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Price in the American economy: A theoretical inquiry

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Price in the American economy: A theoretical inquiry

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Content PRICE IN THE AMERICAN ECONOMY:
ti
A THEORETICAL INQUIRY
by
Raymond Ballard
i"
A Thesis Presented to the
FACULTY OF THE GRADUATE SCHOOL
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements for the Degree
MASTER OF ARTS
(Economics)
June 1968
UMI Number: EP44846
All rights reserved
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UMI EP44846
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UNIVERSITY OF SOUTHERN CALIFORNIA
T H E G R A D U A T E S C H O O L
U N IV E R S IT Y P A R K
L O S A N G E L E S . C A L IF O R N IA 9 0 0 0 7
S / > -
Ec. '68 B 18?
This thesis, written by
Ballard
under the direction of hj,s...Thesis Committee,
and approved by all its members, has been pre
sented to and accepted by the Dean of The
Graduate School, in partial fulfillment of the
requirements fo r the degree of
Master of Arts
Dean
June, 1968
THESIS COMMITTEE
'hairman
TABLE OF CONTENTS
CHAPTER PAGE
I. INTRODUCTION ............................. 1
The Problem............................. 3
A Review of the Literature ............. 6
Relevant Terms and Concepts . . . . 13
Methods of Research and Analysis . . . 15
Organization of the Remainder of
the T h e s i s ......................... 17
II. EARLY THOUGHTS ON P R I C E ................ 18
Medieval and Mercantilistic Thought . . 18
Adam Smith and David Ricardo . . .. 20
Alfred Marshall— A- Synthesis . . . . 26
III. A MORE GENERAL APPROACH................ 34
Foundation for Change— E. H. Chamberlin
and Joan Robinson.......................34
Theoretical Framework— The Approach to
Reality.................... 48
Summation.................... 92
CHAPTER PAGE
IV. EMPIRICAL INVESTIGATION: APPLICATION OF
THEORY......................................94
Market Structure and Market Performance
The Approach............................... 95
The Question of Efficiency..........105
The Question of Cost-Price Relationship . 114
The Question of Selling Costs .... 123
Summation ' .............................. 127
V. IMPACT OF ANTITRUST LAW ON PRICING . . .129
The Sherman Act of 1890
The Federal Trade Commission Act of 1914
The Clayton Act of 1914
The Effects of the L a w s ................. 132
VI. CONCLUSION AND PROJECTION................. 138
The Approach to R e a l i t y .............140
The Future Role of P r i c e .............148
Suggestion for Further Study ............. 150
BIBLIOGRAPHY ....................................... 151
CHAPTER I
INTRODUCTION
The vital role played by price in a capitalist
economy is, in a sense, the essence of capitalism; for if
the price function is removed by removing the price tags
from all goods and services, the efficient production and
distribution of goods and services would become virtually
impossible. It is the economic system of a society that
will determine, in the long run, how efficiently produc
tion and distribution are carried out. If the proposition
that price has a vital role to perform in a capitalistic
society is accepted, then, the proposition that it is
meaningful to inquire into the nature of price must be
accepted.
Every society must make some provisions for decid
ing how to: organize production, fix standards of value,
distribute-what is produced, achieve progress, and recon
cile production and consumption. The existence of alter
native ends implies that there must be some way of placing
values on these ends. In a free-enterprise economy, this
2
task is accomplished through the market place by buyers
/ % indicating their wishes with demand dollars. This process
of going to the market with dollars is often likened to
the voter who goes to the polls and votes. These "votes"
of. the members of a free-enterprise economy are manifested
through prices which, in turn, reveal the standards of the
society, x
Given these standards (what the society wants as
indicated by their dollar votes), there must be some
machinery to translate these values or choices into pro
ductive activity. Production must be organized both
within industries and among the various industries. This
is accomplished by the price system through the inter
action of two prices: prices of resources and prices of
final products. Prices of products in relation to the
costs of producing them determine the distribution of
resources among industries; the relative prices of factors,
then, determine the use or coordination of factors within
industries.
Prices thus serve to determine where resources
are wanted most.
This description of the functioning of price sys
tem implicitly assumes that effective competition exists
3
so that consumer wishes are directly translated into pro
ductive activity. The description also assumes that there
is freedom to compete but not freedom to combine. As will
be shown later, if a realistic inquiry into the functioning
of price in the American economy is to be had, the idea
that firms can not combine must be rejected, as they in
fact tend to combine.
change in ideas as to what makes price what it is, is
directly related to changes in ideas about competition.
That is, the "competitive price" is seen as the price
which has as one of its functions the allocating of
resources in a capitalistic economy.
omy is a mixed economy. Therefore, by definition, some
prices are not the result of the operation of the competi
tive mechanism. The questions of how much, where, and
what type of competition is desirable.or how mixed should
the mixture of competitive and controlled prices be, are
The concept of price has changed over time; this
It is commonly understood that the American econ-
questions which remain open for debate
I. THE PROBLEM
What then is the area with which this paper will
concern itself? What are the limitations and what is the
scope of this inquiry?
Statement of the Problem
The problem is posed: Given the fact that the
American economy is not freely competitive in all areas,
what are the elements which affect price in the areas out
side these known to be noncompetitive areas. Then given
price in the areas outside the known to be noncompetitive
areas, the question is posed, will price continue to play
an effective role in the allocation of resources?
Significance of the Paper
The major reason for this undertaking is to indi
cate the elements which combine to determine price in the
American economy. Since price has as one of its vital
roles the allocation of resources, an understanding of the
elements which combine to determine price and the effect
this determined price has on the allocation of resources,
is necessary to the understanding of the mechanics of the
price system which is in operation in the American economy.
Objectives of the Paper
The purpose of this paper is to present in a gen-
eral way the evolution of the ideas which have influenced
modern thought about price and then to adjust the theoreti
cal thinking to fit the realities of price determination
in the American system. After these adjustments are made,
a logical step is to evaluate the role played by the
adjusted price in terms of its ability to effectively
allocate resources, and then to inquire as to the future
role of price as the allocator of resources. An approach
to reality is then suggested.
Limitations of This Paper
This investigation is not intended to be exhaus
tive. The approach of this study is one of microeconomic
analysis so that monetary theory is not a consideration.
The earlier ideas about price are presented without ques
tioning their merits or weaknesses in regard to modern
insights nor are they questioned in terms of the time in
which they were held. Ideas which marked a real change
in assumptions relative to market structures and therefore
competition and the price which would result, are dealt
with in some detail. The results of empirical investiga
tions of the theory are cited in order to lend insight
into the workings of reality. Institutional influences
6
on price are considered to the extent that the body of
anti-trust legislation influences pricing. Finally, an
attempt is made to evaluate the role played by price,
given the adjustments to the theory that must be made,
in terms of allocating resources. As a terminus to this
study, an opinion is offered as to: a possible method to
be used in approaching reality, and the future role of
price in the American economy.
II. A REVIEW OF THE LITERATURE
Ideas about price are traceable to the beginning
of social thought. The Greek philosophers dealt with
price and the whole of economics as incidental subject
matter related to their primary concerns, which involved
ethical and political matters. It is a meaningful under
taking to review their thoughts on economic matters and
specifically on value price for such a study bestows upon
the reader a feeling of confidence, in that this was the
starting point, and that if he starts here and proceeds
forward in time, he can perceive the whole. However,
given the scope of this paper, no attempt is made to cover
all the ideas from this point of origin to the present.
