microeconomics lee

8/3/2019 Microeconomics Lee

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Microeconomics Comprehensive Exam Study Questions-Lee

14. How do critical realism and the method of grounded theory affect the development

of heterodox microeconomic theory?

In Theory Creation and the Methodological Foundation of Post Keynesian Economics,

(Cambridge Journal of Economics 2002) Lee argued that critical realism is the philosophicalfoundation and grounded theory should be the methodological foundation for Post Keynesianeconomics. Together, critical realism and grounded theory let heterodox microeconomiceconomists develop substantive and formal theories that are able to generate explanationscorresponding to the actual historical contingent economic events.

The critical realism approach is common sense understanding of the world. Thecommon sense propositions hold dear in critical realism include that the real economy is a) non-ergodic, b) an independent system with human agency and economic-social-political structures,and c) compose of institutions embedded in historical processes. From this common sensefoundation, critical realist theorists argue that there are three tier view of economic reality:

1. empirical: experience and impression

2. actual: actual events underlying them3. nonactual: causal mechanisms and socio-economic structures (Lawson, The Nature of

Post Keynesian and Its Links to Other Traditions: A Realist Approach, JPKE 1994).

The goal of critical realists is to find the nonactual. By understanding the relativelyenduring causal mechanisms and social structures underlying the experience and actual events,critical realists are able to discern how the economy really works. For example, heterodoxmicroeconomists, who adopt the critical realism philosophical foundation, do not accept theempirical experience that consumers consume utiles to satisfy some desires and wants. Themicroeconomists probe deeper to understand why consumers consume what they consume; theresult has been that heterodox microeconomists have learned that people consume for a variety ofreasons: a) physical needs, b) pecuniary emulation, c) to gain social status, and so forth.

Lee (2002) and Dow (2001) (Post Keynesian Methodology in A New Guide to PostKeynesian Economics, 2001, Pressman & Holt) have both argued in separate writings theadvantages of the critical realist tradition from the positivist tradition. Critical realistsbeingable to understand the nonactualare able to show that the causal mechanisms operating indifferent situations will produce the same transfactual results each time, but the empirical andactual events need not be regular or repeatable. In another word, heterodox microeconomists whoadopt critical realism are not stuck making this statement: If event X, then Y only if condition Eholds. Critics cannot retort back the question, So what happens if E does not hold?Heterodox microeconomists are able to say definitely that If event X, then event Y but the agentdoes not have to do Y. The heterodox microeconomists allow room for agency in their approachto economic analysis. Secondly, critical realism proposes that all theories and knowledge are

fallible. Because the microeconomists work in a spatially and temporally limited environment,their understanding of the causal mechanisms are also geographically and temporally limited tosome situation. As location or time changes, the critical realists expect the underlying causalmechanismsand hence their substantive and formal theoriesto change. They are constantlyworking to test and retest their theories to see if they correspond to the real world. Hence,heterodox microeconomics is not an immutable joint stock of knowledge. Instead, heterodoxmicroeconomics develops with time and space. Lastly, if the heterodox microeconomistsunderstand the causal mechanisms and social structures, they are able to propose policy


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recommendations enhancing (or restraining) the causal mechanisms and social structures fromproducing the desired (or undesired) transfactual results.

Lee (2002) argued that grounded theory is a methodology compatible with the criticalrealist philosophical foundation. Strauss and Corbin (1998) (Grounded Theory Methodology: AnOverview in Strategies of Qualitative Inquiry edited by Wilber & Harrison) noted that there are

three defining characteristics of grounded theory:1. Those who study grounded theory accept responsibilities for their interpretive roles. It is

not enough to report data, but researchers must interpret what is being observed, heard, orread.

2. There is a mandate to verify resulting hypothesis, and this is done throughout the courseof the research projectnot just through follow up quantitative research.

3. Grounded theory calls for theories to have conceptual density and be fluid.Conceptual density means researchers do not generalize the data, but they should let thedata speaks for itself. The concepts and relationships develop should include all thecomplexities and richness of the data. Fluid refers to the fact that grounded theory callsfor researchers to explore new situations to see if they fit with existing theories and howthey may or may not fit. Knowledge for grounded theory is always provisional, limited

in time, and embedded in history.

These three defining characteristics are very similar to the beliefs of the critical realistphilosophy. It is thus easy to see why Lee advocated critical realists to adopt grounded theorymethodology. According to Lee, he said that grounded theory requires the heterodoxmicroeconomists to do four tasks:

1. They must become familiar with the relevant theoretical, empirical, and historicalliteratures that may assist them in approaching, understanding, and evaluating datarelevant to the research interest. Yet, they must also be aware that the creation of newsubstantive theories usually require them to put aside some of the already gainedknowledge.

2. They must engage in field workcollecting comparable data from economic events.

They must then isolate specific categories, analytical concepts, associated properties, andrelationships.

3. Using the isolated concepts and relationships, heterodox microeconomists must develop atheory in form of a complex analytical explanation based on the datas core concepts.

4. The developed substantive/formal theory must be evaluated to see how well it explainsactual economic events.

If the heterodox microeconomists are able to do these four tasks, they will be able todevelop substantive theories and a formal theory that are a reflection of real economic lifenotan idealized version of the economy. Positivism and empirical realism have put neoclassicaleconomists in a quagmire; they can create beautiful mathematical models and predict outcomesbased on the assumptions made in the model. Yet, they cannot understand or explain anything

relevant to the real world. As social economists, heterodox microeconomists are dedicated tounderstanding the real world. Only by understanding the real world can we actually change it.And critical realism and grounded theory are two ways we can accomplish this task.

1. Provide a theoretical explanation for the existence of stable prices at the level of the

business enterprise and the market.

The earliest work in pricing theory was done by Means and Berle (1932). Berle & Meansfigured out that we were no longer living in the world of free markets where the laws of supply


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and demand applied. Instead, we now live in a corporate economy (collective capitalism) ruledby the corporations. The corporations are distinct in that the roles of ownership and control havebeen separated. Owners have become passive rentiers while upper management controls theworking, survival, and growth of the corporations. The corporations do not produce outputs andlet prices fluctuate. Instead, they administer the prices to the market. Means argued that the firmfigured out its standard average total costs and add a target rate of return to the SATC to arrive at

the price for the product. Later, Andrews would argue that the firm figured out its normalaverage direct costs and add in a gross costing margin to arrive at the price. The gross costingmargin includes the normal average indirect costs and a costing margin (predetermined marginfor profit). The markup approach developed by Kalecki and the Cambridge economists alsosuggested that the controlling managers figured out the average direct costs based on normaloutput and add in a markup to arrive at the price. The markup is supposed to cover indirect costs,shop expenses, and a profit margin (Lee, PK Price Theory, 1998). In all three approaches topricing, we see that the approaches differ in how costs are determined. This reflects real lifebecause firms in reality use different methods to arrive at their costs (Downward, PriceStickiness: A PK Microeconomics Perspective, Eastern Economics Journal, 2001). Despite thedifferences in how costs are determined, everyone mentioned above agreed with Means that oncea markup is added to the costs, prices are then administered to the market. The corporations set

the prices at some fixed point and then let outputs fluctuate. Multiple transactions that occur inthe markets will now have the same prices.

In Andrewss work, he extended the administered prices discovery of Means. Andrewsargued that the price leader in any particular industry has the lowest normal average total costs,and so it sets the prices of goods for the industry. Other firms will have to follow the prices setby the price leaders if they do not want to lose market shares. Kalecki, Robinson, and Steindllater confirmed this belief. As Downward (2000, A Realist Appraisal of PK Pricing Theory,CJE) argued, Kalecki and the Cambridge economists showed us that prices can be expected tovary directly with the level of average direct costs. If newer technology brings down the averagedirect costs, prices will decline. But at the same time, the prices of the firm are bounded by thedegree of monopoly facing it. A firm with a higher degree of monopoly can obviously set

higher prices than firms who have lower degree of monopoly within the same market.

In Eichners Megacorp and Oligopoly (1976) and Harcourt and Kenyons Pricing andthe Investment Decision, (Kylos, 1976), they both argued that the markup is determined by theneeds for internal funds to finance investments. So in setting the markup, the price leader has todetermine the cash flow that would be needed to finance future investments; it does so bycomparing the implicit internal interest rate (r) with the external interest rate (r) from taking outloans in the external market. Firms are only willing to invest up to the point where R = r. Hence,the markup of the firm is restrained by the firms limited future investment; consequently, priceshave to be bounded by some ceiling as well.

