HOW ARE PRICES DETERMINED?

1. CRITICISM OF NEOCLASSICAL THEORIES OF MARKET

STRUCTURE AND PRICING
2. THE POLITICAL ECONOMY APPROACH TO PRICING
3. KALECKIS ENTREPRENEURIAL CAPITAL AND
INVESTMENT
4. WHAT IS THE APPROPRIATE CONCEPT OF COSTS?
5. WHAT FACTORS DETERMINE THE MARK UP?
6. THE EICHNER MODEL

Criticism of Neoclassical Theories of Market

Structure and Pricing
NC pricing theories, based on Demand and Supply
comparative static equilibrium analysis is logically and
empirically flawed
Significant logical flaws highlighted :
Sraffas 1926 critique [paper published in Economic Journal]
of Marshallian partial equilibrium model
the industry supply curve (based on profit maximising
firms) requires perfect competition, and in the long-run no
economies of scale.
U shaped cost curve contradicts assumptions of perfect
competition or partial equilibrium

Criticism of Neoclassical Theories of Market

Structure and Pricing
The unrealistic assumptions about human
behaviour underlying consumer theory (used
to construct individual and market demand
curves)

The unrealistic assumptions about human

behaviour Veblen
The psychological and anthropological preconceptions of
the economists have been those which were accepted by
the psychological and social sciences some generations ago.
The hedonistic conception of man is that of a lightning
calculator of pleasures and pains who oscillates like a
homogeneous globule of desire of happiness under the
impulse of stimuli that shift him about the area, but leave
him intact. He has neither antecedent nor consequent. He is
an isolated definitive human datum, in stable equilibrium
except for the buffets of the impinging forces that displace
him in one direction or another.

Veblen
Self-imposed in elemental space, he spins symmetrically
about his own spiritual axis until the parallelogram of forces
bears down upon him, whereupon he follows the line of the
resultant. When the force of the impact is spent, he comes
to rest, a self-contained globule of desire as before.
Spiritually, the hedonistic man is not a prime mover. He is
not the seat of a process of living, except in the sense that
he is subject to a series of permutations enforced upon him
by circumstances external and alien to him (Veblen, T.B.
(1898) Why is Economics Not an Evolutionary Science?,
Quarterly Journal of Economics, 12 (3), 389-90).

Criticism of Neoclassical Theories of Market

Structure and Pricing
The inapplicability of models based on
assumptions of perfect competition (infinite
number of small buyers and seller, homogeneous
products, zero barriers to entry and exit, perfect
knowledge, no externalities etc)

REJECTION OF PROFIT MAXIMISATION

Profit maximisation firms produce output level [Q]
maximises the difference between current total revenue [TR]
and total costs [TC] where marginal revenue [MR =
TR/Q] equals marginal costs [MC = TC/Q]
The profits maximisation assumption is disputed for many
reasons
1. firms cannot produce where MR=MC, because they can
not be aware of what the MR (or MC) function looks like.
2. the decision making rule is myopic

REJECTION OF PROFIT MAXIMISATION

3. separation of ownership and control: owners may
(?) desire profit maximisation, but what about
managers
4. Empirical evidence: survey responses from firms
(e.g. Hall & Hitch) indicate that firms do not follow
MR=MC rule, but instead use some form of markup pricing
5. Inherent uncertainty bounded rationality and
satisficing behaviour, rely on rules of thumb

POLITICAL ECONOMY APPROACH: BASIC

PROPOSITIONS

2 BROAD SECTORS ARE ISOLATED

1. Flex price sector: Prices [P] determined by Demand &
Supply [D & S]. Mainly primary products.
2. Fixed price sector, price determined on the basis of
costs. Includes most finished goods & services.
This sector is by far the more important one in modern
capitalist economies and is typically oligopolistic in
structure.

INDUSTRIAL STRUCTURE
Markets are not competitive - tend to be
oligopolistic in nature.
Oligopoly: an industry containing a
sufficiently small number of producers that
the actions of any individual will influence its
rivals
essential feature of oligopoly is the
interdependence of producers.

PRICE AND OUTPUT DETERMINATION BY

FIRMS
Prices are not determined by demand and supply,
and output is not set where MR=MC
Prices are largely cost determined: determined by a
mark-up on some measure of unit (average) costs
Mark-up pricing behaviour assumed on the basis of
observation (dating back to Hall & Hitch studies)
Output is responsive to changes in demand, but
prices are not, unless full capacity utilisation is
approached.

