In chapter 5 of Steve Keen’s Debunking Economics, criticizes the neoclassical analysis of labour markets. This chapter is a bit shorter than the previous two, but it still has a ton of great information. Because of the sheer volume of content, I will have to leave some stuff out to avoid writing a 3000 word post and I will probably split this chapter into two parts so I can focus on some of the more interesting points that Keen makes.
Diminishing productivity causes rising prices
The Neoclassical theory of production states that short run capacity constraints play an important role in determining the costs of production, and therefore prices. As producers try to produce more and more output using a fixed number of machines, prices will rise.
Neoclassical theory states that productivity falls as output rises. Falling productivity implies increasing marginal costs and rising average costs, which translates into rising prices and an upward slopping supply curve. From this we can see that there is a direct link between marginal productivity and marginal costs.
I will illustrate this process by using a short run average total cost curve.
When a firm hires its first few worker, production benefits from economies of scale (cost per unit of output decreasing with increasing scale) because of rising marginal productivity. Intuitively this makes sense. With more workers, there is more specialization, which translates to rising marginal productivity per worker and falling marginal cost. From the graph above, as a firm produces more output using more labor inputs, it experiences economies of scale up to a certain quantity.
At some point the productivity of each new worker ceases to rise and each new worker adds less output than his predecessor. As the ratio of variable factors of production (labor) to fixed factors of production (machines/capital) exceeds some optimal level, a firm will begin to experience diminishing returns. Extra workers will still add output, but at a diminishing rate. With this diminishing marginal productivity comes a rise in marginal cost. As the firm continues to produce output, at some point it will begin to experience diseconomies of scale.
However, profits continue to rise. Despite diminishing marginal productivity, the revenue gained from hiring an additional worker (from additional output) still exceeds the worker’s wages. In other words, MR > MC. From this, we can surmise that a firm will keep hiring new workers until MR = MC, or the revenue gained from hiring one more worker (from his/her additional output) is equal to his/her wage.
The bulk of this chapter is Keen citing Sraffa’s famous paper The Law of Returns under Competitive Conditions.
Sraffa argued that two assumption, that some factors of production are fixed in the short run and that supply and demand were independent of each other, could not be fulfilled simultaneously. In circumstances where some factor of production was fixed in the short run, supply and demand could not be independent. Where supply and demand could be treated as independent, it would be generally impossible for any factor of production to be fixed.
Sraffa began by noting that the classical school of economics also had a law of diminishing marginal returns. However, it was not a part of price theory, but part of a theory of income distribution.
Sraffa argued that the neoclassical theory of diminishing marginal productivity is a misapplication of the classical concept:
The development which has emphasized the former aspect of the laws of returns is comparatively recent. At the same time it has removed both laws from the positions which, according to the traditional partition of political economy, they used to occupy, one under the heading of ” distribution ” and the other under “production,” and has transferred them to the chapter of “exchange-value”; there, merging them in the single ” law of non-proportional returns,” it has derived from them a law of supply in a market such as can be co-ordinated with the corresponding law of demand ; and on the symmetry of these two opposite forces it has based the modern theory of value. (Sraffa 1926: 537)
One the one hand, the law of diminishing returns was generalized from a particular case (land) to every case in which their existed a fixed factor of production. While the law of diminishing returns was broadened, the law of increasing returns was greatly restricted. Rather than focus on the greater internal division of labor, the important of “external economies” was emphasized.
Sraffa’s Broad Arrow
If we are to use a broad definition for an industry, e.g agriculture, then it would be valid to treat some factors of production (in this case land) as fixed. Accordingly, this industry will experience diminishing returns.
However, the output of such a large and broadly defined industry will no doubt affect the output of other industries. If the agricultural industry were to increase its output, this will effect the price of its chief variable input (labor) as it takes workers away from other industries. Changing the relative price of land and labour effects the distribution of income, which also changes demand. As Sraffa noted:
As regards diminishing returns, in fact, if in the production of a particular commodity a considerable part of a factor is employed, the total amount of which is fixed or can be increased only at a more than proportional cost, a small increase in the production of the commodity will necessitate a more intense utilisation of that factor, and this will affect in the same manner the cost of the commodity in question and the cost of the other commodities into the production of which that factor enters; and since commodities into the production of which a common special factor enters are frequently, to a certain extent, substitutes for one another (for example, various kinds of agricultural produce), the modification in their price will not be without appreciable effects upon demand in the industry concerned. (Sraffa 1926: 539)
The assumption that supply and demand are independent from each other isn’t applicable. The impacts on demand from changing input prices mean that the demand curve for this industry will shift with every moment along its supply curve. As a result, studying one market in isolation from all the others is impossible.
Sraffa’s Narrow Arrow
When we use a more narrow definition of industry, say wheat instead of agriculture, diminishing returns are not likely to exist. While the assumption that supply and demand are independent is reasonable, the assumption that some factor of production is fixed isn’t:
If we next take an industry which employs only a small part of the “constant factor ” (which appears more appropriate for the study of the particular equilibrium of a single industry), we find that a (small) increase in its production is generally met much more by drawing “marginal doses ” of the constant factor from other industries than by intensifying its own utilisation of it ; thus the increase in cost will be practically negligible, and anyhow it will still operate in a like degree upon all the industries of the group. Excluding these cases, and excluding-if we take a point of view embracing long periods-the numerous cases in which the quantity of a means of production may be regarded as being only temporarily fixed in respect to an unexpected demand, very little remains : the imposing structure of diminishing returns is available only for the study of that minute class of commodities in the production of which the whole of a factor of production is employed. (Sraffa 1926: 539)
In the real world many industries are able to easily vary all factors of production. This is because additional inputs can be taken from other industries or under-utilized resources can be used. All inputs are variable and the ratio of one input to another will remain constant, resulting in constant costs as output rises.
Sraffa’s critique means that the neoclassical theory of production only applies to a small minority of cases. Instead, the output of a single firm is constrained by “all those factors that are familiar to ordinary business men.” These costs (e.g. marketing and financing costs) usually involve a firm’s attempt to manipulate demand for their products. So when we consider industries that don’t have homogenous products (i.e most industries), their output is constrained by their ability to market their product. When they start to market beyond their product’s niche, raising finance becomes a major constraint:
The limited credit of many firms, which does not permit any one of them to obtain more than a limited amount of capital at the current rate of interest, is often a direct consequence of its being known that a given firm is unable to increase its sales outside its own particular market without incurring heavy marketing expenses. (Sraffa 1926: 550)
Sraffa’s conclusions have some major implications. The textbook neoclassical theory of employment and wage determination falls apart, as well as the idea that real wages determine how many workers a firm employs. With a flat production function, the marginal product of labor will never intersect the real wage.
1. Keen, Steve. Debunking Economics: The Naked Emperor Dethroned? London: Zed Book, 2011. Print.
2. Sraffa, Piero. “The Laws of Returns under Competitive Conditions.” The Economic Journal 36.144 (1926): 535-50. Print.