In Chapter 2 of Eichners Megacorp, he did note that the prevailing price is equal to the

historical price plus an incremental increase margin. That is, P = P(o) + P. The historical priceis based on what prices were set in the past. Any prevailing price is constrained by this P(o). Ibelieve this is a very good theoretical lens to understand why prices are stable at both the firmand market level. Corporations are not interested in rocking the boat. They do not want tomaximize their return for any given transaction in the market; corporations are interested inkeeping their market shares, in surviving, and, if possible, in growing and expanding in thefuture. Because they understand that demand is price-inelastic and they have the market power toset prices, corporations are only interested in setting prices at levels where they can recoup theirdirect and indirect costs and have a profit margin appropriate for planned future investment.


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Goodwill is very important to the corporations, and they are not going to let prices fluctuateenormously if that means losing customers goodwill. Furthermore, prices in the market have tobe stable because more often than not, the price leader sets the prices for the industry. The priceleader has to spend time and resources to discover its average direct costs or normal average totalcosts or whatever costing method it uses. Since this process is expensive and time-consuming,managers do not constantly want to figure out changes in costs and move prices up and down.

Once they determine the costs for normal output and a profit markup necessary to financeinvestment in the next period, they are going to keep prices at that level for an extended period oftime. Since the price leader sets the prices for the industry, everyone else will follow. Otherfirms are not going to change their prices arbitrary because they do not want retaliation from theprice leader.

In conclusion, prices are stable at the firms level because managers do not change pricesunless new situations ariseaverage direct costs change, more/less planned investments areneeded, or the degree of monopoly changes. At the market level, prices are stable because pricefollowers do not want retaliation from the price leader. And the price leader is not going to letprices fluctuate enormously in fear of losing goodwill and customers to their rivals.

9. The business enterprise can finance its working and fixed capital expendituresthrough its price policy and hence is independent of the financial system. Discuss.

In Eichner (1976, Megacorp and Oligopoly) and Harcourt and Kenyon (1976, Kylos,Pricing and the Investment Decision), they argued that the business enterprise finances itsworking and fixed capital expenditures through its pricing policy. Yet, Eichner also argued thatthe business enterprise is not entirely independent of the financial system. In this essay, I willdiscuss this contradictory finding.

In Chapter 3 of Megacorp and Oligopoly, Eichner said that the prevailing price is the

result of a historical price plus an incremental price change. P(1) = P(0) + P. Eacholigopolistic industry has a pricing history that provides a base line for subsequent marginal

adjustment. If we assume that variable and fixed costs remain constant, a change in price will bea change in the required corporate levy. Corporate levy is defined as the amount of fundsavailable to megacorp from internal sources to finance investment expenditures. The change inthe corporate levy depends on the megacorps demand for and supply cost of internally generatedinvestment funds.

Megacorp prefers internally financed investment over externally financed investmentbecause the latter means a reliance on the financial intermediaries. If the megacorp borrows fromthe banks, it may have to pay a higher external interest rate. If the megacorp uses its internalfunds, the implicit internal interest rate may be lower (up to a certain point anyways). If themegacorp issues new securities to finance investments, it will pose a control risk to the incumbentexecutive group.

In determining the corporate levy that is needed to increase its cash flow, R&D spending,advertising, and any other activity that will enhance the long run market positions, the megacorpconsiders the amount of funds needed to increase planned investments to meet expected futureaggregate demand. In another word, the firm has to make this decision in the face of someuncertainty. The firm will only use internally financed funds up to the point where the implicitinternal interest rate (R) equals the external interest rate (r). The implicit interest rate is theincome that the firm would lose by increasing its prices. According to Harcourt and Kenyon, thecomparison of R to r gives the tradeoff between internal and external financing, and so


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determines the size of the markup (and hence price) which the firm needs to set to generate thefunds required for its planned investment expenditure.

Despite the fact that the firm can generate the internal funds needed to finance plannedinvestments, Eichner did not believe the firm is completely independent from the financialsystem. Eichner said that firm still borrows to finance their short term activities; they only use

internal funds to finance long term investments because these involve more uncertainty. Eichnerfailed to give examples of what are short term activities. In any case, Eichner did admit thatthe firm is not free from the financial system.

According to some Post Keynesians like Wray and the French Circuitistes, the businessenterprise is linked to the financial institutions. If we given the fact that the firm has all the rawresources and machines, the firm still needs to borrow money from banks to pay workers wages.Production cannot begin if workers are not paid in monetary wages. Once workers are paid andoutputs are produced, the workers use their wages to buy outputs produced from the firm. Thefirm would have to pay this borrowed amount back to the banks. The fact that interest rates existon loans means that the banks would have to continually lend money to the firm so the firm canpay the interest charges on it.

According to Paul Davidson and Marc Lavoie (1992; Foundations of Post KeynesianEconomic Analysis), they believe that, in an uncertain world, internal and external finance arecomplementsnot substitutes of each other. In a world characterizes by uncertainty, financialinstitutions want to be sure that the firms they are lending to are profitable. As a result, banksonly lend money to firms if they see that the firms are able to generate some internal funds tofinance their investments. Lavoie said that firms will only borrow to the extent that they havebeen accumulating their own means to finance investments; firms, thus, set their own limit to howmuch they will borrow. Lenders are always willing to lend more to firms, but firms do notnecessary borrow more due to Kaleckis principle of increasing risk.

In conclusion, firms are not independent of the financial system.

18. Price changes of a product cannot be explained solely in terms of a single enterprise

and nor can they be explained solely in terms of the market. Discuss.

In Downwards A Realist Appraisal of Post Keynesian Pricing Theory (CambridgeJournal of Economics, 2000), he noted that prices for a single firm can be expected to varydirectly with the level of average direct costs but be constrained by the price level in the industry.In another word, no firm can independently set its prices. And yet, no prevailing price level inany market is possible without firms administering those prices to the market.

In heterodox pricing theory, the firm is not simple a price taker or a price setter. Thesituation is much more complex. A price leader usually set prices by first determining their costs

at a normal rate of outputs. Each firm uses different costing methods to arrive at their costs.According to Gardiner Means (Lee, PK Price Theory, 1998), the firm determines a standardaverage total costs. Andrews argued firm finds a normal average direct costs (that is, the averagedirect costs at the normal rate of output). Kalecki, Robinson, and other Cambridge economistssaid firm finds the average direct costs at normal output, and they believe the firms ADC curveis constant up to full capacity. Empirical research, carried out by Downward (2001; PriceStickiness: A PK Microeconomic Perspective, Eastern Economic Journal, showed that each firmused a different strategy for arriving at its cost. Some firms consider overhead costs and fixedcosts as part of their cost determination; others only try to find the direct costs at normal output


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and estimate the fixed, overhead, indirect costs. The estimate for these fixed, indirect costs isadded to the markup. In any case, the price leader, after determining its costs, will consider thecorporate levy needed to generate the funds necessary to undertake internal investments such asR&D, advertising, increasing plants capacity, building new plants, adopting new machines, etc.Harcourt and Kenyon (1976, Pricing and the Investment Decision, Kylos) argued that the priceleader will compare R, or the implicit internal interest rate on using internal fund, with r, the

external interest rate set by financial institutions and the central bank. The price leader will onlyundertake planned investment to the point where R = r. Hence, price leader only change its priceif a) costs have changed and b) a new corporate levy is needed.

Yet, the price leader does not have total freedom in setting its prices. Even if costs andcorporate levy needed have changed, the price leader still needs to consider the degree ofmonopoly it has within the industry. If it has a high degree of monopoly, it has more freedom toset prices at the level it wants. If it has a lower degree of monopoly, it has to be careful in settingits prices because it may easily lose goodwill from consumers. Firmprice leader or notisafraid of losing the consumers goodwill, so it will strive to make sure that whatever prices itdecides upon, those prices must not antagonize the consumers. In another word, the price leaderdoes not have the freedom to act independently from the market. It must considers its rivals, who

may not follow suit and increase their prices just because the price leader did so. It must alsoconsiders the consumers who may be driven to other firms if they deem the price increase isunreasonable. In another word, the price leader is bounded by a general price ceiling level thatexists in any particular market.

Likewise, the price followers are not freed in their ability to set prices. They usually haveto set their prices at the price level determined by the price leader. Although they have higheraverage total costs than the price leader, they cannot afford to set higher prices. They will notlose customers to the price leader. If they do attempt to set their prices below the price leader,they may be facing retaliation from the price leader. Yet, price followers can combine theirmarket power together to rebuff a price leaders attempt to increase prices beyond what isconsider the reasonable price level in that market.