7
Almost any comprehensive work on the history of economic
thought will mention the Greek contribution. A nonrigor
ous treatment on the Greek thought can be found in W. E.
Kuhn's book, The Evolution of Economic Thought.^ A more
rigorous treatment is found in H. W. Spiegel's book, The
2
Development of Economic Thought. In this work the editor
has selected articles by economists about economists.
Joseph Spengler and William Allen's, Essays in
3 . .
Economic Thought: Aristotle to Marshall, specifically
the article by Bernard Dempsey, "Interest and Usuary,"
proves helpful to an understanding of early thoughts on
the idea of fairness of price. A reading of Tawney's
Religion and the Rise of Capitalism,^ proves valuable to
an understanding of medieval thought, with its concern for
1
W. E. Kuhn, The Evolution of Economic Thought
(Cincinnati: Southwestern Publishing Company, 1963).
2
H. W. Spiegel (ed.), The Development of Economic
Thought (New York: John Wiley and Sons Inc., 1952).
3
Joseph J. Spengler and William Allen, Essays m
Economic Thought: Aristotle to Marshall (Chicago: Rand
McNally and Company, 1960).
^R. H. Tawney, Religion and the Rise of Capitalism
(New York: Harcourt, Brace and World Company, 1926).
8
matters such as morality and its deemphasis of economic
concerns. Adam Smith's, An Inquiry into the Nature and
5
Causes of the Wealth of Nations, marks the beginning of
the awareness of the effects of two most important factors
in determining price; these are cost of production and
competition. Ideas on the determinants of price from the
time of Adam Smith until about 1930 can be adequately
explored by a study of Alfred Marshall's Principles of
Economics.^ Since about 1930, the literature on price
has been concerned with reformulations of the idea of
pure competition in an effort to explain the price arrived
at in market structures which are not purely competitive.
E. H. Chamberlin's The Theory of Monopolistic Com-
7
petition, lays the foundation for the study of those
market structures which fall between pure competition and
monopoly. Joan Robinson's The Economics of Imperfect
' ’ Adam Smith, An Inquiry into the Nature and Causes
of the Wealth of Nations (New York: The Modern Library,
Random House, Inc., 1937).
^Alfred Marshall, Principles of Economics (London:
Macmillan and Company Ltd., 1898).
7
Edward H. Chamberlin, The Theory of Monopolistic
Competition (Cambridge: Harvard University Press, 6th
Edition, 1947).
o
Competition, provides necessary collateral reading.
This study emphasizes an integration of competitive and
monopoly equilibrium. Generally, both author's demonstrate
the effect of partial monopoly on price. Pigou's "A Note
on Imperfect Competition"^ proves to be a useful supple
ment to Joan Robinson's work. Accordingly, F. A. Machlup's
"Evolution of the Practical Significance of the Theory of
Monopolistic Competition"^ provides interesting collateral
reading to Chamberlin's work. Smithies' article, "Equilib
rium in Monopolistic Competition"'1 ' ' * ' serves also as collat
eral reading to Chamberlin's work. William Fellner's
I O
Competition Among the Few is a very enlightening work.
He constructs a theoretical framework in which those market
o
Joan Robinson, The Economics of Imperfect Compe
tition (London: Macmillan and Co., Ltd., 1933).
^A. C. Pigou, "A Note on Imperfect Competition,"
Economic Journal, XLIII (1933).
■^F. A. Machlup, "Evolution of the Practical Sig
nificance of the Theory of Monopolistic Competition,"
American Economic Review, XXIX (1939) .
-^A. Smithies, "Equilibrium in Monopolistic Compe
tition," Quarterly Journal of Economics, LV (1940).
■^William Fellner, Competition Among the Few (New
York: Alfred A. Knopf, 1949).
10
structures falling between pure competition and monopoly
are studied. Worthwhile collateral reading in this area
is J. S. Bain's "A Note on Pricing in Monopoly and Oligop-
13
oly." Many journal articles written between the years
1930 and 1950 prove to be necessary reading for a study
on price in markets which are not purely competitive.
Backman's "The Causes of Price Inflexibility,"'*'4 is valu
able when read with Chamberlin's discussion of the kinked
15
demand curves. Rothchild's "Price Theory and Oligopoly"
is helpful in relating traditional theory to the oligopo
listic market structure. Papandreou's article, "Market
Structure and Monopoly Power,similarly proves helpful
in ana'lysis of that continuum between pure competition and
monopoly.
^J. S. Bain, "A Note on Pricing in Monopoly and
Oligopoly," American Economic Review, XXXIX (19 49).
14J. Backman, "The Causes of Price Inflexibility,"
Quarterly Journal of Economics, LIV (1939).
w. Rothschild, "Price Theory and Oligopoly,"
The Economic Journal, LVII (19 47).
•*-®A. g . Papandreou, "Market Structure and Monopoly
Power," American Economic Review, XXXIX (1949).
11
In the area of empirical investigations which
relate market structures as found in industry to the
theory, Joe Bain's Industrial Organization^ is necessary
reading. This study is useful as a guide in determining
the structure of an industry. This work is supplemented
by journal articles such as: Burn's "The Organization of
1 8
Industry and the Theory of Prices"; Bronfenbrenner's
19
"Price Control Under Imperfect Competition"; and R. H.
2 Q
Coase's "Note on Price and Output Policy." An interest
ing discussion on the profit maximizing assumption is
found in Robin Marris's "A Model of Managerial Enter-
21
prise," where he relates the profit maximizing role of
the entrepreneur to the modern corporate manager. In an
effort to indicate how far on the scale in the direction
-*-7Joe s. Bain, Industrial Organization (New York:
John Wiley and Sons, Inc., 1959).
18
A. R. Burns, "The Organization of Industry and
the Theory of Prices," Journal of Political Economy, LVI
(1948).
19
M. Bronfenbrenner, "Price Control Under Imperfect
Competition," American Economic Review, XXXVII (1947).
20r. h . Coase, "Note on Price and Output Policy,"
Economic Journal, LV (April 1945).
21Robin Marris, "A Model of the Managerial Enter
prise," Quarterly Journal of Economics, LXXVII (May 1963).
12
of monopoly an industry can be and still perform in an
acceptable manner, the concept of workable competition is
developed in J. M. Clarke's article, "Toward the Concept
of Workable Competition.1 '^
An understanding of the institutional influences
on price is aided by a reading of Dewey's book, Monopoly
in Law and Economics.23 Various journal articles round
out the study in this area. Especially enlightening are
Keezner's "The Effectiveness of the Federal Anti-Trust
p 4
Laws," Simkin's "Some Aspects and Generalizations of
the Theory of Discrimination,"25 and Reynold's "Cut-throat
Competition."26
22J. m . Clarke, "Toward a Concept of Workable Com
petition," American Economic Review (June 1940).
23oonald Dewey, Monopoly in Economics and Law
(Chicago: Rand McNally and Company, 1959).
2^D. M. Keezner, "The Effectiveness of the Federal
Anti-Trust Laws," American Economic Review, XXXIX (1949).
2^g. G. F. Simkin, "Some Aspects and Generaliza
tions of the Theory of Discrimination," Review of Economics
Studies, XV (1947).
2®L. G. Reynolds, "Cut-throat Competition,"
American Economic Review, XXX (19 40).
13
John Galbraith's The New Industrial State,2^ serves
to stimulate thought as to the possible role of competition
and therefore price, is to play in the American economy.
