Debunking Economics Part 2: Why there is no Supply Curve

Chapter 4 of Steve Keen’s Debunking Economics looks at supply curves. Keen analyzes a number of other economic theories; perfect competition, Marginal Cost (MC) equals Marginal Revenues (MR), and when put together, they all of lead to the idea that a supply curve cannot be derived. This is another long and complicated chapter, so I’ll do my best to summarize its main points in a clear and concise manner.

First, I think it’s important that we lay out the conditions needed to draw a supply curve. The supply curve can only be derived if price equals marginal cost. If this condition isn’t met, then the supply curve cannot be drawn, which explains why supply curves are only drawn for markets under perfect competition.

According to neoclassical economics, if firms can freely enter and exit the market (a requirement for perfect competition), firms have identical costs, and input prices are constant, then the long run individual supply curve is flat.

Long Run Supply CurveA firm’s output won’t effect the price of the commodity in question and it will sell all of its units at the same price. Firms under perfect competition are price takers, i.e. any one firm cannot significantly affect the market price for its output and any additional revenue firms receives by increasing output equals the price, or MR = P. Given the assumption of profit maximization, these firms will produce until MC = MR, and the amount the firm produces corresponds to the marginal cost curve. What we essentially have is MC = MR = P, or MC = P. The marginal cost curve is the supply curve.

However, with a monopoly (or any scenario where a firm has market power), there is no supply curve because for a given price there isn’t a unique quantity supplied. The amount a monopolist will supply depends on the firm’s MC function and the market’s demand function. Many different demand curves can be drawn (and by extension, many different MR curves) and it is impossible to derive a curve that shows how much a monopolist will supply at a given price level. A change in demand can lead to either a change in price, output, or a combination of both. This is why that in order to graph a monopoly, you need three curves, price, marginal revenue, and marginal cost.

Many economists and economic textbooks tell you that perfect competition is optimal because it maximizes social welfare. Consumers and producers are both trying to maximize their benefits, the consumer trying to get the most benefit out of consumption and the producer trying to get the most benefit out of production. However, these interests only coincide under perfect competition, when the change in revenue (MR) is equal to the price. Price tells you about the ‘marginal utility’ the consumers get from the last item consumed. Consumers receive less utility from a given commodity as more and more of it is produced (law of diminishing marginal utility). The price they are willing to pay for a commodity gradually decreases as they receive less marginal utility from it. Only under perfect competition does the MR that a firm receives from selling its very last unit of output equal the price (or the individual gain from a producer (MR) equal the benefits of society (P)). Another way to think about it is that the value the consumer puts on a good is identical with the cost of resources used in producing it (MC = P), an allocative efficiency. Either way, the main idea behind this is that there is no dead-weight loss under perfect competition.

Infinitesimals do not equal zero

An individual firm under perfect competition will have a horizontal demand curve. The firm is so small relative to the market, so a change in output will not affect the market price. In other words, the slope of the individual firm’s demand curve is zero. Since the firms are so small, they do not react to any changes in behavior by other firms. In other words, their “conjectural variation” is zero. So when a firm increases output by one unit, the output of the entire industry will also increase by one unit.

However, as Keen notes, these two assumptions are inconsistent.

If the market demand curve is downward sloping, then an increase in total market output, no matter how small, will result in a fall in the market price. Even in the case of a small firm increasing its output by one, the market price will decrease. The only way for this not to happen is if all the other firms decreased their output by one. However, the theory assumes that firms don’t react to the actions of other firms. Put another way:

The economic argument is that if you break a large downward-sloping line (the market demand curve) into lots of very small lines (the demand curve perceived by each firm), then you will have a huge number of perfectly flat lines. Then if you ad all these perfectly flat lines together again, you will get one downward-sloping line.

This is mathematically impossible. If you add up a huge number of flat lines, you will get one very long flat line. If you break one downward-sloping line into many small lines, you will have many downward-sloping lines. The economic concept of perfect competition is based on the mathematical error of confusing a very small quantity with zero.

This conclusion was also noted George Stigler in 1956:

The difficulty arises because the demand (or supply) functions do not possess continuous derivatives: the withdrawal of even one unit will lead to a large change in price, so that the individual trader-even though he has numerous independent rivals-can exert a perceptible influence upon price.

MC = MR does not maximize profits

Keen argues against the idea that firms maximize profits when MC = MR. This is fallacy of composition. While it might be rational for an individual firm to produce until MC = MR, it would be irrational for an entire industry to do so; firms will produce to a point where marginal cost exceeds marginal revenue and operate at a loss.

