Debunking Economics Part 3.5: The Real Shape of the Average Cost Curve

Update: Unlearning Economics reminds me in the comment section that this has implications for the short run average cost curve as well. In fact, the paper by Wilford Eiteman and Glenn Guthrie specifically talks about the short run average cost curve. So a mistake on my part. They both tell the same story of “rising MC”, so for this post it doesn’t matter too much. But I need to be more careful to not confuse terminology for future posts.  

In chapter 5 of Steve Keen’s Debunking Economics, Keen talks about some empirical papers that show the real costs curves of actual firms. Unsurprisingly, these empirical findings do not corroborate the neoclassical theory of long run average costs (see below):

LRAC

In reality, most firms have very large fixed costs combined with constant or falling marginal costs. The average cost of production falls as output rises, i.e. economics of scale. This is completely at odds with the textbook version of long run average costs, which shows that diseconomics of scale kicks in as output rises, reflecting rising marginal costs.

The Shape of the Average Cost Curve by Wilford Eiteman and Glenn Guthrie, though old, provides some interesting data. This wasn’t a study on what cost curves actually looked like, but what factory managers thought they looked like. Eiteman’s and Guthrie’s reasoning is as follows:

Marginal price theory stands or falls depending upon what businessmen think, because their short-run decisions to expand or to contract are based upon what they believe rather upon what is actually true. (Eiteman and Guthrie 1952: 832)

Questionnaires were sent to one thousand manufacturing companies. The questionnaires came with several questions and eight average costs curves:

Cost Curves

It turned out that most managers did not pick curves that had rising average costs. Only 18 companies out of 366 picked curves that support the neoclassical theory. If we look at the costs of producing individual products, only 62 out of 1082 picked products conform with rising average costs. Eiteman and Guthrie conclude with, “the replies demonstrate a clear preference of business men for curves which do not offer great support to the argument of marginal theorists” (Eiteman and Guthrie 1952: 838).

Even if we look at how average costs curves are actually shaped, empirical evidence is still at odds with neoclassical theory. Keen takes a quote from Alan Blinder’s book Asking About Prices:

The overwhelmingly bad news here (for economic theory) is that apparently, only 11 percent of GDP is produced under conditions of rising marginal cost […]

Firms report having very high fixed costs – roughly 40 percent 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.

Many other empirical studies confirm this result. If you want study the issue more, this paper references some of those studies and other relevant material. Also check out these links.

What I really find odd about this is why textbooks still teach the long run average cost story. It clearly has little practical or theoretical use and I don’t think it would be difficult to incorporate real world findings into undergraduate textbooks. The “Post Crash Economics” group might be onto to something here.

Advertisements

4 Comments

Filed under Economics, Home

4 responses to “Debunking Economics Part 3.5: The Real Shape of the Average Cost Curve

  1. Blue Aurora

    I personally don’t think that Alfred Marshall’s formulations of what we would now call “microeconomic theory” are totally beyond repair, though they certainly aren’t the complete story. Any sensible person knows how to distinguish between a model of reality and the actual nature of reality itself. That stated, wouldn’t ATC also depend on the type of industry a firm is in?

  2. It’s not just long run but short run, too. As Keen notes, firms just vary quantity in response to demand changes, and utilise spare capacity to do so. There is no ‘rising MC’ phenomenon as assumed by the textbooks, except perhaps in agriculture where land is fixed.

    • Thanks for the correction, I added an update up top. But ultimately, when it comes to the shape of the long run and short run average costs curves, they both tell the same story of diseconomics of scale and ‘rising marginal costs’, which is mostly bunk. That’s probably why I left out the short run here. I also wrote this at 2 a.m. and was probably too tired to think properly.

  3. Pingback: Rich people could benefit if everyone else were also rich. | direct economic democracy

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s