On the other hand, we also know that the market cannot set prices for the firm. In themodern corporate economy, the laws of supply and demand no longer applied in the oligopolisticsectors (which is the majority of the economy!). Instead, the executives, who hold the control ofthe corporation, determine the costs, the markup, and, hence, the prices. These prices are thenadministered to the market, and the executives allow the outputs to change. Prices remain stableuntil the executives determine they should be altered. No prices are determined solely by marketforces in the oligopolistic sectors, and yet at the same time, no single enterprise has the freedomto arbitrary set its prices at any desired level.

22. Central to heterodox microeconomics, prices do not allocate resources among

competing ends. So what do prices do?

In heterodox microeconomics, prices serve two roles: 1) generates aggregate demand foroutputs and 2) allows the firm to internally finance its investment, and hence, its long run growth.

In his article entitled Saving and Profit in Capitalist Economies, (JEI 1991) Wray usedKaleckis assumption that workers spend what they get and capitalists get what they spend tomake the following argument. Executives, who determine and administer prices, set prices abovethe wage bill. In this way, the firms can get back the entire wage bill from the workers and stillhave outputs leftover to sell to the rentiers and the executives themselves. A component in the


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price called the dividend payout, according to Eichner, is considered a cost in the price. Thisdividend payout is necessary to keep takeover attempts away, and it gives the rentiers income tospend on consumption goods and more paper securities. A third component in the price is calledthe corporate levy by Eichner. The corporate levy is an internal fund used to purchase investmentgoods to help the firm meets future demand and extends its long term growth. Hence, prices incapitalist economies are set to generate monetary income so workers, rentiers, and

executives/firms can effectively demand and purchase the aggregate outputs.

Second, prices serve as a mean for the firm to grow in the long run. According toEichner (1976) and Harcourt and Kenyon (1976), firm sets prices with this goals in mind. Theprices provide, during the current period, the funds necessary to lay down the capacity requiredby the beginning of the next period (i.e. internally finance investment expenditures). In the PostKeynesian pricing theory tradition, Eichner, Harcourt, and Kenyon believed the profit markup isdetermined by the corporate levy needed to finance R&D, advertisement, adoption of newtechnology, building new plants, etc. The firm will only use internally financed funds up to thepoint where the implicit internal interest rate (R) equals the external interest rate (r). The implicitinterest rate is the income that the firm would lose by increasing its prices. According toHarcourt and Kenyon, the comparison of R to r gives the tradeoff between internal and external

financing, and so determines the size of the markup (and hence price) which the firm needs to setto generate the funds required for its planned investment expenditure. Harcourt and Kenyon alsosaid that the markup over costs is always set with an eye to the general economic conditions. Sothat while a firm may desire to have a higher markup and hence higher rate of growth, the generaleconomic conditions may not allow for it. Consequently, firms are always looking to fulfill twogoals in setting their prices: to generate internal funds, in this period, to finance plannedinvestments in the next period and to meet the aggregate demand in the next period.

In Foundations for Post Keynesian Analysis (1992), Lavoie argued that prices are meansfor the firm to grow, and that growth is the mean to the ultimate goal of every firm: power. Inanother word, prices are indirect means for firms to gain power. According to Lavoie, every firmwants to have power over its socio-politico-economic environment. Power means the ability for

firm to direct the consequences of decisions it made. Power is the tool that firm needs to secureits survival in an uncertain world. Lavoie said explicitly that every firm wants to be powerful,and to be powerful means one has to growand grow fast in expanding markets. Since acomponent in the markup is set to generate internal funds to finance investment, one can say thatprices are means for the firm to obtain power.

25. Using a heterodox price-quantity model, explain why an increase in the money wage

rate does not alter the wage share whereas a change in the profit markup does alter

it.

See question # 10.

10. Using heterodox price and production/quantity models in the context of a monetaryproduction economy, what happens to the profit markup, prices, the wage share,

and aggregate economic activity when there is a change in the money wage rate?

According to Eichner in Megacorp and Oligopoly (1976), costs and the profit margin (i.e.the markup, the target rate of return, Eichner called it the profit over costs) are two separatecomponents. Costs include the average variable cost and fixed costs (which includes acomponent for dividend payouts). The profit markup is the corporate levy, or the internal funds


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needed to generate to finance R&D, advertisement, cash flow, and anything that enhances the LRmarket position of the megacorp. Consequently, this is the formula for determining the price:

P = AVC + [(FC+CL)/(SOR * ERC)] where SOR = standard operating ratio and ERC =engineer rated capacity or the point of full capacity operation.

If we use Eichners formula, we would have to arrive at this conclusion. If the money

wage rate were to increase, the AVC would have to increase. Lee (1986; PK View of ADC)had stated that direct costs include the labor and material costs directly used to produce output;variable costs consist all of those costs that vary as the flow rate of output varieswhich meansthe variable costs include the direct costs, overhead costs, and any other costs that may variedwith the flow rate of output. Getting back to the problem we are trying to solve at hand, anincrease in the money wage rate means an increase in the direct costs and, hence, an increase inAVC. The FC and CL (corporate levy) will remain constant. Eichner had said that the CL is themarkup needed to internally finance investment projects, and it is set by the executives. CL doesnot change unless the investment needs of the firm change. Consequently, price has to increasewhen the money wage rate increases.

Because the corporate levy has remained the same, we have to conclude that the wage

share of the workers has not increased. In fact, it has remained constant because the corporatelevy has not decreased. Because the income share has remained the same, we are not going to seeany increase in aggregate demand and, hence, no increase in general economic activities.

Downward (2000, A Realist Appraisal of Post Keynesian Pricing Theory, CJE) hascriticized Eichners approach to pricing as being too deterministic. Downward argued that PostKeynesian economics is built upon the critical realist philosophical foundation, which emphasizesthe importance of an open system. Eichners modelas presented aboveis a close systemmodel. Lee, in a private conversation, had also said that Eichner made incompatible assumptionsto close his model; Lee noted that the closing of economic models was quiet common in the1970s. Downward said that we do not know what will happen to prices when there is an increasein direct or overhead costs. While we can expect prices to vary directly with the level of average

direct costs, we also know that prices are constrained by the price level in the industry. AsKalecki has taught us, prices are connected to the degree of monopoly. Hall and Hitch said thatthe determination of prices will be historically specific. I must note here that Eichner also saidthat the prevailing price is the result of a historical base price plus an incremental change: P(1) =

P(0) + P. Post Keynesians (as Downward would admit) believe that prices are set followingstandard rules and procedures, but these pricesand hence the markupcan be adjusted as anew environment historically emerges for the firm. Consequently, if we are to follow the PostKeynesian tradition delineated by Downward, we have to conclude that we do not know how thefirm will react when there is an increase in the money wage rate. It is possible that they willincrease their prices and keep the corporate levy the same, but it is also quite possible that they donot increase their prices. If they do not increase their prices, then the wage share would increasewhile the corporate levy would decrease. The fact that the corporate levy has decreased means

the firm can only internally finance less investment projects. Unless the workers spend theirentire wage bill on either consumption goods or paper securities (i.e. buying bonds and stocks),the firm can finance a greater number of investment projects then what its internal funds allow(i.e. financing some of the investment projects using external funds), or the government increasesits spending, we will see effective demand declining, and hence, general economic activitiesdecline as well.


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7. Use heterodox price and production models to critically evaluate the following

statement: The reduction of the profit markup increases economic activity by

increasing the wage share in net national income.

See question #10.Only if the workers spend their entire wage bill on buying goods, services, and securities. If theyspend less than what the firms would have spent on investment if they had retained their original

profit markup, then the effective demand level would decline.

Spending from wage bill > what the firm would have spent on investment AD increases.

Spending from wage bill < what the firm would have spent on investment AD decreases.

Once AD increases (due to spending from the wage bill), firms will think that the secular trend ofdemand is increasing. They will use both internal and external funds to finance more investmentand hence AD will increase further.

Eichner (1973, A Theory of the Determination of the Mark Up under Oligopoly, EJ) and Foster(1981, Reality of Present and Challenge of the Future, JEI) both argued that in the aggregate,S =I. Hence, if one sector decides to save more than to spend (that is S > I), then another sector

must pick up the slack because in the aggregate, S = I.

12. In heterodox production theory there are no marginal products. Why? What does this

mean about the origin of profits and about the determinants of the profit mark up?