CAPACITY UTILISATION
Excess capacity is the normal situation for firms
(i.e. plant and equipment are not operating at
full (potential) capacity)
Firms output to meet unanticipated increases
in demand and/or to take advantage of potential
market share expansion opportunities, without
incurring significantly higher average costs of
production
Related to decision-making under uncertainty

MARK-UP PRICING MODELS

P = mU
Where P = price,
m = the mark-up
U = unit (average total) costs
BUT
a) What factors determine the mark-up [m]?
b) What is the appropriate concept of costs [U]?

WHAT DETERMINES THE MARK-UP? PART 1

According to Kalecki, the mark-up is
determined by the following structural/
institutional/ strategic factors:

the degree of industrial concentration

extent of sales promotion activities (product
differentiation)
trade union influence
strategic behaviour by firms; e.g. entry
prevention, investment financing decisions

RELEVANT COST CONCEPT

Some definitions:
Total Costs = Total Fixed Costs [TFC] plus Total Variable Costs [TVC]
By definition, total fixed costs do not vary with output TFC = 0
Average total costs [ATC] = Total Costs divided by the level of output
produced by the firm [Q]
ATC = U = TFC/Q + TVC/Q
= average fixed costs [AFC] plus average variable costs [AVC]
output (Q) average fixed costs (=TFC/Q)
AVC: assumed to be constant (for given input prices) up to (or close to) full
capacity utilisation

Cost Curve Diagrams

Traditional Textbook

(V = total variable costs)

Political Economy Cost Curves

AVC

Q*

Q* = full capacity output

Cost Calculations
How can the firm calculate U (ATC) if it does not
know what Q will be equal to?
General Approach: Define unit (average) costs
that would apply not at the actual level of Q and
capacity utilisation, but at a normal or expected
level of capacity utilisation
Therefore, AFC calculated relative to expected /
planned/normal levels of capacity utilisation

DIFFERENCES IN PREDICTIONS

1. INCREASE IN VARIABLE COST (WAGES)

The mark-up model predicts:
AVC (unit costs, wages) P
Little change in Q (if demand responds)
The traditional textbook theory
marginal costs supply P, Q

DIFFERENCES IN PREDICTIONS

2. INCREASE IN DEMAND FOR THE PRODUCT

The mark-up model predicts:
Q (provided excess capacity exists)
no change in P (at least not in the short period) as Q had
no effect on AVC or PAFC.
Note that since Q > Qexpected, AFC < PAFC, leading to
higher profits at the fixed mark-up (m).
The traditional textbook theory
Q and P

IMPORTANT QUALIFICATIONS

If the Q means that the firm is

approaching full capacity utilisation Q
AVC P
If Q leads to higher raw material costs
because of demand pressures in those
markets

LONGER PERIOD PRICING MODELS

Survival and growth of the firm through time.
For growth, firms need to invest (increase
productive capacity).
Two possible sources of funds to finance
Investment:
1. Internally generated funds (retained earnings)
mark-up internal funds
2. Externally generated funds (debt & equity)

KALECKI 1937 "PRINCIPLE OF INCREASING RISK

Kalecki: financial markets imperfectly competitive ease of borrowing
related to the profits and wealth of the borrower.
The larger the external financing requirement relative to internal funds, the
more reluctant will firms be to borrow, and the more reluctant will the
capital market be to lend to the firm.
The access of a firm to the capital markets for finance depends on its own
entrepreneurial capital, and there is an upper limit to a firm's ability to
borrow which depends on its own capital and on availability of internally
generated funds. (note this depends upon size of the firm, not simply
profitability)

Kalecki
The limitation of the size of the firm by the availability of entrepreneurial
capital goes to the very heart of the capitalist system. Many economists
assume, at least in their abstract theories, a state of business democracy where
anybody endowed with entrepreneurial ability can obtain capital for starting a
business venture. This picture of the activities of the 'pure' entrepreneur is, to
put it mildly, unrealistic. The most important prerequisite for becoming an
entrepreneur is the ownership of capital.
The above considerations are of great importance for the theory of
determination of investment. One of the important factors of investment
decisions is the accumulation of firms' capital out of current profits. P. 107

Increasing Risk
imperfections in financial markets mirror
imperfection in the product markets
If a firm requires funds to finance an investment
project, the ability to generate internal funds is
critical
link between the firm's pricing decision
(determination of the mark-up) and its need for
funds in the form of retained profits, used to finance
investment
How can more internal funds be generated?
By increasing the mark-up on costs.

