Nov 29

Stigler’s cost analysis theory

As a contribution to industrial organization, George Stigler developed his “own” theory on cost analysis in his article “Production and Distribution in the Short Run”, 1939, which moved slightly away from neoclassical cost analysis.

This theory arises as many economist started to criticize the traditional U-shaped representation of a firm’s average costs. George Stigler used empirical data to question the traditional theory. His cost theory can be divided into the analysis of both the short-term and long-term average costs:

Average Costs in the short-term

According to classical economics, each plant ensured only a specific level of output could be produced in the short-run because of production inflexibility. However, Stigler introduced the notion that firms could adapt to changes in demand and be flexible even in the short-run. His main argument in favour of this idea is that whenever a firms built a plant they would have what is known as a reserve capacity.

The existence of this reserve capacity is justified by economic and technical reasons. From the former we include possible changes in the good’s demand due to cyclical reasons, favourable changes in consumers’ tastes or as a preventive method to avoid a production stop in case there is a breakdown or a repair. The latter can arise as there are some basic installations that are indivisible or as managers and workers are hired in excess to allow future expansions.

-before X₁ : marginal costs < decreasing average costs (increasing returns to scale)

-X₁ to X₂: marginal costs = average costs (constant returns to scale, maximum efficiency)

-after X₂: marginal costs > average costs (both increase, therefore decreasing returns to scale)

It must be noted that this theory allows for maximum efficiency to exist for a while, which completely differs from the neoclassical view, which viewed maximum efficiency as a point of inflection, rather than a straight line.

Average Cost in the long-term

Taking into account production costs and managerial costs, Stigler argued that in the long-run average costs will decrease until a point where they cannot longer do so and from which they will become constant.

Production costs will decrease due to economies of scale until the optimum size is reached and then remain constant. Further average production cost reduction could come along with technological or skills increase. As for managerial cost, he considers, they will start to increase after a certain size is reached. However, managerial diseconomies of scale would be compensated by technical economies of scale, with a zero sum net effect and therefore would remain constant as a result.

Nov 27

Lope Gallego

Edward Chamberlin

Edward Hastings Chamberlin, 1899-1967, was an American economist and Professor at Harvard University. He performed a major innovation in modern microeconomic theory, specially regarding the study of the structure of markets, developing monopolistic competition.

With his clever and original work “The Theory of Monopolistic Competition”,1933, Chamberlin became the father of modern industrial organization analysis providing this field with the theoretical core that it was lacking. He changed the focus of microeconomics from the industry to the firms, including important variables as selling costs and product differentiation, in contrast to neoclassical economists, who studied markets only from a pricing power perspective.

Chamberlin gave special importance to what he coined as product differentiation, as a key aspect through which firms are able to control the prices of their products without being monopolists. Along with Joan Robinson’s work, Chamberlin’s book is considered to be the foundations of market structure analysis.

Nov 25

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Structure, conduct, performance paradigm

Structure, Conduct and Performance paradigm (SCP) is used as an analytical framework, to make relations amongst market structure, market conduct and market performance. It was developed in 1959 by Joe S. Bain Jr., who described it in his book “Industrial Organization”. The SCP paradigm is considered a pillar of industrial organization theory, and it has been since its conception a starting point when analysing markets and industries, not only in Economics, but also in the fields of business management and controlling. For instance, the mainline of Michael E. Porter’s works on competition are based on premises derived from this paradigm.

Following its reasoning, an industry performance (which could be considered as the potential benefits to consumers and society as a whole) are determined by the conduct of the firms within the boundaries of this industry, which in turn depend on the structure of the market.

Elements of the Paradigm

– Structure: those set of variables that are relatively stable over time and affect the behaviour of sellers and/or buyers. The way in which markets fail to follow perfect competition conditions, depends basically in the degree of: supply concentration, demand concentration, product differentiation and market entrance barriers. Also, the structure of the market will always be determined by the nature of the product and the technology available.

– Conduct: the way in which buyers and sellers behave, both amongst themselves, and amongst each other. Firms choose their own strategic behaviour, investment in research, in development, advertising levels, collusions, etc.

