintosh PC was set by production and marketing costs long before a single computer was sold and extremely weak consumer demand became evident.

In the real world, producers determine price by considering cost data plus their own strategic pricing plans, which take into account their power in relation to potential competitors. Their power may derive from legal monopolies, such as copyrights or patents; from large size; from branding and other strategies of product differentiation; and from surprise and first mover advantages. But all this contradicts consumer sovereignty and thus must be ignored until much later in the textbook, after unwary economics students are already potentially convinced that markets free of private power might actually exist (which they don’t).

Only after producers determine price, investment capacity, production rates, and marketing campaigns, do consumers begin to have their say. But even as the sales figures start to flow in, real producers have an important choice always denied to them by textbooks: whether to adjust price or production rates. Producers make this decision, not consumers. If sales are booming, producers might increase output or increase price. Likewise if sales disappoint projections, producers still have a choice to cut production or lower price. They are not constrained to do one or the other.

Modern textbooks deny producers this vital strategic choice by sleight of hand, simply by the order that topics are presented. Classical political economy is not so deceptive. By presenting supply before production and costs, modern textbooks implicitly assume that the quantity available for sale in the marketplace is pre-determined. The only thing suppliers (who are not yet producers) decide in the earliest textbook version is whether to sell at the market price or hold onto their goods for personal use or later sale if the price might move in their favor. This has little to do with real capitalism.

In fact, when textbooks finally arrive at “the theory of the firm” and treat producer costs (of course never with real data), the supply curve gradually disappears (see the diagram here). Oh yes, here is more sleight of hand: the magically disappearing supply curve, which exists long enough to show that consumer choice is what really matters, then disappears as we “discover” in the theory of the firm how constrained and non-strategic free market producers supposedly are. Consumers choose; producers merely obey the laws of the market. This is the myth of the market at work to obscure private power.

Yes, I do know that the textbooks claim that the portion of the marginal cost (MC) curve above the average variable cost (AVC) curve represents an individual firm’s supply curve, but then the textbooks also assume that profit-maximization under free competition will drive all producers to the point where marginal cost intersects average total costs (AC), where, by the way, profits are both maximized and zero. If both are true, then in fact there is no supply curve, but only an equilibrium supply point. A truly free market gives producers no choices. Since more advanced mathematical general equilibrium models assume markets are always in equilibrium, all points on the imagined supply curve other than the equilibrium point are irrelevant anyway.

If you are not completely confused at this point in the typical microeconomic textbook, you are not the typical student. Such confusion is understandable because the entire convoluted argument is absurd and unnecessary unless you are determined to “prove” that free market economies exist and they are stable, efficient, and fair. Absent the burden of that ideological agenda, political economy is much more direct, sensible, and empirically consistent.

Actually, the problem of the supply curve is much worse than just this. Since the firm’s supply curve is assumed to be based on the marginal cost curve, students invariably learn that average cost curves are U-shaped and marginal cost curves are positively- or upwardly-sloped, thus giving the aggregate industry supply curve the same upward slope when the supply curves of all the individual curves are added together to get the total supply in the market as a whole. However, there is no empirical evidence that this is true, and none is ever presented. Instead, real cost curves are almost certainly horizontal at best or downward sloping, thus destroying the upward-sloping supply curve and the entire free market theory of the firm, along with the “proof” that free markets are efficient, which depends on these assumptions.

Piero Sraffa, an Italian economist teaching at Cambridge University during the middle part of the 20th century, made a very strong argument in a 1926 Economic Journal article that the neoclassical theory of the competitive firm is nonsensical, but ninety years later this article is still ignored by all but a handful of critics. Although mainstream economists do not encourage study of real cost curves, because they prefer to assume the truth rather than discover it, a few critical studies have looked at actual cost curves and found that the textbook case is very unlikely, just as Sraffa argued.

Next week we will explore a little more closely why production costs generally should be expected to decline as a firm’s output increases. The implication of this is that every element of the textbook foundation of the supply curve is untenable.

What should take its place? Half of the answer was already commonplace in political economy two centuries ago until the wrong turn into neoclassical marginal economics derailed empirical political economy and replaced it with an ideological imperative. The other half of the answer is a refrain I have repeating throughout this blog series: business power matters. There is no such thing as markets free of private power. Efforts to pretend the contrary lead only to the illogical and unempirical economics that dominate textbooks today.

*****

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Cory M. Grenier]

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