III. RELEVANT TERMS AND CONCEPTS
The Price System
The first task of every economic system is to
determine the composition of output. Some may believe
this is simply a matter of deciding what is more or less
important, then proceeding to produce the items which have
been given greater priority and to continue down the list
until the productive capacity is exhausted. However,
determining the composition of output involves much more
than simply giving priority numbers to various categories
of goods. It also must be decided how each increment of
output will be produced. In the United States society,
the basic method of organizing production is through the
price system. If a given set of technologies leave some
resources unemployed, their prices tend to fall and it
will become cheaper to use production methods that use
2^John Kenneth Galbraith, The New Industrial
State (Boston: Houghton Mifflin, 1967).
14
relatively more of these resources.
The American economy does not rely exclusively on
private efforts directed by prices to organize production.
There are many social restraints on the production proc
ess. Since a monopoly is free of the restraints imposed
by competition, there are antitrust laws and public
utility regulatory agencies which curtail possible abuses
of monopoly power.
Value
Value must be looked at in three different ways.
First, the ratio at which a good is exchanged for other
goods is its market value or price. The second kind of
value that has been distinguished is the value or price
toward which the day to day prices of the market tend.
This approximates the cost of production of the good and
represents its long-run value or price. Finally, the con
cept of value as being dependent upon the usefulness of
the good to the possessor in satisfying his wants, should
be mentioned. Economists in the past have varied in their
appraisals as to what constituted value. It is certainly
necessary that a good have value, at least in the eyes of
the potential purchaser, or there would be no incentive
15
for the producer to offer the good and thus there would
be no cost of production to consider. It can then be said
that it is necessary that a good seem to have value to the
buyer but that this perception of value alone is not suffi
cient to determine the value or price of the good; costs
of production must also be considered.
Pure Competition
Pure competition may be described as a market
situation comprised of so many buyers and sellers that no
one individual acting alone can alter the market price.
The product traded is homogeneous; there are no barriers
to entry and exit from the industry; there is perfect
market knowledge regarding the input and output markets.
Oligopoly
Oligopoly is said to exist where the structure of
the market in question is characterized by the presence of
a few sellers whose actions influence the actions of the
others in some way.
IV. METHODS OF RESEARCH AND ANALYSIS
The methodology employed in this presentation is
that of gleaning the ideas of renowned thinkers in the
area of price theory and attempting to collect their
specific thoughts on price from early times to the present.
The study, of course, involves ideas about competition,
as price is affected in a significant way by various mar
ket structures. The price that emerges is one that has
had to be adjusted to fit reality, thus in Chapter III an
adjustment model is presented. This model does not pre
tend to represent reality per se, but rather attempts to
indicate a logical approach to realistic market struc
tures. Therefore, the approach of this paper is basically
one of briefly reviewing the evolution of thought which
has gone into the makeup of price theory then to build a
model, which does not represent reality in itself, but
indicates a realistic approach to reality. Empirical
observations are brought in in an effort to see what
reality looks like. Then, based upon this look at reality
and the theoretical model which indicates the proper
approach to reality, a tentative approach, to be used in
the study of all real industries, is offered.
17
V. ORGANIZATION OF THE REMAINDER OF THE THESIS
Chapter II will review the various concepts about
price up to the significant changes in approach made by
E. H. Chamberlin and Joan Robinson. Chapter III will be
concerned with presenting the ideas of Chamberlin and
Robinson as the foundation or beginning of approach to
price theory by way of intermediate market structures.
The larger part of Chapter III will be used to present a
model for intermediate structure, which can be used as a
guide or approach to reality. Chapter IV will bring in
some empirical research in an effort to indicate what
reality looks like. Chapter V brings in the reality of
the institutional influences upon price, to the extent
that the antitrust laws affect pricing. Finally, Chapter
VI will attempt to summarize the previous five chapters
with the goal in mind of indicating a methodology to be
used in the study of reality and an opinion will be
offered as to the future role of price in the American
economy as the allocator of resources.
CHAPTER II
EARLY THOUGHTS ON PRICE
It is meaningful to review the ideas of past
thinkers on the subject of prices before exploring the
ideas of the twentieth century. The very early ideas are.
presented in somewhat of an overview; as later writers
tend to synthesize and combine the ideas of their predeces
sors. The approach will be to begin with the medieval
thought, which was influenced by the Greek philosophers*
ideas regarding ethics, then a review will be made on Adam
Smith's ideas on price. Alfred Marshall's thoughts will
serve as the terminus of this chapter. Thus, we proceed.
I. MEDIEVAL AND MERCANTILISTS THOUGHT
Economic ideas are found in the writings of the
Greek philosophers, but these thoughts are only incidental
to ethical and political concerns. However, these ideas
18
19
had a great deal of influence on medieval thinkers.^-
■ Medieval writers perceived that value is not some
thing absolute inherent in goods, but value depended on
man's wants. Labor was seen as the major factor in the
cost of producing a good.7 The idea of a just price indi
cates the prevailing thought of the times. The determining
elements of price involved the common estimate by all
buyers and producers as to what was the social utility of
the product in question. This estimated price based on
an estimate of what was socially equitable was not neces
sarily absolute. That is, there was a margin in which the
price of a given item could fluctuate. The trading price,
which fell within this allowable margin, was influenced by
such things as the magnitude of the buyer's need to buy
the item and/or the magnitude of the seller's need to sell
the item. The margin itself was determined by the pre
vailing idea in this time period, that a person should do
to others as he would have them do to him.
The mercantilistic writer, Cantillon, was the first
to note that the quantity and quality of natural resources,
■ ' " H . W. Spiegel, The Development of Economic
Thought (New York: John Wiley and Sons, Inc., 1952).
20
and the quantity and quality of human labor, are compo-
2
nents of the intrinsic price or value of a finished good.
He noted that market price may well deviate from the in
trinsic price. He recognized that a time element is
involved in the adjustment of productive resources in
response to a price change.
However, no great ideas in relation to the ques
tion of price were forthcoming during these periods.
II. ADAM SMITH AND DAVID RICARDO
Adam Smith indicated that "value in use" or the
utility derived from a good has no part in determining
the market price of the good. He used the analogy of
water and diamonds to make this point. He wrote:
Nothing is more useful than water, but it will
purchase scarcely anything. A diamond, on the con
trary, has scarce any value in use; but a very great
quantity of other goods may frequently be had in
exchange for it.3
2
Philip C. Newman, et al., Source Readings m Eco
nomic Thought (New York: Norton and Company, Inc., 1954).
Adam Smith, An Inquiry into the Nature and Causes
of the Wealth of Nations (New York: The Modern Library,
Random House Inc., 1937). p ^
21
Smith, thus, rejected the idea that utility had any part
to play in determining price. However, he indicated that
utility will have some effect in determining the temporary
/
market price. ! Smith saw labor as the measure and source
of value. According to this labor theory of value, goods
are exchanged for equal quantities of labor which have
gone into the producing of the good. He distinguishes
between what he calls real and nominal prices. Real price
refers to the price of a good expressed in terms of labor,
where the nominal price refers to the price of a good as
expressed in monetary terms. Smith believed that in the
absence of time period considerations, the real and the
nominal price would be the same, because at a given time,
a given quantity of a good, as expressed by its price,
enables us to get a quantity of some other good, again
expressed by its price. The real or natural price will be
forthcoming in the following circumstances, as stated by
Smith:
When the price of any commodity is neither more
nor less than what is sufficient to pay the rent of
the land, the wages of the labour and the profits
of the stock employed in raising, preparing, and
bringing it to market, according to their natural
rates, the commodity is then sold for its natural
22
price.