– Performance: It is measured by comparing the results of firms along the industry in efficiency terms, and different ratios are used to assess different profitability levels. The variables considered at this level are such as pricem quantity, product quality, resource allocation, production efficiency, etc.

The dynamic behaviour of buyers and sellers have an effect on the markets, making it harder to predict and establish fixed market structures. Difficulties arise when trying to explain the paradigm and this is due to data shortage, and the multiple definitions and extension of markets. Actually, the main problem when using this methodology to analyse a market or an industry is the difficulty of defining the limits or boundaries of a given industry.

As implications of all this, regarding economic policies, Harvard school recognizes market power as being dangerous, and establishes a relation between, the concentration ratio, and the harmful effects on social welfare.

Nov 25

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Friedrich von Wieser

Friedrich von Wieser Friedrich Freiherr von Wieser, 1851-1926, is one of the founding trio of the Austrian school along with Carl Menger and Böhm-Bawerk. He taught in the largest Austrian universities, mainly in Vienna. Amongst his students, there were well-known would-be economists such as Friedrich A. von Hayek and Joseph A. Schumpeter, who were strongly influenced by the thoughts of their professor.

Wieser’s main works include “On the Origin and the Main Laws of the Value of Factors”, 1884, where he develops the concept of marginal productivity valuation of factors and his cost theory; “Natural Value”, 1889, where Wieser further develops his previous work, but giving it normative distributional content; and “Social Economics”, 1914, which is considered the definitive textbook of the Austrian school.

Nov 21

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Knut Wicksell

Johan Gustav Knut Wicksell, 1851-1926, was a Swedish economist and Professor at Lund University. He is considered one of the most important founders of the school of Stockholm.

In his most influential contribution, “Interest and Prices”, 1898, Wicksell made the differentiation between the natural rate of interest and the money rate of interest. The former was the interest rate that was neutral to prices in the real market, that is, at which equilibrium between supply and demand was found in the real market, and the latter was the interest rate in the capital market. This notion would be used by Milton Friedman when formulating the natural rate of unemployment.Wicksell carried out a remarkable synthesis of other economist works. In his “Value, Capital and Rent”, 1893, he used marginal utility, the marginal productivity theory of William S. Jevons, Carl Menger and Alfred Marshall and he combined it with Böhm-Bawerk’s analysis of capital. He then fused the result in a Walrasian comparative static general equilibrium framework, by which he became the father of the marginal productivity theory of distribution.

In many aspects, Wisksell is considered to be a precursor of J. M. Keynes, especially regarding his emphasis towards the role of the levels of saving and investment in the cumulative process of expansion and contraction of the economy.

Nov 20

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Industrial organization

Industrial Organization is the economic field that studies the strategic behaviour of firms, and their interaction to determine the structure of markets. Knowing their evolution helps to understand them. The traditional neoclassical theory made the relation between “industrial” and “manufacturing”, making the manufacturing market the main target of studies focusing in the technological result. It left aside aspects, such as organization, management and property. This perspective was criticized for using unrealistic assumptions and because it failed to explain a series of phenomena such as imperfect competition and asymmetric information amongst others.

During the 1930s, a new perspective started to take shape, especially from ideas coming from the Harvard school, and theory began to focus in the behaviour of agents in the industry and in the structure of both firms and industry. In his book “The Theory of Monopolistic Competition”, 1933, Edward H. Chamberlin wrote about imperfect competition and found that many markets were differentiated, thus turning markets into unique. There were many works and papers produced on how markets were arranged in terms of the concentration of suppliers, describing how some markets were dominated by a relatively small number of firms.

In his book “Industrial Organization”, 1959, Joe S. Bain Jr. provided the Structure, Conduct and Performance paradigm (SCP), which is used as an analytical framework, to make relations amongst market structure, market conduct and market performance. The market structure will determine its conduct and thereby its performance.

As implications of all this, regarding economic policies, Harvard School recognizes market power as being dangerous, and establishes a relation between, the concentration ratio, and the harmful effects on social welfare. The dynamic behaviour of buyers and sellers have an effect on the markets, making it harder to predict and establish fixed market structures. Difficulties arise when trying to explain the paradigm and this is due to data shortage, and the multiple definitions and extension of markets.