Marginalism:Q = f(K,L)Assumptions:-exogenously given resources and technology-constant return to scale-diminishing marginal productivity-competitive equilibrium

Three parables from this:1. Rate of return is determined by the technical properties of the diminishing marginal

productivity2. Greater quantity of a factor of production leads to lower marginal product of that

additional factor3. Distribution of income between laborers and capitalists is explained by relative factor

scarcities and marginal product. [Price of K is determined by relative scarcity of K andmarginal productivity of capital; price of L is determined by relative scarcity of L andmarginal productivity of labor] (Cohen & Harcourt 2003 JEP Whatever Happened to theCambridge Capital Theory Controversies?)

Heterodox economics dismissed the notion of marginal products in production anddistribution theories. According to Eichner (1976), he said that the modern megacorp requiredfixed coefficient inputs. The firm has multiple plants, and each plant has its own fixed coefficientinputs. Eichner said that each plant segment either produces at the plants minimum AVC (or fullefficiency) or not at all. The firm expands output through opening and closing of plant segmentsand plants. Lee (1986; A PK View of ADC; JPKE) did argue that the firms coefficient inputscan vary as the flow rate of output changes even though each plant has a fixed coefficient inputs.In any case, Eichner said that the fact of fixed coefficients production means men of differentskills must be used in fixed combinations. To say that the equilibrium wage is equal to the


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marginal productivity of labor seems obsolete when labor is a heterogeneous input, and we haveto use labor of different qualities in fixed coefficient production.

Likewise, Cohen and Harcourt (2003; JEP; Whatever Happened to the CambridgeCapital Theory Controversies) argued that there cannot be a marginal productivity of capitalbecause we cannot measure capital. Capital goods are heterogeneous; capital goods cannot be

measured by some unknown common unit. We, thus, must use capital valuation. Furthermore,we cannot determine one capital getting more of the income share than another or that capital getsmore/less income share than labor because Joan Robinson had nullified the three parablesmentioned above.

Robison had argued that reswitching and capital reversing can occur in production.Reswitching occurs where the same technique (same K/L ratio) is preferred at two or more ratesof interests while other techniques are preferred at intermediate rates. At lower values of interestrates, the cost minimizing technique switches from a to be and then reswitches back to a.Reswitching is in violation of parables # 1 & #2 mentioned above. Capital reversing occurs whena lower K/L ratio is associated with a lower interest rate. So that K has a lower price when K ismore scarce. Capital reversing implied that the demand curve for K is not always downward

sloping. CR is in violation of parables #2 & #3. Hence, the whole purpose of the capital theorycontroversy, according to Joan Robinson, is not merely to quarrel about the measurability ofcapital. By saying that capital cannot be reduced to a common unit, the Cambridge economistswere trying to pinpoint at a deeper problem. Neoclassical economics is wrong in saying that thecapitalists profit is governed by the marginal productivity of capital. If we cannot measurecapital, we cannot determine its marginal productivity.

In Browns Is There an Institutional Theory of Distribution (JEI 2005), he argued thatmarginal productivity theory is based on a flawed assumption. Marginalists assume that allresourcesincluding labor and capitalare like vessels that have so many productive energyor potential exchange value. That is, labor and capital somehow have intrinsic worth, and thatlabor and capital empty these inherent units of productive energy into semifinished and finished

goods whose market value is the sum of values transferred by land, labor, capital, andentrepreneurship needed to produce it. As long as free competition exists, marginalists contendfree competition will give to labor what labor creates, to capitalists what capital creates, and toentrepreneurs what the coordinating function creates (Brown 2005).

In contrast, Veblen argued that labor is efficient and material objects are useful inproduction only insofar as the joint stock of knowledge allow them to be. In another word,workers can only be trained to be productive because the state of the industrial arts is at a pointwhere we know how to do these tasks. Material objects are tangible capital goods used inproduction because the state of industrial arts has discovered uses for them. That is, resources arenot (given); they become (De Gregori; Resources are Not; They Become: A InstitutionalTheory; JEI 1987). Consequently, Veblen said it is absurd to think of labor and capital as having

some intrinsic marginal productivity. Furthermore, it is absurd to believe that labor and capitalare redistributed an income share based on their relative scarcities and marginal productivity.

Economists ranging from Marx to Veblen, from Eichner to Harcourt believe that theincome distribution between workers and capitalists are determined by a bargaining process.Whichever group that has more power will receive a greater share of income. Marx and Veblenbelieved that the capitalists have the upper hand because they own the means of production.Hence, they hire workers, who have knowledge on how to turn material objects into consumptionand capital goods, to do the work. Capitalists deduct a portion of their profits to give to the


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workers. Veblen noted that in an economy where means of production are concentrated in thehands of a few capitalists, the capitalists will drive the income share given to workers to its mosteconomical footing (On the Nature of Capital, 1908, QJE).

Eichner emphasized that the national incremental wage pattern depends largely on thewill of the trade unions in setting the key bargains in bellwether industries. Harcourt and Kenyon

(1976) and Eichner (1976) said that the profit markup is set by executives to generate thenecessary internal funds to finance investment. Downward (2000) had questioned the closesystem approach to profit markup of Harcourt, Kenyon, and Eichner. Downward (2000) andLavoie (1992) have both said that profits are not determined by the marginal productivity ofcapital or the relative scarcity of capital. Instead, the profit markup is determined by theexecutives and added onto some costing method to arrive at an administered price. Downwardsaid that we cannot say that the profit markup is the corporate levy needed to be generated tointernally finance investments. There are many other factors that play into the determinations ofthe profit markups. Kalecki mentioned the degree of monopoly facing the firm. If the firm set itsmarkup above what the degree of monopoly allows, it may lose customer goodwill. Hall andHitch said that the determinants of prices will be historically specific; Andrews also said that therules of markup are context specific. Lee (1998; PK Price Theory) explicitly said that we do not

know what is in the profit markup. The role of custom, fairness, and conventions play asignificant place in the profit markup determination. Determinants of profit markup vary frommarket to market at any single point in time and in any particular market over time.Consequently, we can only say that a profit markup exists, but it is not determined by themarginal productivity of capital, relative scarcity of capital, to generate internal funds to financeinvestment, or to generate a profit-maximizing price.

8. Heterodox production and cost theory is not dependent on the marginal product of

labor. Why is this the case, and what implications does this have for using equilibrium

analysis to explain the economic decisions of the business enterprise?

First part of question- refers to #12 above

Implications for using equilibrium analysis:

1. Since we diminished the notion of marginal productivity, there is no labor demand curve.Keynes showed in Chapter 2 of General Theory that the labor supply curve is not afunction of the marginal disutility of labor because involuntary unemployment exists.Consequently, there is no labor market. There are no supply and demand curvesintersecting to give us an equilibrium wage.

2. In loanable fund theory, the saving curve, which is a function of thriftiness, and theinvestment demand curve, which is a function of the marginal productivity of capital,intersect to give us the resulting interest rate, or profit, on capital employed. We havedismissed the notion of marginal productivity of capital above, so we cannot say that

profit is a function of MPK.3. Instead, the distribution of incomethe share going to labor and share going to

capitalistsis the result of a bargaining process between laborers and capitalists(Eichner, Megacorp & Oligopoly 1976; Cohen and Harcourt, Whatever Happened to theCambridge Capital Theory Controversies, JEP 2003; Kurz and Salvadori, Representingthe Production and Circulation of Commodities in Material Terms: On SraffasObjectivism, Review of Political Economy 2005).


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4. Because the profit markup is determined by the firm, the firm also administers its ownprice to buyers. Price is not determined in the market by supply and demandconsiderations.

5. Growth of the firm is not at the whim of the markets and aggregate demand for itsproduct. Instead, the firm actively finds ways to ensure its survival and growth. Mostimportantly, the firm seeks to increase its power over its environment. It does so by

investment in R&D, advertisement, building plants, adopting new technology.Arguments have been made that the firm generates internal funds to finance itsinvestment through the profit markup (Harcourt & Kenyon, 1976, Pricing and theInvestment Decisions; Eichner, 1976, Megacorp & Oligopoly).

23. Profits are produced and hence non-scarce; thus the distribution of income is not an

important economic variable and the labor theory of value is invalid. Discuss.

Heterodox economics dismissed the marginalist notion that the rate of return on capital,or profits, is a function of the marginal productivity of capital and the relative scarcity of capital.The Cambridge capital controversy showed us that capital is heterogeneous. Consequently,capital cannot be reduced to a common unit, and hence, cannot be measured. Furthermore, Joan

Robinson (Cohen & Harcourt, 2003, JEP, Whatever Happened to Those Cambridge CapitalControversies?) effectively nullified the three parables of marginalist production theory:

1. Rate of return of capital is determined by the technical properties of diminishing marginalproductivity.

2. The marginal productivity of capital declines when additional capital is employed.3. Price of capital is determined by MPK and relative scarcity of capital.