4
Two Theories of Value
Smith's labor theory of value may be said to
actually involve two subtheories. These theories are the
labor-cost theory and the labor-comraand theory. The
labor-cost theory indicates that the value of a good is
determined by the number of labor units required to pro
duce it and the labor-command theory indicates that the
value of an object is determined by the amount of labor
which can be purchased in exchange for it. Evidence of
this concept of labor-cost can be seen in the following
passage:
. . . In the early and rude state of society which
precedes both the accumulation of stock and the
appropriation of land, the proportion between the
quantities of labour necessary for acquiring dif
ferent objects seems to be the only circumstance
which can afford any rule for exchanging them for
one another. It is natural that what is usually
the produce of two days' or two hours * labour
should be worth double of what is usually the pro
duce of one day1s or one hour1s labour.5
certain passages in Smith's writing. The following is an
The labor-command theory can be seen underlying
23
example:
. . . Wealth is the quantity either of other men's
labour, or what is the same thing, of the produce
of other men's labour, which it enables him to
purchase or command. The exchangeable value of
everything must always be precisely equal to the
extent of this power which it conveys to its owner.^
What, then, is the difference between these two
concepts? If those who worked to produce a good received
all that it would command in exchange, the two concepts
would be the same. This is probably the case in a primi
tive society, there being no factors of production, other
than labor which must be paid. However, if some of the
factors of production, other than labor, are introduced,
then a difference emerges. If goods exchanged according
to the amount of labor which went into their production,
then this exchange price would be less than the amount of
labor which the possessor of the good could command. The
distinction between the two concepts is best emphasized by
an example given by Paul H. Douglas:
. . . thus, if the share of labor amounted only to
two-thirds of the total product, then the workers
who expected five units of labor required for shoes
(it takes five units of labor to make a pair of
shoes), would receive in return commodities in which
only three and one-third labor units were contained
6 A
Ibid., p. 63.
/
24
(labor represents only two-thirds of the factors
involved). The given pair of shoes would indeed
sell in the market for a price which would enable
it to purchase seven and one-half units of labor.
(As the production requires five units of labor,
which represents only two-thirds of the total
costs, therefore, it is easily seen that the total
cost of producing a pair of shoes is five plus two
and one-half or seven and one-half.)?
Therefore, seven and one-half would be the value
from the standpoint of the labor-command theory and from
the labor-cost theory, the value would be only five.
This distinction between value as determined by
labor-cost and value as determined by labor-command was
brought to light by David Ricardo; Adam Smith did not make
such a division.
Ricardo’s Value Theory
Ricardo indicated that price will be equal to
value (value as determined by human labor) in the presence
of competition. Therefore, in referring to goods and
their value, he states:
. . . we mean always such commodities only as can
be increased in quantity by the exertion of human
7 . . .
An article by Paul H. Douglas xn Spxegel, op. ext.
p. 83.
25
industry, and on the production of which competi
tion operates without restraint.8
Therefore, it was recognized that in the absence
of competition, price does not measure the value of a
good (value, being synonymous with the human labor in the
good).
As to the other elements influencing price,
Ricardo indicated that utility was necessary to a good
if it was to have value, but utility in itself is not
sufficient to determine the price of a good. The costs
of production were viewed as the primary determinants of
value, given a certain demand. The cost of production in
the long run would determine value which would be equal
to price under conditions of competition. As previously
indicated, Ricardo saw in Smith's labor theory of value,
two subtheories; however, he preferred the labor-command
theory. This is not to say simply that there is nothing
contributed by the tools or machinery that a worker used
in producing a good. Ricardo indicated that in determining
the cost of production of a good, account should be taken
^David Ricardo, The Principles of Political Econ
omy and Taxation (London: J. M. Dent and Sons, 1948).
26
for the labor which was used in creating the tools and
machinery with which current labor was used to produce a
good. Thus, the element of time is introduced in order
to take account of the labor invested in making tools to
9
make goods. He is referring here to goods which require
the application of more capital in their production.
Thus, Ricardo held a very broad concept of labor as is
evidenced in his viewing machinery (fixed capital) as so
much compressed labor. Therefore, according to Ricardo,
commodities exchange according to their cost of produc
tion which is determined by the amount of labor used, and
this labor used is interpreted in a very broad way as indi
cated above.
III. ALFRED MARSHALL— A SYNTHESIS
Alfred Marshall's greatest contribution to price
theory was, perhaps, the development of supply and demand
curves and the concept of elasticity of demand and supply.
The basic proposition of Marshall's system is that the
9
"Ricardo's Theory of Value" from: Alfred Mar
shall, Principles of Economics (London: Macmillan and
Company, 8th ed., 1920).
27
equilibrium output of a commodity is that at which the
supply price and the demand price are equal. Marshall
showed how the demand curve depended on the underlying
utility relationships, and how the supply curve was related
to costs. We are also indebted to him for the distinction
between short-run and long-run situations.
Price Determination— Demand and Supply
*
Marshall indicated that it was meaningless to
argue the point that value was determined by the cost of
production alone or utility (demand) alone. He uses the
famous analogy of a pair of scissors to show the futility
of arguing that either the cost of production or demand
considerations alone determine price. As it is meaning
less to say that the cutting of a piece of paper is
affected by the blade which is moving when the other blade
is held stationary, so it is meaningless to claim that
demand is all that matters once the cost of production of
a good has already been incurred. Therefore, the demand
price will depend, not on just the amount which buyers
can afford to spend, but also on their ability to get a
-^Kenneth E. Boulding, Economic Analysis; Micro
economics , Vol. I (New York: Harper and Row, 1966).
28
good like it at as low a price at some future time.
Whether or not a similar good can be obtained at the same
price in the future depends on the causes which govern
the supply of the good over time, and thus upon the cost
of production. However, the magnitude of the influence
of the cost of production and the demand is a function of
the time period involved. That is, in the shorter time
period the influence on price of demand will be greater
(given that we have a stock of a perishable good, for if
it were not perishable, it could be stored for sale at a
later time) and in the longer period, the influence on
price of the costs of production will be greater.
On the demand side, Marshall explores the Law of
Diminishing Returns in an effort to discover the relation
ship between the rate of the decrease in utility and the
lowering of price in order to induce the purchaser to
increase his purchases by a given amount. Thus, Marshall
derives the concept of the elasticity of demand which is
based on human wants. This concept indicates the magni
tude of the response of the quantity demanded to a given
change in the price of the good. He makes a distinction
between the elasticity of individual demand and the elas
ticity of the market demand for a good. Within the analy-
29
sis of individual demand the elasticity of demand for
rich men and poor men is distinguished. By combining the
demand curves representing the demand of the rich, the
average, and the poor buyers, a total demand curve is
derived.
Availability of Substitutes
Marshall incorporated the availability of substi
tutes in the analysis of the elasticity of demand for a
particular good. The relationship is such that, if the
price of a good is raised slightly while the price of a
close substitute remains fixed, the demand for the good
in question tends to be highly elastic; therefore, pur
chasers will shift their purchases from the now higher
priced good to the purchase of the close substitute. The
variety of uses to which a good can be put also influences
the nature of demand elasticity. That is, the greater the
number of uses to which a particular good can be put, the
more elastic will be the demand for it.