Determination of Mark Up

1) Related to market structure

competitiveness etc.
2) Need for funds to finance investment
(Harcourt & Kenyon, Wood & Eichner): more
longer run considerations
Both price part of firms strategic decision

EICHNERS MODEL
Industries has a price leader - a megacorp
Firms have growth targets met through investment,
part funded internally, part externally.
The price leader sets a price to yield a target rate of
return just sufficient to finance the investment
necessary to meet desired growth plans.
This price is then adopted by the other firms in the
industry

CAPACITY
Plants full capacity defined in physical or engineering terms: engineerrated capacity (ERC).
Firms have some expected level of capacity utilisation industrial plants
are designed to operate below that capacity level, at what the standard
operating ration (SOR) = % of ERC at which firms expect to operate plant.
AVC are assumed constant up to capacity, fixed costs fall as output
increases

Supply of funds
1. internal = corporate levy [CL]
2. external = borrowing rate of interest [i]
Eichner suggests that firms estimate standard
operating ratio, and then charge a markup to
cover fixed costs and the corporate levy at this
expected level.
Cost of external finance is assumed to be constant

P = AVC + [AFC + ACL] / [SOR.ERC]

COSTS OF INTERNAL FUNDS

For internal funds, P CL but limited by:
(1) the substitution effect,
(2) entry factors,
(3) government intervention.
R = implicit interest rate
= probable loss of future cash flow resulting from these factors
R increasing function of the size of the mark-up
mark-up more funds CL but cost of funds
Solution: For a given demand for Investment funds:
Use internally generated funds (increase CL & P) up to the point where CL = the
external costs of borrowing (i)

 External funds are available at an interest rate i

overall supply curve of additional investment funds is shown by
SS

Extensions to Model
The Eichner model developed by Harcourt and
Kenyon, and Adrian Wood.
These models similar to classical analysis allowing
for the development, in modern capitalist
economies, of monopoly and oligopoly.
Markup plays the role of the source and motive for
accumulation.
Market imperfections mirrored in the financial
sector: larger and wealthier firms have access to
more and cheaper finance faster growth rate
degree of monopolisation etc.

STEINDLS ANALYSIS OF THE LIMITS OF

COMPETITION
Competitive capitalism has within it the seeds of its
own destruction: Steindl Maturity and Stagnation
in American Capitalism
Firms plan excess capacity to be prepared for sales
expansion, and as barriers to entry
Industrial concentration and excess capacity as
outcomes of the process of competition between
capitalists.

STEINDLS ANALYSIS OF THE LIMITS OF

COMPETITION
Competition between firms the number of firms within an industry
monopolization only a few firms left stagnation
existence of cost differentials between firms, due to technological differences in
production methods
lower cost firms greater profit margins invest more in the newest plant
and equipment industrys capacity
If > growth in demand unplanned increases in the degree of excess capacity
attempt to secure a greater share of the market at the expense of other
firms.
either reduce profit (P ) Price War or increase expenditures on sales efforts

STEINDL
small firms leaving industry
industrial concentration
Eventually, price wars too expensive other forms
of competition
excess capacity
industrial concentration and excess capacity as
outcomes of the process of competition between
capitalists
Ie: competition has, within it, the seeds of its own
destruction

Summary
NEOCLASSICAL ECONOMICS
Price is everything.
Determined by the interaction of supply and demand
unfettered markets produce optimal outcomes.
Price signals are the important ones influencing changing economic behaviour.
Price acts as a scarcity index, reflecting the relative scarcity of the good being
produced.

Summary
POLITICAL ECONOMISTS/POST-KEYNESIANS
Prices part of the strategic decisions of firms
Reflect nature of interaction with other firms in industry
Part of long-term investment/accumulation strategies.
Short run shocks (demand changes) little influence on
prices output, with prices unchanged.
Oligopoly firms cannot calculate marginal revenues
Profit maximising price simply does not exist.
Uncertain environment, firms rely on rules of thumb markup pricing
unwilling to change price except in exceptional
circumstances