Steve Keen on Supply and Demand Models

There is some obvious appeal in supply-demand models, especially when one is not trained as an economist: if there is much of something available, especially if there is more than people demand, one cannot charge high prices because people won’t buy. If there is much demand for something, especially if it exceeds total supply, one has to pay much to get the good.

So far, so appealing, although some obvious caveats come to mind, such as: any producer will try not to be in the situation that the prices it has to offer are below its costs of production. Some cannot help it, if for instance the IMF and the World Bank convince lots of third-world farmers to all start producing a certain cash crop such as cocoa, then it might just become oversupplied but those farmers cannot simply decide to hoard their produce and finance their livelihood in some different manner in the meantime. A large corporation, however, just might. That is, it might decide to lay of workers and have some of its productive capacity lay idle, rather than produce for an over-saturated market, which is what we’re seeing right now in a lot of places. Also, monopoly or oligopoly producers might be able keep the price high, as long as there is any demand at all.

As Steve Keen point out at the Business Spectator, this obviously appealing model is neither classical:

One of the many schisms in economics is between economists – new and old – who believe that prices are set by supply and demand, and economists – also new and old – who believe they are set by a mark-up on the cost of production.

The former argument is the overwhelming favourite today, but two centuries ago, it was the minority view. Though modern ‘neoclassical’ economists are wont to claim Adam Smith as one of their own, he disowned their preferred ‘supply and demand’ pricing model to argue that products exchange at prices that are related to their relative costs of production.

nor does it stand up to empirical scrutiny:

It’s a nice theory, but if reality had its way, it would experience what Thomas Huxley called “The great tragedy of science – the slaying of a beautiful hypothesis by an ugly fact”. Over 150 empirical studies since the early 1930s have found that at least 90 per cent of firms don’t face rising costs as output rises – and in fact for the majority of firms, unit costs fall as production increases.

The most recent person to rediscover this particular wheel was none other than Alan Blinder, a one-time vice chairman of the Federal Reserve. He undertook a huge survey of American business to find out why prices might be ‘sticky’, which is an essential part of the “New Keynesian” explanation for unemployment. As part of that he instructed his PhD student interviewers to find out what costs were like for the average American business – and he fully expected to confirm the standard “upward sloping” supply curve.

In fact, his empirical research contradicted it. Much to his amazement, he found that almost 90 per cent of his sample reported that their unit costs either remained constant or fell as output rose.

“The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 per cent of GDP is produced under conditions of rising marginal cost…” Blinder wrote in 1998.

“Firms report having very high fixed costs – roughly 40 per cent of total costs on average. And many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks.”

The first paragraph also immediately hints at another caveat that even non-economists would have run into from time to time – economies of scale. Keen of course makes a principled argument but as a rule of thumb, I am currently arriving at “if an economic theory doesn’t agree with your everyday lived reality, it might just be wrong”.
Supply-side labor market theories that claim that people trade off leisure with wage and are less motivated to hold a job, the less this giving up leisure is reimbursed, for instance: in a capitalist society, there’s simply no way around making money to finance once needs. So quite contrary to the theory, people need to work more when they’re getting paid less since that’s the only way to make enough money to pay the bills.

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