Internal and External Economies
On the supply side, Marshall developed the con
cepts of external and internal economies, which arise from
an increase in the scale of production. When the resources
30
of a firm enable it to improve the organization of eco
nomic activities, management efficiency, use of a refined
division of labor, et cetera, internal economies may be
said to exist. External economies are dependent upon
the general development of the industry, which benefits
the firms of the industry. These economies may be largely
the result of localization of industry. An advantage
coming from such localization may be the development of
skills which are passed on. Marshall indicates that this
may be the case, referring to the labor skills which sur
round an industry:
. . . the mysteries of the trade are as it were
in the air, and children learn many of them un
consciously. H
He indicates that in those instances of production in
which nature plays a minor role, a law of increasing
returns is observable. In which case an increase of labor
and capital provides, through improved organization, a
return greater than in proportion to the increase in
factor costs. He further indicates that these increasing
returns may overbalance decreasing returns in other indus
tries .
■'"■'"Marshall, op. cit. (1898), p. 350.
The Element of Time
As mentioned previously, Marshall indicated that
to determine the equilibrium between supply and demand and
therefore to determine price, the time element must be
taken into account. Thus, he distinguishes between the
short, intermediate, and long periods, in an effort to
indicate the nature of the price and output which results.
A period may be so short that supply is equal to
the current stock of a good. In the intermediate period
the supply is influenced by variable costs or the costs of
producing additional quantities of the good. And in the
long period, where the supply of the factors of production
themselves can be increased, the cost of production will
be influenced by the costs involved in increasing these
factors of production.
Marshall further indicated that an increase or
decrease in long-run demand or an increase or decrease in
long-run supply can be viewed in terms of their quantity
components and/or price components. Thus, an increase in
demand may mean that at each of several possible prices
purchasers would take a greater quantity than before or
that for each of several possible quantities which they
may buy they would be willing to pay a higher price.
32
Similarly, an increase in supply can be interpreted as an
increase in the amounts that would be offered for sale at
each of several possible prices or as a fall in the prices
at which each of several possible quantities would be
offered for sale.
Interplant Cost Conditions
Marshall also indicated that the price forthcoming
from changes in demand would be influenced by the condi
tions of return (whether constant, decreasing, or increas
ing) . The reasoning goes like this: Given an increase
in demand in the face of constant returns, the price would
not change and given an increase in demand in the face of
decreasing returns, the price would increase (costs have
increased) and given an increase in demand in the face of
increasing returns, the price would go down (costs have
decreased).
In summary, then, it may be said that Marshall
settled the controversy about the part played by demand
and the part played by cost of production in determining
the price of a good. Perhaps the greatest contribution
«
was his development of supply and demand curves, with the
basic proposition being that the equilibrium price and
33
output of a good is that at which the supply price and the
demand price are equal.
The assumption of perfect competition which under
lies the pre-Marshallian and Marshallian systems is a
special case of a more general theory. The more general
theory will be discussed in Chapter III, where the assump
tion of perfect and pure competition will be set aside.
CHAPTER III
A MORE GENERAL APPROACH
The elementary theory of the firm and industry in
its modern form, especially as it involves the use of the
marginal revenue curve, is to be attributed mainly to
1
Edward H. Chamberlin and Joan Robinson. They view the
concept of perfect competition as a special case of a more
general theory.
The goal of this chapter is twofold. One will be
to explore Chamberlin's, and to a lesser extent Joan
Robinson's, works as the foundation of this general theory,
and the other to indicate the elaborations and extensions
to this theory.
I. FOUNDATION FOR CHANGE— E. H. CHAMBERLIN
AND JOAN ROBINSON
Chamberlin realized that the observable market
^Kenneth E. Boulding, Economic Analysis: Micro
economics, Vol. I (4th ed.; New York: Harper and Row,
1966) .
34
35
phenomena did not fit the theories of pure competition or
pure monopoly, and that observable conditions indicated
that a theory of the markets lying between the extremes
of pure competition and monopoly was required. Thus, the
formulation of a theory of prices cannot be had by merely
defining the two basic forces of competition and monopoly;
a synthesis is required.
Chamberlin's study is concerned with partial
monopoly centered around the concept of monopolistic com
petition, and different positions of the demand curve of
a firm as the rival firms change their strategies.
Joan Robinson, it may be said, started with perfect
competition and proceeded to indicate that this was a
special case and that monopoly elements should be taken
into consideration.
Before developing this theory of intermediate mar
kets, it will be helpful to review the theories of pure
monopoly and perfect competition.
2
Edward H. Chamberlin, The Theory of Monopolistic
Competition (Cambridge: Harvard University Press, 19 47).
36
Monopoly
Monopoly is defined as a market condition where
a seller perceives that he has no competitors; thus, the
monopolist is free to take those steps which will benefit
him most in view of the demand conditions he faces. By
definition, then, the monopolist will face the industry
demand curve. When he increases his output, the resulting
fall in price will be borne by himself alone. Maximum
profits are had when an increment of output adds as much
to revenue as it adds to cost. The demand curve of a
monopolist must have a negative slope, because if a firm
is the only producer of a good and consumers display nor
mal demand characteristics, the firm will sell more at a
lower price. Only if there is at least one other producer
of the same good will the monopolists demand curve be
horizontal over some range.
The slope of his demand curve (the one he faces)
will be dependent upon how good the substitutes for the
monopolized good are and on the number of substitutes.
Unlike the purely competitive firm, the monopolist must
consider the future effects of his present pricing policy.
The monopolist may be restrained in his pricing when there
is indirect competition of other goods for the purchaser's
37
dollars. That is, the potential buyer may decide to
forego the purchase entirely if the price is too high.
(This case should not be confused with the substitution
by the buyer of a high priced good for a lower priced
substitute.) The monopolist may also be restrained in
regard to setting price above a certain level as this may
attract competition (the potential entrants to the market
may be attracted to the high excess profits which result
from the monopolist's setting prices so high).
There are several potential sources of monopoly
power. Such power may derive from the control over raw
materials, control of patent rights, and economies of
scale, or his market power (derived from product loyalty).
Competition
A competitive market, at the other end of the
continuum, is easily defined only for a perfect market; it
is a market in which the individual buyer or seller does
not influence the price by his actions (the elasticity of
supply facing the buyer is infinite, the supply curve is
horizontal; and the elasticity of the demand curve is
infinite, the demand curve is horizontal). However, an
imperfect market may be competitive on one side only. That
38
is, there could be many thousands of buyers and only two
sellers or there could be only two buyers and many thou
sands of sellers. The perfectly competitive situation
may be said to exist when four conditions are satisfied:
(1) There must be perfect knowledge, and if there is not,
there will be several prices at which transactions will
take place; (2) there must be many buyers and sellers so
that no one of them will have a significant influence upon
the price; that is, the largest buyer or seller should
provide only a small fraction of the total quantity
demanded of supplies; (3) the product should be homoge
nous, because if it is not, buyers will not be indifferent
to the total output, and the requirement that there be
large numbers of sellers becomes meaningless if the prod
ucts of different firms become unique; and (4) all re
sources must be mobile, thereby permitting free entry and
exit from the market.
In the short run, a competitive firm will supply
the quantity determined by the crossing of the marginal
cost curve and the marginal revenue curve (which is the
case in monopoly; however, the difference lies in the
fact that the marginal revenue curve for the competitive
firm is identical with the price-line, whereas in the case
39
of the monopolistic firm, the price-line and the marginal
revenue curve are not identical).