Robinson cited the case of reswitching where the same technique (a given K/L ratio) ispreferred at two or more rates of interest while other techniques are preferred at intermediaterates. A cost minimizing technique switches from a to b and then reswitches back to a.Reswitching violates parables 1 and 2. Also, Robinson noted the case of capital reversing, wherea lower K/L ratio is associated with a lower interest rate. This means K has a lower price when K

is more scarce. Capital reversing violates parables 2 and 3.

If capital cannot be measured, we cannot figure out its marginal productivity. As JoanRobinson noted (quoted in Browns Is There an Institutionalist Theory of Distribution, JEI,2005), the purpose of disputing the measurability of capital is to show that profit is notdetermined by marginal productivity of capital. In another word, profits are not determined byrelative scarcity or some fair, unconscious mechanism. Instead, as many economists rangingfrom Eichner to Harcourt to Veblen to Sraffa have argued that profit is determined by thebargaining process between laborers and capitalists. But even if profits are produced and non-scarce, I do not think the distribution of income is not an important economic variable. In fact,under this new finding, the distribution of income is an even more important economic variable toconsider. Also, even if wage is not determined by the marginal productivity of labor, I still

believe that the labor theory of value is valid. I will discuss these two thoughts below.

In heterodox economics, we know that profit is consciously determined by peopleengaging in the production process in society. Wages and profits no longer based theirmagnitudes on their scarcity or marginal productivity. Instead, we know that wages and profitsare determined by the bargaining process between workers and capitalists. Since we know thatsome individuals in society own means of production, we know that they have an upper hand inthe bargaining process (Veblen, On the Nature of Capital, QJE, 1908). Sraffa noted that there aresocial costs to production that all persons involved in production have to bear simply because the


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capitalists have the power to withdraw their capitals from the production process. In thissituation, we know that the capitalists have the power to force a smaller income share upon theworkers. Veblen said that in the modern economy where capitalists have concentrated capitalinto fewer and fewer hands, they have more power than ever to force workers to accept lowerwagesto the point of subsistence. Marx was less kind when he noted that capitalists, whoinvest in capital intensive production, can force employed workers to receive less than

subsistence wages. If workers are at a disadvantage in the bargaining process, we then have anincome distribution problem. Workers will only be able to purchase as much as the wage billpaid to them. Capitalists, who own the means of productions and the produced outputs, will setprices above the wage bill. If the capitalists are willing to purchase the remaining output that theworkers cannot purchase beyond their wage bill, then society will have no effective demandproblem. But as soon as the capitalists do not spend all of their profits on consumption andinvestment goods, the level of effective demand will decline. Capitalists will react by cuttingdown production, which in turn means rising unemployment for the workers. The wage billcontracts; Post Keynesian price theorists including Means, Kalecki, Hall, Hitch, and Andrewshave shown us that the firm does not reduce its administered price during economic downturn(Lee 1998; PK Price Theory). With fixed prices and a lower wage bill, workers effectivedemand declines. This will make the capitalists cut back production and employment further.

As we can see, income distribution is an enormously important problem in heterodoxeconomics. As Fagg Foster noted once, society either progresses or decays. It cannot stay thesame (Fagg Foster, Reality of the Present and Challenge of the Future). If we do not understandthe bargaining process to determine income distribution, we cannot help to make incomedistribution more equitable. Inequitable income distribution creates miseries not just for theworkers but even for the capitalists in the long run. Unequal income distribution is a road leadingto a decaying society. If we want our economy to grow and prosper, we cannot ignore the issueof income distribution.

While it is true that the price of labor is not determined by the marginal productivity oflabor and its relative scarcity, we do not think the labor theory of value is invalid. We are

reminded of Sraffa, who began his economic career as a dismissive critic of the labor theory ofvalue. Sraffa compared human labor to horses labor and noted that there is no differencebetween the two. But as Sraffa matured, he began to realize that labor is not something to beignored. Once Sraffa moved out of an economic system where workers are only paid subsistencewage to where they are directly involved in the bargaining process of the surplus product, itbecame obvious that human labor is not the same as a horses labor; labor has value in a societywhere there is income bargaining. Kurz and Salvadori (2005, Representing Production andCirculation in Material Terms: On Sraffas Objectivism)

While I did have my doubts about the labor theory of value for a while, I becameconvinced of its important in economics after reading Sraffas struggle with the theory. I nowbelieve that while we do not determine wage by the units of labor embodied or the marginal

productivity of labor, at its core, the labor theory of value contributes to the heterodoxeconomists general understanding of the socio-economy. In fact, I think Sraffa was correct instressing that instead of saying the labor theory of valuethat object X has this much valuebecause it has a certain labor hours embodied in it, we should call it a value theory of laborthat labor has value unto itself. I am with Marx in believing that capital is dead labor. Yet,Veblen also taught us that labor becomes efficient and useful due to the existing state of theindustrial arts. Thus, I believe that labor is the mean by which we use existing knowledge to turnneutral objects into capital and other material things. The labor theory of value shows us thatlabor is just as important as capital. If the capitalists are capable of withdrawing their capital


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from the production process, laborers need to realize that they have the same power as well.Instead of following the status quo in saying that the capitalists have the upper hand because theyown the means of production, we can use the labor theory of value in making a case that bothlabor and capital should be looked as equals in the income bargaining process. Labor and capitalboth makes invaluable contributions to the production process. If we can make this argument, wewill be able to use the bargaining process to ensure more equitable income distribution between

laborers and capitalists.

27. Why are there product and labor markets in neoclassical microeconomics but not in

heterodox microeconomics?

Neoclassical economics:

In neoclassical economics, product and labor markets are the explanations for theseclaims:

1. Equilibrium price is determined in the markets at the point where demand equals thesupply for good X.

2. There are no conscious efforts at income distribution. The markets give to labor whatlabor contributes to production, give to capitalists what capital contributes. That is, thewage paid to workers is determined by MPL and relative scarcity of labor; profits paid tocapitalists are determined by MPK and relative scarcity of capital.

3. All firms are price takers, and all firms are small. That is, perfect competition prevails ifmarkets are allowed to operate freely. Imperfect competition and monopolies aremarket failures.

4. If perfect competition prevails, P = MR = MC. Consumers benefit from low prices.5. Firms will invest in industries where MR > MC until MR = MC. This means more

outputs, more product choices, and lower prices for consumers.6. Markets work if we leave it alone. No government intervention is needed if markets

bring out the most efficient technique of production, highest wages & profits.

To sum it up, product and labor markets must exist in neoclassical theory because thedetermination of wages, profits, and outputs are simultaneously determined in the markets at thepoint where the demand and supply curves intersect. Furthermore, the claim that markets existallow neoclassical economists to argue in its efficiency if we just leave it alone.

Heterodox economics:

In Chapter 2 of General Theory (1936), Keynes argued against the second postulate in theneoclassical labor market. The first postulate states that the wage is equal to the marginalproductivity of labor (labor demand curve); the second postulate states that the wage is equal tothe marginal disutility of labor (labor supply curve). Keynes said the second postulate is null

because we know involuntary unemployment exists. If a small rise in price causes the number ofemployment to increase, we know that involuntary unemployment must have existed. Manyheterodox economists have also disputed the existence of a labor demand curve. Eichner (1976)argued that in the modern megacorp where production requires fixed coefficients (inputs), wehave to use a fixed number of men at the same time for any particular task in any particular plantsegment. Since men have different capabilities and motivationsthat is, labor is heterogeneous,we cannot measure labor, and, hence, cannot determine the magnitude of the marginalproductivity of labor. Brown (2005) has also noted that the notion of marginal disutility of laborrequires us to think that labor is like a vessel that has some intrinsic worth. Labor, somehow,


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possesses X units of productive energy, and that production refers to labor transferring its units ofproductive energy to a semi-finished/finished good. Brown dismissed this neoclassical view.Instead, Veblen had told us that labor is only productive and efficient insofar as the state ofindustrial arts has allowed it to be so. That is, labor has to be trained to be productive, and thisrequires the application of the communitys joint stock of knowledge (On the Nature of Capital,QJE, 1908). Because of this long heterodox tradition of rejecting marginal productivity of labor,

we have to conclude that without MPL, there is no labor demand curve. If there is no labordemand or supply curve, there is no labor market.