The Chicago school criticized the “empiricism without theory” of the SCP paradigm, and so returned to the Neoclassical pricing theory, having a more benign view of the market’s results, and having a theoretical (rather than empirical) approach. They start from the framework of perfect competition, and consider interventionism as being the source of monopolies. From Chicago’s point of view, the market’s efficiency guarantees the achievement of social welfare, and therefore firms are encouraged to seek efficiency in their production and distribution. As to the implications regarding economic policies, government intervention is considered undesirable, as the market’s forces should be left to act, and the cost of the intervention is believed to be higher than the social benefit, producing a deadweight loss.

The Austrian school also contributed to the development of the Industrial Organization theory, breaking with the Neoclassical approach. From the same school we can distinguish two main views: von Mises and his disciples’ view and Schumpeter‘s.

Mises describes the structure of the market as a dynamic process of exploration of new methods and opportunities to improve the use of resources, and thus competition is beneficial, as it encourages efficiency and innovations. Therefore, markets have to be free, and it dismays government intervention, although some regulation is praised when innovation is promoted.

From Schumpeter’s point of view, technical progress comes from a process of creative destruction, in which innovations make prior technology out-dated and originate from the innovative entrepreneur. Monopolies have a positive consideration, as they carry out the function of promoting innovation and investments, and government intervention should guarantee both of these.

Contestable markets came up as an alternative approach to the problems concerning market power. These ideas were first introduced by William J. Baumol in his “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982. In contestable markets there are no entry or exit barriers, no sunk costs and firms have access to the same level of technology. All this makes the number of firms irrelevant, as many will access it and then leave, following different strategies. This view has important limitations: for instance, its starting assumptions are quite restrictive; the definition of cost is not fully suitable; and that, in the real world, a market with such characteristics, is unconceivable.

Between the 1970s and 1980s, a series of theoretical models formulated using game theory in a framework of imperfect competition, made obsolete previous models, such as the SCP paradigm. As a result, there is more emphasis in imperfect information, in firms’ behaviour and, also, in mathematical tools used to calculate social or optimal equilibrium and market equilibrium. In general, there is a shift towards analysing the internal structure of firms, and different views of the firm arose.

Ronald H. Coase, described businesses as being a series of contracts amongst its workers, and explains that it is more beneficial to form firms, since there are a number of transaction costs that can be reduced or even eliminated.

When a business grows in size, there will normally be a distinction between managers and owners. Olivier E. Williamson took notice of the internal boundaries that firms have, and distinguished between decision-making, management and business ownership. The agency theory describes and explains the issues that arise between business managers and owners, as their respective objectives differ.

George Stigler’s contributions to industrial organization must also be mentioned, even though they were more focused on the economical aspect of the theory, rather than opening a debate on how firms interact with each other. Stigler stressed the importance of economies of scale, since it would make a big difference when concentration in the market and firms’ size increased. Furthermore, Stigler developed his “own” theory on cost analysis in his article “Production and Distribution in the Short Run”, 1939 (see Stigler’s cost analysis theory), which moved slightly away from neoclassical cost analysis. When considering the size of firms, economies of scope are also a possibility, as Baumol pointed out in his co-authored book “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982.

To conclude, it is necessary to clarify that, nowadays, the industrial organization theory accepts multiple perspectives. This theory has not only grown within its field, but also in others, such as applied microeconomics and business management, and, as we have seen during the last years, the boundaries of business and markets have become less clear, and many new definitions and shapes are appearing. This explains the flexibility and the relevance of the industrial organization theory.

Nov 18

Lope Gallego

Economies of scope

The concept of economy of scope is very similar to that of economies of scale. When we talk about economies of scope, we mean that average costs are reduced by introducing another product into our portfolio that can share some of the infrastructure or know-how, thus reducing overall average cost per product. It is essentially the same concept as economies of scale, but based on producing more than one product instead of producing more of the same one.

This can happen for various reasons. Firstly, because fixed costs do not increase proportionally with production but rather in stages, we can introduce a second production line that benefits from the common infrastructure whilst reducing average cost per unit.