By producing the quantity indicated by this inter
section, the firm will maximize profit. In the short run,
the competitive firm can make excess profits (diagrammati-
cally, the price would be above the intersection of the
marginal revenue and marginal cost curves); however, since
one of the elements of a competitive market is free entry,
other firms will see these excess profits and will come
into the market and thus prices will go down as total
output rises. There may in fact be too many entrants
attracted to the high profits, and their entry will cause
price to go below the intersection of the marginal revenue
and marginal cost curves. However, in the long run the
point of crossing of the marginal revenue and marginal
cost curves will mark the market price.
Having reviewed the concepts involved in the
theory of the competitive and monopolistic markets, we can
proceed to the discussion of structures which lie between
these special cases.
Monopolistic Competition
Edward Chamberlin developed the concept of mono-
40
polistic competition in an effort to establish a more
realistic approach to market theory. The basis for mono
polistic competition is the apparent fact that products
are not homogenous but are differentiated, at least to
some degree. Thus, the theory of pure competition fails
to explain prices adequately as soon as a product is even
slightly differentiated. Also, the theory of monopoly is
inadequate to describe many actual situations because it
deals with the isolated monopolist facing a given demand
curve for his product, whereas generally competitive
interrelationships of groups of sellers indicate problems
in taking the demand schedule for the product of any one
seller as given. Monopolistic competition, not only takes
into account the problem of individual equilibrium, but
also the problem of adjustments of the economic forces
within a group of competing monopolists. Monopolistic
competition thus describes a series of related markets
and indicates the monopoly elements which arise from the
firms' partial independence.
As mentioned previously, the stimulus for mono
polistic competition is the fact that all products are
^Ibid., p. 1.
41
differentiated to some degree. Chamberlin defines a
product as being differentiated when "... any signifi
cant basis exists for distinguishing goods of one seller
from those of another."4
Under pure competition, the individual seller can
sell all he can produce at the market price but under con
ditions of monopolistic competition, his sales are affected
not only by the price he charges but also by the nature
of his product and by the amount he spends for advertising.
If he raises price, he will have to give up volume (his
demand curve, like the pure monopolist's is not horizon
tal) and if he lowers price, he can sell a larger quantity.
His profit may be increased by lowering price, thus
increasing sales volume, or raising price and decreasing
sales. His actions in lowering or raising price in an
effort to increase profits will be based upon his estimate
of the elasticity of the demand curve for his product and
upon the position of the demand curve in relation to the
marginal curve.
As respects the influence of the nature of his
product, the volume of sales of the monopolistic competitor
4Ibid., p. 56.
42
will depend upon the manner in which he is able to vary
his product from that of his competitors.
Finally, the volume of sales may be influenced by
expenditures on advertising. The effect of such expendi
ture is to raise costs and selling price. The monopolistic
competitor will incur selling costs to the point where an
additional expenditure fails to result in revenue equal to
the expenditure.
In monopolistic competition, the price adjustment
is a relatively unimportant phase of the competitive
process, whereas product adjustment may be most important.
The adjustment process for the individual seller must be
defined with reference to the availability of competing
products and their respective prices, because the markets
for goods which are substitutes for each other are closely
interrelated. If the monopolistic competitor can not
adjust his price, then equilibrium adjustment involves
only his product and if product is somehow given, he can
only vary price. Many cases of adjustment may involve
both price and product adjustments. Chamberlin indicates
that the effect of monopoly elements on the adjustment of
the seller typically results in a higher price and a
smaller output than would be had under pure competition,
43
because the demand curve in monopolistic competition is
sloping rather than horizontal.
Normal Profits— Entry
As respects the equilibrium analysis for all the
firms in a market, Chamberlin indicates that where there
are excess profits for the typical firm, the entry of new
firms shifts the demand curve faced by the typical firm
down and to the left. This occurs because total purchases
by buyers from all firms must now be distributed among the
now larger number of sellers. If cost curves are taken
as given, this process (entry, thus the shifting downward
of demand curves) will continue until the demand curve for
each firm is tangent to its cost curve. Thus, excess
profits are removed by the entry.of new firms.
Conversely, had there been pure losses rather than
pure profits for the typical firm, the exit of firms in
response to losses would result in the demand curve shift
ing upwards (as firms leave, total sales are shared by
fewer firms) and finally becoming tangent to the cost
curve.
As previously mentioned, by incurring selling
costs the firm can increase the demand for its output.
44
These expenditures can be separated from production costs.
Chamberlin indicates that criteria by which selling costs
can be distinguished from production costs is the effect,
if any, the expenditure has on the demand curve. Thus,
if demand is changed by the expenditure, it can be said
that the expenditure was a selling cost as distinguished
from a production cost.
Therefore, as respects price, in the presence of
monopolistic competition, it can be said that it tends to
be higher because selling costs must be added to production
costs and because the monopolistic competitor faces a
sloped demand curve. The steepness of the slope is deter
mined by the magnitude of his monopolistic power, that is,
if he has only slight monopoly power, the curve will be
flatter.
Imperfect Competition
Joan Robinson's The Economics of Imperfect Compe-
5
tition covers much of the general area that Chamberlin
does. It should be stressed that these two studies were
made independently of each other but at about the same
^Joan Robinson, The Economics of Imperfect Compe
tition (London: Macmillan and Co., Ltd., 1933).
45
time. Joan Robinson's work is geared more to a study of
pure monopoly rather than to monopolistic competition.
She is concerned with price discrimination,,which may be
said to exist when a monopolist is able to sell the product
to different buyers at different prices. In order for the
monopolist to practice price discrimination, certain con
ditions must prevail. Markets must be separated from each
other so that it is not possible to resell the product in
question, which has been bought in a cheaper market, in a
higher priced market. Buyers in the higher priced market
must not be able to go into the lower priced market.
Thus, price discrimination presupposes some degree of
market imperfection.
Such division of markets may be accomplished by
geographical separation. However, in the absence of
natural barriers between markets, price discrimination may
be achieved by selling brands of the same product under
different names in order to appeal to a different income
i
group. Thus, the monopolist will be selling the same
product at various prices. It is profitable for the monop
olist to price in such a manner when the elasticities.of
demand are different for different markets. The monopo
list will maximize his profits by selling less where the
46
elasticity of demand is less than in other markets, and
by selling more in markets where the elasticity of demand
is greater. He will adjust his sales so that the marginal
revenue will be the same for all those markets that he is
selling in. His profits will be maximized by selling the
output in each market indicated by the intersection of
the marginal cost curve for the total output for all mar
kets and marginal revenue curve of each separate market.
The monopolist can no longer increase his profits by
dividing the total market once he has reached the point
at which each submarket consists either of a single buyer,
or a group of buyers with elasticities of demand which are
equal.
Robinson also deals with the discriminating buyer.
Again, he must be able to divide sellers into separate
markets. To maximize the surplus coming to him, the
buyer (monopsonist) will purchase from each seller such
output that his marginal expenditures are equal to each
other and are also equal to the marginal utility of the
total amount purchased. The possibility of discriminating
in such a way is dependent upon there being differences
in the elasticities of the average cost curves of each
seller (that the supply curves have different slopes).
47
In order to maximize his gain from purchases, the monop
sonist will reduce the quantity purchased from the less
elastic sources of supply below what he would have pur
chased from these suppliers under monopsony without dis
crimination, and he will increase his purchases from the
more elastic sources. This is because in the case where
the supplier's supply curve is relatively inelastic,
buying a larger quantity will not reduce price much and
in the case where the supply curve is relatively elastic,
buying a large quantity will reduce price paid per unit
by a significant amount. Thus, Robinson concludes, "the
common-sense rule that the individual will equate marginal
gains with marginal cost, applies equally to monopsony,
to monopoly and to perfect competition."^
In summary then, it may be said that Joan Robinson
was primarily concerned with the problem of price discrim
ination and that Edward Chamberlin was concerned with the
study of partial monopoly based upon his concept of mono
polistic competition. Thus, both were concerned with
that continuum of market structures lying between pure
and perfect competition and pure monopoly.