Furthermore, the Post Keynesian works on pricing and investment theories have taught usthat firms do not let the markets determine their prices or where and how much they shouldinvest. Instead, Berle and Means (1932, The Modern Corporation and Private Property) showedus that prices are administered by the firms onto their customers. Means told us that firmsdetermine their standard average total costs and then add a target rate of return to arrive at themarket price. In Hall and Hitchs work on full cost pricing, we also learned that firms are pricesettersnot price takersand that they do not set prices to maximize profits. In Andrewss workon normal cost pricing, he argued that firm determined their normal average direct costs (that is,ADC at the normal rate of output) and then add a gross costing margin onto it to arrive at the

price. The gross costing margin consists of normal average indirect costs and a costing margin (aprofit margin). In the markup pricing tradition of Kalecki and Robinson, we learned that theprofit markup is related to the degree of monopoly (Lee 1998). Eichner (1976) and Harcourt andKenyon (1976) have argued that the profit markup of the firm is determined by the amount ofinternal fund that is needed to be generated in this period to finance planned investment in thenext period. Downward (2001, Price Stickiness: A PK Microeconomic Perspective, EasternEconomic Journal) have surveyed companies in the UK to show that prices are indeedadministered by the firmsnot set in the market by the laws of supply and demand.

We have also learned that firms are not passive price takers waiting for the markets togive them signals on where and how much to invest. Instead, Lavoie (1992, Foundations of PKEconomic Analysis) told us that firms seek power over their environment. Power is the ability to

direct the consequences of the firms economic decisions. Consequently, the making of profit is amean to growing the firm, and the growth of the firm is a mean to achieve the ultimate goal ofgaining power. Firms invest, according to Eichner (1976), by setting the profit markup at thecorporate levy, or the amount of internal funds needed to generate to finance planned investment.By having internal funds and by showing that they make profits, firms are able to borrow morefrom external sources like other financial institutions (Lavoie 1992, Foundations of PK EconomicAnalysis). In fact, Davidson has noted that internal and external funding are complements for thefirms. With the available funds, firms can engage in R&D and advertisement to create new needsfor their products (Matthaie, Rethinking Scarcity: Neoclassicism, NeoMalthusianism, andNeoMarxism, Review of Radical Political Economy, 1984; Moss, An Economic Theory ofBusiness Strategy, 1981). By creating new products and new needs at the same time, firmsensure that there is always demand for their goods. As long as there is demand, firms will grow.

And as long as they grow (and grow fast), firms will have power over their environment.

With all of our heterodox understanding on how firms behave and make businessdecisions and none of it having any reliance on the existence of labor or product markets, we cansay that we do not need product or labor markets in our heterodox microeconomic theory. Beforeconcluding, we would like to bring up another interesting point. Lee, in a private conversation,has argued that since Keynes had dismissed the notion of a labor market, we can further deducethat no other (product) market exists. In capitalism, labor is a commodity like any other product.If there is no market for labor, then there should not be a market for any other commodity.


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28. Why are diminishing marginal products necessary for neoclassical cost theory but not

necessary for heterodox cost theory?

Marshall:Demand curve is downward sloping because of diminishing marginal utilitySupply curve is upward sloping because of diminishing returns which produce rising marginal

cost curve.

Modern Neoclassicism:Demand curve is downward sloping because of strictly quasi-concave utility functionSupply curve is upward sloping because of diminishing returns

In neoclassicism, diminishing marginal products are necessary because they imply diminishingreturns, and, hence, costs rising more than proportions to output at some point. Holding one fixedinput constant, the more variable capital and labor dosages we add to it, we will get a less thanproportionate increase in the amount of output. In another word, diminishing marginal productsensure a rising marginal cost curve. Since the supply curve is the MC curve above normal output,the supply curve ensures that demand has a relationship with equilibrium price. In the

neoclassical market, the demand curve is downward sloping. Because the supply curve is upwardsloping, it ensures that an increase in demand means the supply price will increase until it equalsthe demand price. That is, an increase in demand will result in an increase in prices. At the sametime, the rising MC curve guarantees the relationship between costs and outputs. As you increaseoutputs, ATC will eventually rise at some point because MC is rising.

In Sraffas 1926 article entitled The Laws of Returns Under Competitive Conditions,he dismissed the marginalist claim that the demand and supply curves are independent of oneanother. Sraffa noted that if industry 1 demands a factor input more in proportion than theeconomy average, then the factor inputs price will increase. Since substitute good industries willalso use that factor input in their production, this means their costs, prices, and quantitydemanded for their goods (substitute goods) will increase. This, in turn, will cause the quantity

demanded and prices of good in industry 1 to change. Sraffa showed that the ceteris paribusassumption that guarantees the independence of supply and demand curves to be void.

On the other hand, if industry 1s demand for factor input is less than the economyaverage, then it can draw the marginal doses away from other industries. This means prices ofinputs will probably not increase, and, hence, the price of good produced by industry 1 will notincrease. This implies the supply curve for industry 1 to be horizontal. If the supply curve ishorizontal, then this indicates a horizontal MC curve. This will means there is no relationshipbetween costs and outputs and no relationship between price and demand. No matter what thedemand is, price will not increase or decline. It will remain constant.

In heterodox microeconomics, we do not assume diminishing marginal products because

we do not need it to guarantees the behavior of MC curve or supply curve. In fact, we do notassume there is an upward sloping supply curve or a downward sloping demand curve. We haveno reliance on the workings of the market to produce an equilibrium price level. We know thatprices are administered by firms to customers. Firms figure out their costs and then add a profitmarkup to arrive at the prices. Empirical studies have shown that firms use different strategiesand methods to arrive at their costs. Some firms find their normal average total costs, some findtheir direct costs and then estimate their indirect costs (Lee 1998). There have been some debatewithin PK microeconomics regarding the direct costs curve. Lavoie (1992; Foundations for PK


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Economic Analysis) and Eichner have both argued that the firms average direct costs is constantup to full capacity. This claim implies several others:-MC is constant up to fc.-ATC is declining up to fc.-AVC is constant up to fc.-MC = AVC up to fc.

Lee disagreed, however; he argued that the firms average direct costs curve can only beconstant if all the plants direct costs curves are constant. But since plant and plant segmentsvary in their technology adoptions, we cannot say the firms ADC and MC are constant up to fc.The only thing we can say is that empirical evidence shows MC does not seem to be rising in theshort run (1986; A PK View of ADC).

While the debate about the behavior of cost curves in PK microeconomics rage on, we doknow some things for sure. Prices are administered by firmsnot by the markets. Consequently,heterodox micro has no need for supply, demand curves, or even product markets to deriveequilibrium prices. Furthermore, PKs do not assume there is a positive relationship betweencosts and outputs.

20. It is the fertility rather than the niggardliness of technology that dominates the

production and cost structure of the business enterprise. Discuss and relate the

discussion to the theoretical issues of constant average direct costs and the size of

the business firm.

In neoclassicism, technology plays a very peculiar role in its production and cost theory. First,technology is taken as exogenously given. No inquiry is made into the nature of technology orhow it may endogenously change over time. Second, if technology does progress forward andproduction does become more efficient over time, neoclassical theorists still argue that at somepoint, diminishing returns will set in and marginal costs will rise. Consequently, if we let laissezfaire rules and if there are no market failures or imperfections, we can be sure that no matter what

technological technique reigns in the industry, there is limit to the size of the firm. That is, uponfacing increasing costs and diminishing returns, firm will stop expanding output. They will cometo an equilibrium level of output and prices.

Because the firm will still be subject to diminishing returns and a rising MC curve nomatter how productive technology is, the neoclassical view focuses on the niggardliness insteadof fertility of technology. On the other hand, institutionalists, PKs, and evolutionary economistshave noted the ability of technology to produce more outputs without being subject todiminishing returns or increasing costs. Veblen, in all of his writings ranging from Theory ofLeisure Class (1989) to Theory of Business Enterprise (1904) to Absentee Ownership (1923) andOn the Nature of Capital (1908; QJE), argued that machines are able to mass produce goods atincredibly low prices. If the machines were not under the control of the captains of finance, we

would be able to eliminate all scarcities because with our joint stock of knowledge, we cancontinually turn neutral things into material objects to serve human needs and wants. In recentyears, evolutionary economists have been studying the nature of increasing returns anddecreasing costs. They have found that in industries producing tech goods, the most expensiveoutput is always the first one, and all the output after that costs considerably less. The first copyof some computer program may cost $50 million, but the second copy may cost pennies.Evolutionary economists rely on the works of Brian Arthur (1990, Scientific America, PositiveFeedbacks in the Economy,) and Paul David (AER, 1988, Clio and the Economics ofQWERTY) as evidences for increasing returns.


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least productive. Not a nature of technology (Sraffa 1926, The Laws of Returns UnderCompetitive Conditions).

