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Cost and Competitive Power

By James H. Nolt

Last week, I ended by talking about production costs and how they undermine the neoclassical idea of the supply curve. The supply curve relates the quantity producers are willing to supply to the price of the product. Under the imaginary general case of perfect competition, each supplier is too small to affect the price of the product. Economists say such tiny producers are “price takers.” They can choose how much they are willing to produce at the going price, but cannot affect the price itself. Economists always start with them and seldom go beyond this assumption because such idealized producers fit with the ideology of consumer sovereignty and producer powerlessness.

Of course, idealized powerless producers are a far cry from the giant corporations that produce most of today’s output. Textbooks sometimes give examples of family farmers as typical of free market producers. It is true that unorganized farmers (though worldwide, many are well organized) are relatively powerless, but even so, markets for farm produce are not free of power because the buyers of most farm produce are themselves giant corporations. Throughout history, I know of no markets that are nearly as free of private power as economics textbooks expect in their “perfect market” idealization.

The main reason that markets cannot be free of private power is that most of the time size confers competitive advantage. Economists do mention this possibility, but do not consider it as the general case. They label this “economies of scale.” In other words, the larger the firm or the scale of production, the cheaper the per-unit cost of production. A lower cost of production allows firms that enjoy economies of scale to undermine the prices of smaller firms producing more expensively. A classic example of this is the way Ford’s large-scale assembly line drove down the cost of cars a century ago, destroying dozens of smaller car manufacturers in the process. Ford, in turn, prospered from economies of scale.

On the other hand, economists are uneasy about the concept of economies of scale because it does imply that markets tend toward monopoly power rather their perfectly competitive ideal. If textbooks were honest, they would put this problem near the beginning, but they pretend that free markets are the general rule and monopoly power is an exception that can be ignored until near the end of the book and the microeconomic course.

Instead, textbooks teach the fiction, as I discussed last week, that average cost curves are U-shaped and marginal cost curves have a positive slope. This assumes the opposite of economies of scale. This also assumes that the per-unit cost of producing things increases the more a firm produces. As I mentioned last week, Piero Sraffa already debunked this idea quite powerfully 90 years ago. His arguments have never been refuted. In fact, economists rarely even try to demonstrate this case with real data. They can’t, they merely assume it is true because they cannot demonstrate that it is. This idea of increasing costs is also what gives the fictional supply curve its assumed upward or positive slope.

Let’s be clear, key assumptions such as this one are absolutely necessary to sustain the Three Golden Pillars of economic ideology: that free markets are stable, efficient, and fair. If you wonder why economics starts so oddly and makes so many absurd assumptions the answer is that it is ideologically compelling to do so. (At certain points, it is also mathematically easier.) There are much more direct and scientific ways to study the economy, but they have been submerged by the “don’t worry, be happy” consumerism of the mainstream message. Economics is training, not truth. It is useful for crowd control, for producing sheep, but not for understanding the real business of the economy.

Returning to the issue of economies of scale, larger firms have lower costs and therefore greater competitive advantage than smaller firms for various reason, including that most of the time manufacturing on a larger scale leads to cheaper per unit costs. There are many reasons for this. One reason was given by Adam Smith: large factories can benefit from greater worker specialization or, as he called it, division of labor. Another is that many complex or highly engineered products incur great initial costs of research and development before even a single unit can be produced.

If only a few units are produced, the cost per unit would be very high, but the more units that are built, the lower the cost per unit. Accountants define a “breakeven point” when the number of units sold is finally sufficient to cover the sunk costs. Only after that are profits earned on every additional unit sold. Business strategy emphasizes a downward sloping learning curve, indicating that the more units you produce, the better you learn how to perfect the production process, leading to decreasing costs. All of these practical ideas contradict the standard textbook cost curves.

The excuse given in textbooks for increasing marginal costs are based on the idea is that production occurs in the “short run,” which is an artificial unit of time after decisions have already been made about the factory size (i.e., capital is fixed) but before deciding on the number of workers to hire and how much to produce. Thus within a fixed factory size, you can only produce more by making more intensive use of existing equipment, perhaps maintaining it less often and suffering more breakdowns. Another way to tell the story is that to get maximum output from the same capital, you must work it 24 hours a day, requiring a more expensive or less productive night shift to avoid idle capital equipment.

Finally, it is possible that producing more and more leads to increasing cost of some input, such as cotton if you are making cloth. This is the case that Sraffa demolished. Economists usually do not dwell on this part of the story because it is necessary nonsense for their purposes. People who investigate real businesses find very few managers actually believe they face rising costs as output increases, so the positive slope of the supply curve is rooted in myth.

Reality is dangerous for economic theory, and thus must be avoided at all costs. If cost of production declines as output increases, then all the results dear to the hearts of economists are lost. Market economies are no longer necessarily stable, because stability requires a stable equilibrium point where the supply and demand curves, being well behaved, uniquely intersect. This requires that these curves have opposite slopes. A downward-sloping supply curve might not intersect with the downward-sloping demand curve, implying firms overproduce, or it might intersect at multiple points.

Free market economies are no longer necessarily efficient, because the proof of efficiency requires U-shaped average cost curves. Economies are no longer necessarily fair, because bigger firms tend to dominate smaller ones and private power becomes highly concentrated. Economists must start with unlikely cost assumptions in order to “prove” any of their big points about the superiority of free markets.

Next week, I will argue why private power, rather than equilibrium of supply and demand, is what actually stabilizes real markets, to the extent they are stable. In other words, such stability as we do have is more a product of what J. P. Morgan called “organized capitalism,” rather than the magic of the Adam Smith’s invisible hand of free markets. Private capitalists, in fact, avoid free markets as much as they possibly can.

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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 BiblioArchives/LibraryArchives]

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