6Ibid., p. 230.
48
Having laid the foundation for the study of those
intermediate structures between competition and monopoly,
a more sophisticated framework can be constructed.
II. A THEORETICAL FRAMEWORK— THE APPROACH TO REALITY
Within the general area of imperfect competition,
three important cases can be distinguished. The first of
these cases which is monopolistic competition, has been
mentioned. The second and third cases whose results
differ significantly are the cases of perfect oligopoly
and imperfect oligopoly.
When a few firms are selling a homogenous product,
the situation may be referred to as perfect oligopoly, and
when a few firms are selling heterogeneous products the
situation may be referred to as imperfect oligopoly.
The oligopoly situation, which involves various
assumptions regarding the reaction processes by which
firms react to the behavior of others, will be of primary
concern.
Instead of setting up a supply function, the oli
gopolist attempts to select a definite price to be charged
49
7
and a definite quantity to be sold. He knows that the
quantity that he can sell at various prices depends upon
the prices his rivals are charging. Also, the rivals are
affected by the price which he sets. Thus, the oligopo
list does not set up a supply function, nor can he define
the demand curve he must face based on buyer's preferences
alone,, as he knows that his rivals' actions affect the
demand he will face.
Bi-Lateral Monopoly
In cases where there exists one large buyer and
one large seller, the buyer will not set up a demand func
tion for himself but will select a price to be paid and
a quantity to be bought, which given all the price-quantity
combinations acceptable to the seller, are optimal from
the buyer's view. At the same time, the seller will pick
points also and not set up a supply function. Thus, equi
librium in terms of the crossing of supply and demand
curves will not exist. Though no one equlibrium point
will be established based on the traditional crossing of
supply and demand curves, a range in which the transaction
7
Boulding, ojd. cit. , p. 704.
50
will occur can be defined. The cost functions of the two
firms will determine this range. The limits will then be
set by the long-run zero profit points for the two firms.
The final point (point of imaginary crossing of supply and
demand curves) will be determined by the relative bargain
ing power of the two firms. This is the case of bi-lateral
monopoly and oligopoly.
In oligopoly and bi-lateral monopoly there is a
tendency toward the maximization of joint-profits of the
group of firms, with the profit being distributed based
upon the relative power of the firms as respects bargain
ing ability. Given whatever agreement these interdependent
firms may have as respects sharing in the joint profits,
it is possible to describe individual market functions
for the firms. As previously indicated, these functions
are not derived solely from utility functions and techno
logical functions (the firms do not set up supply and
demand functions), but are affected by the consideration
of rival's reactions and by relative strength in bargaining.
However, it should not be assumed that joint-profit will
be the guiding principle in all actions taken by the
firms. This is because all relevant variables are not
jointly controllable. It is implied when firms agree upon
51
joint-profit maximization, rather than individual maximi
zation, that the firms involved are able to agree upon a
method of discounting their own future possible share of
the market. However, variables which require skill and
creativity in handling, such as advertising, product
variations, and technological innovations, tend not to be
subject to joint-control. Thus, if a firm sees an oppor
tunity to better its position, due to success achieved in
those areas outside the joint-control, a conflict can
develop between joint-profit maximization and individual
firm profit maximization.
As to a possible attitude towards individual versus
group considerations, R. F. Kahn sees the individual firms
acting to maximize their individual position and not
maximizing their reactions relative to the reactions of
their rivals. He states:
. . . I imagine my firms to be searching by means
of experiment or trial and error, for the most
profitable price and output, but not for more than
that, not for the most profitable line of reaction
to a change in a competitor's behavior.8
^R. F. Kahn, "The Problem of Duopoly," The Eco
nomic Journal (March 1937), p. 14.
52
Thus, the implication appears to be that firms are not
mindful so much to a rival's actions but with maximizing
his own profits. But by definition, a rival's actions
will affect the firm's own profits so that maximizing
one's own profits becomes the same thing as reacting to
a rival's actions in a maximizing fashion.
The Profit-Maximizing Principle— Uncertainty
The profit-maximizing principle itself is subject
to qualifications, which are unrelated to the problem of
distributing profits between the group. It has been said
that the business man does not want to maximize today's
profits, if thereby they diminish tomorrow's profits to
such an extent that the profits of the two periods are
9
smaller than if today's profits had not been maximized.
Of course, this implies that the firm possesses some knowl
edge of its future demand and cost schedules. Since the
firm cannot be certain as to the future shape of these
curves, the element of uncertainty must be introduced as
affecting the profit-maximizing goal. Thus, with the
inclusion of uncertainty, account must be taken for out-
9William Fellner, Competition Among the Few (1st
ed.; New York: Alfred A. Knopf, 1949).
comes other than those appearing most profitable. Since
the possibility of less favorable outcomes is usually
considered to have greater weight than the possibility of
more favorable outcomes, it is likely that firms will have
a smaller scale of operations than would be required for
the maximization of profits. The smallness of scale
relative to the profit-maximizing scale will probably be
evidenced by a larger liquid position than required for
profit maximization. Thus, it can be said that the firm
provides a margin of safety due to the uncertainty as to
the future. Safety margin considerations alone (given the
other influences on profit maximization arising from the
interdependence of actions of the firms in question) tend
to result in the oligopolist's trying to maximize the
margin between average cost and average revenue. By defi
nition then, this margin between average cost and average
revenue is called a safety margin. Of course, a firm
that maximized the safety margin would probably not be
able to survive over a long time period, as his price
would be too high and his output too small relative to
his rival's. Thus, he will probably compromise between
the maximization of the safety margin and the maximization
of profits (producing the quantity indicated by the inter-
section of the marginal cost and the marginal revenue
curve). A clarification should be made in that it is
recognized that the firm can afford to lose the greatest
profit when total profit is greatest; that isr when the
margin between maximum profits and zero profits is great
est (when the output indicated by the intersection of the
marginal cost and marginal curves is produced). However,
the safety margin that is of concern here is the one
against downward shifts in demand or upward shifts in
costs. This margin is not usually maximized at the output
indicated by the point where marginal cost and marginal
revenue curves cross. A diagram will probably make this
concept of a safety margin clearer. Thus, in Diagram 1
P
0
MR
Diagram 1.
55
the safety margin (as measured by the total profit area)
against downward shifts of the demand function and/or up
ward shifts of the cost functions is maximized at the rate
of output for which the gap between the average revenue
and the average variable cost is at a maximum. It can be
seen that this output is less than the output indicated
by equating marginal cost and marginal revenue (q^ is the
output indicated when equating marginal cost and at output
q^ the firm is maximizing its safety margin). As indi
cated previously, the firm can generally be expected to
pick an output intermediate between q^ and q^ for the
reasons stated.
Another influence on a firm's output-price deci
sion (given the other influences on profit maximization
which arise from the interdependence of actions among
oligopolistic firms) is the fact that price and output
today affect price and output in the future.
One method of taking into account this long-run
influence is that of substituting the principle of maxi
mizing current value of the firm for profit maximization.