We can also see a reduction in average variable costs. Employees can benefit from shared know how or from a certain skill set that can be transferred to a much wider range of products, raising productivity across the board. In this way, labour need not increase proportionally with production output, as it is the case for economies of scale. What we can also see here are skills being transferred from one production range to another, resulting in synergies that are unique to economies of scope instead of economies of scale.

In the adjacent figure we see the case of two multi-product firms. The fact that the lower production possibility frontier (PPF) is concave rather than a straight line means that firm B will enjoy economies of scope, and be able to produce two goods for a lower average cost than when producing only one. Therefore, economies of scope exist if, for two goods, we have:

C(x₁,x₂) < C(x₁,0) + C(0,x₂)

Nov 15

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Ludwig von Mises

Ludwig Heinrich Edler von Mises, 1881-1973, was an Austrian economist and Professor at the universities of Vienna, Geneva and New York. Mises greatly contributed to neoclassical economics and was one of the leaders of the Austrian school.

Mises was a staunch advocate of economic liberalism, based on the idea that demand and supply theory will lead to the resources’ most efficient allocation. He believed socialism would fail due to economic calculation problems, as it wouldn’t be able to produce an efficient price system. In his “Human Action: A Treatise on Economics”, 1949, he analyses both economic systems. His defence of the classical school led him to argue that any separation from orthodoxy would lead to socialism and the end of capitalism.

Mises also worked in the analysis of economic cycles, particularly in the monetary aspects, and his influences were clearly felt in two of the most notable members of the Chicago school: Friedrich A. von Hayek and Milton Friedman.

Nov 14

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Long run cost analysis

In the long run, no cost is fixed. We can determine our production level and adjust plant sizes, investment in capital and labour accordingly. As we can see in the diagrams below, this gives us unlimited options. Depending on the scale we choose to implement, each level of production will be associated to new, short run cost curves. When we exhaust the infrastructure these provide us, we can upgrade to a new production level and so forth. The actual long run cost curve is made up of all of these individual scenarios, built up year after year.

If we look at average costs, the curve these draw is also the build up of the individual short run curves. These form a U shape, as we can see in the diagram. When average cost is decreasing with each additional investment, we are enjoying economies of scale, but not yet working at maximum efficiency. We reach this maximum efficiency at the minimum point, before the average cost per unit begins growing again.

Marginal costs only really make sense in the long run for each individual level of production. At optimal levels of production for each level, they intersect the long run average cost curve where this meets the short run average cost curve. This is what determines our optimal level of production. In summary, at our optimal level of production:

AC_SR = AC_LR = MC_SR = MC_LR

which is known as Le Châtelier’s principle.

The other important lesson to take away from this is the fact that, when we reach the optimal point where efficiency is at its best, average and marginal costs are the same, as happened in the short run (see detailed graph below these lines). At this point, the slope of the tangent line, that is, the derivative, of the short run total cost (TC_SR) is equal to zero, which is consequent with the fact that we are operating at maximum efficiency. What we can also glean from the graph is the fact that TC_SRand TC_LRare tangent where short run average cost (AC_SR) and AC_LR also meet, which is not necessarily an optimum. In fact, the only time where these junctions do suppose an optimum is in case 2.

Nov 14

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Short run cost analysis

In the short run, fixed costs include capital, K, whereas labour, L, is considered variable. Fixed costs are represented as a horizontal line and do not vary whatever level of production we achieve.

The two graphs show how the two phases pan out. In the first phase (I), variable costs (and therefore total costs, seeing as fixed costs are a constant) grow slower than growth at first, before reaching a point of inflection (II) and beginning to grow much faster than the output they are capable of generating.

This is related with returns to scale. In phase I, where the elasticity of scale is greater than 1, there are increasing returns to scale, while phase III corresponds to decreasing returns to scale. In point II, the elasticity of scale equals 1, which represents constant returns to scale.

If we translate this into average and marginal costs, an optimal level is reached along the stretch between which marginal costs are equal to average variable and fixed costs respectively. This coincides with the stretch just before costs begin to grow exponentially.