3. The existence of agency enables the household to overcome the advertising of

corporations and determine their own patterns of consumption. Discuss.

The statement the existence of agency enables the household to overcome theadvertising of corporations and determine their own patterns of consumption is not true in theheterodox consumption theory tradition. In neoclassical revealed preference theory, it is assumedthat people choose what they want and want what they choose. Hence, agents, who possesssubstantive/global rationality, can determine their own patterns of consumption by maximizingtheir subjective utility with regard to some constraints (such as a budget constraint) (Devetag,From Utilities to Mental Models, Industrial and Corporate Change, 1999).

In the heterodox tradition, consumption is considered more than a physical activity. It istrue that physical goods may be involved in the act of consuming, but consumption is more than abiological activity. Consumption is also a social activity. In his article entitled Institutional

Economics and Consumption, Hamilton (JEI 1987) reminded us that the most importantmessage Veblen wanted us to take away from Theory of the Leisure Class (1899) is not thatconspicuous consumption implies we are always trying to outdo and out-consume other people.Instead, people strive to abide by a pecuniary standard of living, which is set in a cultural andsocial class context. People do not want to consume less or more than what their culture andsocial class dictate is acceptable because they will attract unwanted attention.

Furthermore, in a Marxist inspired piece entitled Rethinking Scarcity (Review ofRadical Political Economics, 1984), Matthaei pointed out a very interesting observation. Shenoted that the goal of a capitalist economy is not the allocation of scarce resources to fillconsumers needs but rather to keep the accumulation of capital going. Consequently, capitalistsneed to continuously redefine what are needs so they can ensure the effective demand level for

their outputs. If capitalists cannot transform produced commodities back into its monetary form,capital accumulation will cease and so will the capitalist economy and the capitalist class.Getting back to our main point, capitalists redefine the term needs in capitalist society bymeans of massive advertisement. For example, Apple has been marketing the new iPhone as theit does everything electronic device. By showing images of a man who goes from surfing theinternet for movie times for Pirates of the Caribeans to instantly looking up the nearest seafoodrestaurant, Apple tells us we need to have the new iPhone to become multi-tasking geniuses. Butmore than that, Apple advertisements tell us that by obtaining the new iPhonewhich is inlimited supplywe will be the envy of all our friends. We will belong to an exclusive iPhonersclub, and we will gain social prestige. Hence, it seems that the marketers for Apple understandperfectly Veblens pecuniary standard of living. We all have a need to feel belong, and capitalistmarketers tell us what products to buy and consume so as to achieve this belonging feeling

(Scitovsky, The Joyless Economy, 1976; Polanyi, The Great Transformation, 1944).

In conclusion, we do not independently determine our consumption patterns. Instead, wehave been habituated by our culture and social classes since birth on how to consume and what toconsume (Lavoie called this the principle of non-independence; Foundations of Post KeynesianEconomic Analysis, 1992; A PK Approach to Consumer Choice JPKE 1994). Much of ourconsumption patterns are copied from other people, who in turn are emulating people they haveseen in advertisements. And the people in those advertisements were paid by capitalists todemonstrate the pseudo-joy of satisfying a newly defined need, such as owning a new iPhone. It


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thus seems that if we cease to copy each others consumption behavior and really focus ondetermining our own consumption patterns (which seems doubtful because we do not possesssubstantive rationality), the capitalist mode of production will cease to be.

6. Heterodox microeconomics does not have a theory of consumer choice between work and

leisure, but it still can discuss employment decisions by business enterprises and workers.

Discuss.

In neoclassical microeconomics theory, the substitution effect dominates the incomeeffect. In another word, given the decision between work and leisure, workers will choose towork more and take less leisure when wages are high and vice versa. Likewise, employers willhire more workers when there is a technology shock that makes the marginal productivity of labormore productive. We can summarize the neoclassical argument by referring to thecharacterization of the neoclassical labor market by Keynes in Chapter 2 of the General Theory:-wages is determined by the equilibrium point where demand for labor and the supply for laborintersect.-the demand for labor curve is a function of the marginal productivity of labor-the supply for labor curve is a function of the marginal disutility of labor.

In heterodox microeconomics, habits and income effect are more important thansubstitution effect. Substitution effect is limited to goods that have similar characteristicsmeaning that goods that fulfill the same wants. In other words, the substitution effect only haspower within a category of need or a category of sub-need (Fuller, Elements of a PK Alternativeto Household Production, JPKE 1996; Lavoie, Foundations of PK Economic Analysis 1992).

Veblen noted in the Instinct of Workmanship and the State of the Industrial Arts (1914)that humans are possessed with an instinct of workmanship, whose functional content isserviceability for the ends of life. That is, all agents have a desire for work (which is not thesame as a desire for labor, which is irksome). If we apply the lexicographic preference orderingtheory to the present situation, we can say that all agents have a need for work; the level at which

the need for work is fulfilled is different for each agent. Heterodox microeconomists call this thethreshold level. Once a persons threshold for work is reached, he/she will not work more justbecause wages are higher in t period relative to t-1 period or t+1 period. The person will focus onsatisfying other categories of needs and sub-needs.

Furthermore, no worker or business enterprise possesses global rationality. Hence,workers cannot know with certainly that todays wages will be higher than tomorrows wages, sothey should work more today. Likewise, no business enterprise assumes that todays MPL ishigher than tomorrows. Business enterprises hiring activities are congruent with effectivedemand. If the level of effective demand is higher, the firm hires more workers (Keynes, GeneralTheory, 1936). And vice versa. As a result, the neoclassical assertion of the dominance of thesubstitution effect (intertemporally or not) is wrong.

13. Heterodox microeconomics does not have a theory of rational consumer choice. Does

this mean that in heterodox economics the consumer makes irrational choices when

he/she decides to purchase goods, such as a bike instead of an SUV?

Heterodox microeconomics does not have a theory of substantive/global rationalconsumer choice. Yet, it does have a theory of bounded rational consumer choice. Heterodoxeconomistsranging from Post Keynesians to Institutionalists (OIE) to Evolutionary Economics(EE)believe that agents do not have the cognitive capabilities for what Gary Becker called


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substantive rationality. That is, agents cannot perform a single constrained optimizationproblem as presented in most neoclassical models. Human cognition and time limitations do notallow for global rationality. Instead, agents possess what Herbert Simon calledprocedural/bounded rationality. That is, agents use rules, subjective guesses, and sociallyobserved norms and conventions to make their consumption decisions (Fuller, Elements of a PKAlternative to Household Production, JPKE 1996; Lavoie, Foundations for PK Economics

Analysis, 1992; Hamilton, Institutional Economics and Consumption, JEI 1987; Witt, Learningto Consume, JEE 2001). Under bounded rationality, agents do not maximize utility. Instead,they opt for satisficing. Agents have rules and habits to enable them to reach decisions despiteinaccurate or incomplete information. When a satisfactory solution has been reached, agents stopsearching. The bounded rational agents also try to avoid complex calculations. If not enoughinformation is present for agents to make decisions, they could either search out for moreinformation to make a decision or postpone making a decision for the time being (due touncertainty being such a large factor at the moment) (Lavoie 1992; Lavoie, A PK Approach toConsumer Choice, JPKE 1994; Lavoie, PK Consumer Theory, JEL 2003).

In addition to recognizing that agents are not globally rational, utility-maximizers,heterodox microeconomists also assert that consumption is purely a physical or biological

activity. Consumption is also a social activity. We spend most of our youths learning how toconsume, what to consume, and when is the appropriate time to consume what (Hamilton,Institutional Economics and Consumption JEI 1987). Our conceptions of needs and wants areculturally and social class specific. We consume what is appropriate for our social class and ourculture. As Veblen noted in The Theory of the Leisure Class (1899), we strive to live up to apecuniary standard of living, as dictated by our social class and culture. We prefer not to livebelow or above the appropriate pecuniary standard of living because it can result in our attractingunwanted attention. Witt (Learning to Consume, JEE 2001), Scitovsky (Joyless Economy, 1976),and Devetag (From Utilities to Mental Models, Industrial and Corporate Change 1999) have alsodiscussed the fact that we have to learned how to consume. When our income changes (andhence we change social class), it takes time for us to learn and copy the appropriate consumptionbehaviors of our peers in this new social class. Hence, we are not born with the capabilities to

maximize utility. Instead, we have to learn how to consume by observing and emulating othersaround us.