The neoclassical profit maximizing formula only looks at an individual firm’s output as the only factor in determining its profits. However, what should be looked at is how the output of the entire industry affects the firm’s profits. Intuitively, this implies that a firm should produce less than what the neoclassical formula recommends. This is because the impact on a firm’s profits when other firms change their output will mostly likely be negative. What’s missing from the neoclassical formula is that when other firms increase their output, the price of the commodity produced will fall, not stay unchanged. As price falls, so does marginal revenue and the perfectly competitive industry will produce where MC = P, but exceeds MR. When compared to a monopoly:

The monopoly set price where marginal revenue equals marginal cost, while competitive industry sets price were the supply curve (which is the sum of all individual firms’ marginal cost curves) intersects the demand curve: this is supposed to be the result of setting marginal cost equal to marginal revenue at the firm level, which means each firms makes the maximum profit that it can. Yet at the aggregate level, while the monopoly has produced where profit is maximized, the competitive firms have produced beyond this point, so that the industry’s output past the point of the monopoly output has been produced at a loss – which is why the profit level for a competitive firm is lower than that for the monopoly, even though all its firms are supposed to be profit maximizers.

Real world problems concerning perfect competition

There are many real world problems concerning perfect competition, but Keen focuses on  returns to scale. Returns to scale is analyzing how output changes if a firm increases all of its inputs proportionately. There are three types of returns to scale, constant, increasing, and decreasing returns to scale. Keen focuses on increasing returns to scale and how very large firms have scale advantages over very small firms, especially when we look at homogenous products (an assumption for perfect competition).:

A single example is in farming, where farms need to be separated from each other by fences. The amount of fencing required depends on the perimeter of the farm. If we consider a square block of land, fencing will depend on the length of the four sides of the square. Cost is thus the cost of fencing per mile, times four times the length of a side. But the area enclosed by the fence depends on the length of a side squared. The output of a farm is related to its area, so that the output is a function of the length of a side squared. Doubling the perimeter of a farm thus doubles its fencing costs, but increases it output fourfold.

Apply this type of example across numerous industries and you will get similar results. Increasing returns to scale shows how a perfectly competitive market is unstable. It will over time break down into an oligopoly or maybe even a monopoly.

Economists have been aware of this problem, so they use a concept known as the long run average cost curve. LRAC

The curve is U-shaped, which shows how production exhibits increasing returns to scale, then constant returns to scale, and eventually decreasing returns to scale. The curve implies that there is some ideal scale of output at which the cost of production is minimized and a competitive industry is supposed to converge to this point. However, there are two problems with this:

1. The question whether on not perfect competition can exist in a given industry is an empirical one and this will vary across industries.

2. The long run supply curve is derived under the assumption of constant technology. There is no concept of time involved. Increasing returns to scale can be exploited at any time.

Conclusion

Keen concludes his chapter by claiming that supply and demand, the “Totems of Micro”, are invalid. This is by far the most controversial chapter in Keen’s books and is the one that is the most disputed. I might look into those criticisms in a future post, but I’ll leave that untouched for now. Personally, I thoroughly enjoyed this chapter, especially the way Keen highlights the real world complication concerning perfect competition. Many neoclassical economists note some of these limitations as well, but Keen does it in a clear and concise way that makes it easy to understand for laypeople.


Links:

  1. Perfect Competition, Profit Maximisation and Non-Existent Supply Curves by Unlearning Economics

References:

1. Keen, Steve. Debunking Economics: The Naked Emperor Dethroned? London: Zed Book, 2011. Print.

2. Perloff, Jeffrey M. Microeconomics. Boston: Pearson Addison Wesley, 2012. Print.

3. Stigler, G. J. (1957) ‘Perfect Competition, historically contemplated,’ Journal of Political Economy, 65(1): 1-17

 

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4 Comments

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4 responses to “Debunking Economics Part 2: Why there is no Supply Curve

  1. I think the first two chapters of Debunking Economics have the key points that really get at the core of neo-classical economics. Economies of scale pretty much debunks rising marginal costs and it is interesting that whenever actual business people see traditional economic models they can’t relate to them.

  2. Blue Aurora

    Does Steve Keen cite his 2006 Physica A: Statistical Mechanics and Its Applications article (which was co-written with Russell K. Standish) on perfect competition in this chapter?

    http://www.sciencedirect.com/science/article/pii/S0378437106004456

    What about his 2004 article in Utilities Policy or his 2004 article with Frederic S. Lee in the Review of Social Economy?

    http://www.sciencedirect.com/science/article/pii/S0957178704000475

    http://www.tandfonline.com/doi/abs/10.1080/00346760410001684433

    Does he cite all three articles in the previous chapter as well?

  3. Pingback: Market Competition – the small guide

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