Throughout his writings on consumer choice theory, Lavoie noted that agents uselexicographic preference ordering in determining their consumption decisions. All agents haveneeds, which can be divided into sub-needs. Each need and sub-need has its own category; wantsemerge within each need category. Agents order their categories of needs in order of priorities.Once needs of lower order are satisfied to some threshold level (which is different for differentpeople), agents then focus on satisfying other higher order needs. Of course, we must note herethat not all agents have the same priority ranking of needs. While it is true that some needs suchas food and shelter are more basic than the need for belonging, Veblen had also told us that it isalso possible for the need of having a new hat to have priority over feeding ones family. Our

ranking of needs depend on influences of advertisement campaigns, other peoples consumptionbehaviors, etc. That is, our ranking of needslike our formation of needsis culturally andsocially determined.

Now that we have this more complete view of heterodox consumer theory, we have tomake the case that the consumer under heterodox microeconomics is not irrational. Instead,heterodox microeconomics consumer is more realistic than the neoclassical consumer. No reallife consumer sits down with a calculator, a pencil, and some paper and uses calculus to perform aconstrained utility maximization problem (as oppose to us economic students). People consume


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certain things because they have learned that these are the appropriate ways. Hence, a personwho buys a bicycle is no more irrational than a person who buys an SUV. We have to considerthe fact that the person who buys a bicycle may live in a culture where everyone else drivesbicycles too. Having a bicycle may be a fairly fashionable thing for this person in his culture.Even if the person lives in a society like America where SUV is the fashionable mode oftransportation, it may be that the person is a college student, and in his social environment,

having a bicycle is okay. And even if the person is not a college student, it may be that theperson is an environmentalist. He has concerns about the environment and believes that bydriving a bicycle, he will be one less person emitting pollutants. As Devetag noted, choicesdepend on context; decision makers try to assess what they prefer by anchoring their estimation totheir perceived identity, their goal hierarchy, and their framing of the situation.

15. Heterodox microeconomics does not have a theory of consumer choice. Therefore it

cannot say anything about consumer demand. Discuss.

I disagree with the statement that heterodox microeconomics does not have a theory ofconsumer choice. Instead, I firmly believe heterodox microeconomics has a theory of consumerchoice, and this theory is in a much better health than its neoclassical counterpart. Neoclassical

consumer choice theory is based on the axiom of revealed preferences, which says that theconsumer want what they choose and choose what they want (Devetag, From Utilities to MentalModels, ICC, 1999). Consumer maximizes their utility with respect to some constraint, such as abudget constraint. Furthermore, production is the mean, and consumption is the end of alleconomic activities. Since neoclassical economists have such a simple understanding of whatconsumption is, there is not much left to study, question, or analyze after we accept revealedpreferences and utility maximization. In fact, Hamilton, in his article entitled InstitutionalEconomics and Consumption (JEI 1987), dryly noted that the only worth studying underneoclassical theory of consumption is postpone consumption, or saving. That is, consumption isnot even worth studying under the neoclassical regime.

While heterodox microeconomists have written many considerable pieces on

consumption in general [some come to mind such as The Theory of the Leisure Class (1899) byVeblen; The Joyless Economy (1976) by Scitovsky, The Economic Imagination (1983) by Earl,and A PK Approach to Consumer Choice (1994) by Lavoie (JPKE)], it is true that there is nosingle unified consumer choice theory. Yet, from my very minimal reading of the heterodoxconsumer choice theory, I have noticed several common strands of thought:

1. Agents do not possess substantive or global rationality; they possess procedural orbounded rationality.

2. Consumption patterns abide by rules and habits that had to be learned. In another word,consumption is a social activity that takes place in a specific culture, specific social class,and in a specific time and space.

3. Agents cannot satisfy all needs and wants at once by performing a utility maximizationproblem; instead, they rank their needs based on priorities and try to satisfy them from

bottom up (that is, needs at the lower level are satisfied before needs at the higher level).

Bounded rationality

In the Gary Beckers Chicago approach to consumer choice theory, agents are assumed tohave substantive rationality. That is, agents are all seeing, all knowing individuals who cancalculate the utiles they will receive from all possible baskets of goods and choose the basket thatmaximizes their utility given a budget constraint. In the heterodox tradition, agents are thought tohave limited cognitive capabilities and time. Agents get overwhelmed when there is too much


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information, and they are usually unable to make decisions when there is too little informationand too much uncertainty. Furthermore, agents have time limitations to search for informationand alternative choices. As a result, agents follow Herbert Simons rule of procedural rationality(also called bounded rationality). Under bounded rationality, agents do not maximize anything.Instead, they follow the rule of satisficing. Agents look to satisfy their needs and wants to somethreshold levels and no more. In order to make their decisions, agents use rules of thumbs, habits,

and past experiences. Scitovsky (The Joyless Economy, 1976) and Devetag (From Utilities toMental Models, ICC, 1999) noted how people like a little redundancy in their consumptionpatterns. Agents are likely to find novelty more enjoyable if there is some degree of redundancyin the activity.

Under the bounded rationality assumption, agents make decisions with regard toconsumption activities by looking at the available information. If the information is sufficientand/or agents can rely on rules and habits to fill in the missing pieces, agents will choose aparticular action. If the information is insufficient to the point where uncertainty is loominglarge, agents have three choices: 1)They can try to find more information, 2)Follow their animalspirits, as Keynes said, and make a decision anyways, or 3)Postpone making a decision until alater day (Lavoie, Foundations of PK Economics Analysis, 1992).

Hence, in the heterodox consumer theory tradition, agents are not deemed globallyrational or completely irrational. Instead, they are boundedly rational.

Lexicographic Preference Ordering

Heterodox microeconomists agree that agents do not simultaneously satisfy all theirneeds and wants at once. Instead, they all believe that agents order their needs, sub-needs, andwants in some priority ranking (Lavoie, A PK Approach to Consumer Choice, JPKE, 1994; Witt,Learning to Consume, JEE, 2001; Earl, The Economic Imagination, 1983). According to Lavoie,he argued that agents form categories of needs, which in turn may have categories of sub-needs.Wants arise from needs, and they are, thus, specific means to satisfy a need or sub-need. Lavoie

(1994) and Fuller (Elements of a PK Alternative to Household Production, JPKE, 1996) notedthat substitution effects only works within a category of need or sub-need. Wants can besubstituted for each other. Needs, on the other hand, cannot be so. Among categories of needs,the income effect and habits dominate. That is, when income increases, agents can satisfy theirlower level needs much quicker and can move up to focus on higher level needs. Agents do notbuy more of goods satisfying lower level needs relative to goods satisfying higher level needs justbecause the goods in the former categories have lower prices than the ones in the later categories.

Of course, we must note here that agents do not all rank the same needs, sub-needs, andwants in the same manner. Instead, agents have different need priorities due to their social classand cultural influences. Veblen noted in The Theory of the Leisure Class (1899) that although wewould expect need such as having food and shelter to be of higher priorities (that is, these needs

are lower level needs) in most people, we should not be surprised if some people prioritize hatsabove food, however. The manner in which we rank our needs is dependent on our socialcontext.

Consumption as a Social Activity

Heterodox economists do not see consumption as a mere biological, physical end of alleconomic processes. Instead, they have noted that consumption is linked to production in acontinuum and that we cannot separate the two activities into means and ends. Furthermore,


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heterodox economists emphasize that consumption is a social activity. All consumers areembedded in a social environment (Granovetter, Economic Action and Social Structure: TheProblem of Embeddedness, American Journal of Sociology, 1985). We are born into a socialenvironment; we are social creatures, and we learn to consume in a social context. Since ouryouths, we learn the right things to consume and the right way to consume those things. Ourconsumption patterns, rules, and habits are formed by our imitating and copying other individuals

we come into contact with. Since consumers come into contact mostly often with people of ourown culture and social class, it is not surprising that people within the same social class andculture have similar consumption behaviors and consumption goals. In his article entitledInstitutional Economics and Consumption (JEI 1987), Hamilton noted that Veblen saw thecultural and social class dependency effects on our consumption behaviors. Veblen argued thatpeople try to live up to a pecuniary standard of living for their social classes. The failure to liveup to this standard or the ability to live above and beyond this standard usually attracts unwantedattention.

In addition, heterodox microeconomists have emphasized that since consumption is asocial activity, consumers must learn to consume. Consumers are not born with predisposedabilities to maximize utility. Witt, in Learning to Consume (JEE 2001) had noted that people

discover and adopt new consumption habits through associative learning and that consumptionthrough associative learning requires repetitions. Without repetitions, consumers will eventuallylose the association that good x tends to satisfy need y. Consequently, advertisement campaignsare incredibly important in the capitalist economy. Since the purpose of capitalist mode ofproduction

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