1^Ibid., p. 15. Also see "Cost Behavior and Price
Policy, A Study Prepared by the Committee of Price Deter
mination for the Conference on Price Research" (National
56
Again, a diagram will serve to make this concept more
clear. Where complementary relationships are dominant
between periods, the intersection of the marginal cost
and marginal revenue curves occurs to the left of point P
in Diagram 2. If under purely short-run influences the
price corresponding to this intersection was selected, the
price would be too high for long-run maximization of
profits because the beneficial effect of lower price now
on future demand would be disregarded. If a rival rela
tionship exists (less output today, more tomorrow), the
marginal intersection is to the right of P. Only if there
is no intertemporal effect does the marginal intersection
a
Diagram 2
Bureau of Economic Research, 1943).
57
lie directly below P and therefore directly below the
maximum point on the long-run current value or net worth
function N. This net worth function represents the present
net worth determined by output produced in the immediate
following short period, given the average revenue or demand
for that period. Thus, profit-maximization can be seen to
be affected by long-run considerations by using this method
of emphasizing net worth presently, rather than equating
current marginal cost and marginal revenue.
It has been shown that the profit maximization
principle itself requires some adjustment. It has been
assumed that,the other influences on the price-output
relationship arising from the interdependence of actions
of oligopolistic firms were given. In order to proceed
with the theoretical structure these givens will now be
removed.
Reaction Functions
The next step indicated is to view the oligopolis
tic firms as reacting to a given change in a rival's
actions. Thus, the concept of a reaction function will
be incorporated into the analysis.
Since the oligopolist does not set up a supply and
58
demand function but attempts to select a definite price to
charge and a definite output to produce, keeping sight of
the prices and outputs of his rivals, it is meaningful to
try to incorporate his actions into the theoretical
framework. This is attempted by use of the reaction func
tion.
Reaction functions will be used which express
each producer's profit maximization for given values of
the rival's variables. These reaction functions are
derived from the profit-indifference maps of the individ
ual producer's drawn against axes along which the value
of the producer's own variable and that of his rival's
variable are measured. The profit-indifference map of a
producer shows those combinations of the value of his own
variable and of his rival's which give the producer in
question identical aggregate profits. ^
For purposes of analysis, it is supposed that
short-sighted behavior is the case so that each firm
assumes that the price charged by the other firm will
remain constant and then selects its own price at the level
that maximizes its net revenue (profit). Diagram 3 will
1-*-Fellner, o£. cit., p. 18.
59
serve to make this concept more clear. In the diagram, the
lines M A and N_B„ are the reaction curves. The point
o m o m c
where these two reaction curves cross is equilibrium. If
: s
m
Mo
/ |4s7 * ftcrc-fiuc-
It
Diagram 3
60
.firm A thinks firm B will maintain its price at OH, A will
charge the price HM^ to maximize its profit. However, both
firms can improve their position by moving from the cross
ing of these reaction functions anywhere within the area
bounded by firm A's net revenue (profit) contour at
E,ETa,F, and firm B's net revenue (profit) contour at
E,ETb,F.
By bargaining, then, the firms can move to some
point on the line T T,, which is the locus of all points
cl ID
where one of firm A's net revenue contours is touched by
one of firm B1s net revenue contours. Thus, from point E
a move to any point within the area E T FT, will benefit
cl ID
both firms and any movement from the line TaTb will result
in one firm losing revenue. In this analysis, it is
assumed that each firm assumes that the other will sur
vive. However, conditions may exist which will induce one
firm to try to eliminate the other. A survival model will
be helpful at this point.
Survival Conditions
Assume that the contour A M A1 in Diagram 3 is
o o o
firm A's net revenue contour representing the smallest net
revenue at which firm A can survive, thus this will be the .
61
contour of zero net revenue (net revenue being defined as
abnormal profits) and assume that B0N0Bo t^le correspond
ing survival contour for firm B. These contours inter
sect at points C and D; thus, the area bounded by CNQD is
the area of coexistence because at any combination of
prices within this area both firms can survive indefi
nitely.
On the other hand, if the survival contours were
A3A3 and B3B3, there would be no area of coexistence (the
curves do not cross).
A number of conditions of coexistence can be dis
tinguished. Again, it is believed that diagrams will serve
to make this idea of coexistence more clear. The illustra
tions in Diagram 4 which follow the area of firm A's neces
sary survival (the area is bordered by the zero net
revenue curve) is shaded horizontally to indicate that
firm A can only move in that direction, and firm B's area
of necessary survival is shaded vertically as it can only
move in that direction. Diagram 4a indicates the impos
sibility of coexistence, Diagram 4b shows conditional
coexistence. There is a cross hatched area of coexist
ence; however, firm A can move out of the area of coexist
ence to a point such as (R), where firm A can survive but
62
Diagram 4
firm B can not (point (R) is outside firm B's zero net
revenue function). Similarly, firm B could move out of
firm A's survival boundary.
Diagram 4c shows a state of conditional viability
for firm B and unconditional viability for firm A. It can
be assumed that the same level of net revenue exists which
is too low even in the short-run, below which the firm
will close down. The contours representing this low
63
revenue are represented by the dashed lines in Diagram 4c.
Thus, firm A can move to a point (R) at which it is within
the survival boundary, but firm B has to close down opera
tions at this point because point (R) is outside firm B's
survival area. While coexistence is possible in the cross
hatched area, firm A will constantly be tempted to elimi
nate firm B by going outside B's survival area. Diagram
4d shows a situation of unconditional viability for both
firms, thus, coexistence is secure.
A problem is raised by the existence of what may
be called market extinction lines. Their effect is shown
in Diagram 4e. Here E^E^ anc^ EaEa are the market extinc
tion lines. If movement is made vertically downward from
point A, lowering the price P^ and keeping P& constant,
above the line EaEa, firm A is the only firm in the field.
As this line is crossed, firm B enters the field and firm
A's net revenue is reduced. As the downward movement is
continued, when the line E^E^ is crossed, firm A becomes
no longer viable (its net revenue disappears). Firm A's
survival area then, shaded horizontally, shows kinks at
the line EaEa and is cut off sharply by the line E^E^.
Firm B's survival area has like properties. Again, con
ditional coexistence has been produced by the introduction
64
of the idea of market extinction. Firm A could force sur
vival warfare on firm B by going to the price indicated
by H; similarly, firm B could force warfare for survival
on firm A by going to the price indicated by K. As the
firms get closer together, unconditional viability for
both becomes less likely. When the two market extinction
lines coincide as in Diagram 4f, the condition of perfect
oligopoly exists. The area of coexistence becomes the line
HC. In Diagram 4f, firm B will be the price leader under
coexistence and will move to N, where the line OE touches
one of its net revenue contours. Firm A will not be able
to achieve its preferred position at M, but may still be
able to survive at N. If the two firms are exactly alike,
so that H coincides with K and C with G, no one will be
tempted to start a price war. In the case where the firms
are not similar (for example, they have different cost
functions), firm B can move to K, at which point firm A
cannot survive. Therefore, firm B has the temptation to
1
begin a price war.
Limiting the approach to reaction functions which
express individual profit maximization for given values of
12
Boulding, op. cit., p. 59 8.
65
the rival's variable does not solve the problem of col
lusion and spontaneous coordination which is found in the
oligopoly situation. The firm in question may be unwilling
to select any point along a reaction function which ex
presses individual profit maximization of the second firm.
Refusal on the part of the firm in question to select
values within the relevant range (in a range that is
acceptable to the other firm) means that an attitude of
cutthroat competition prevails. This is the leader-
follower case, in which the leader refuses to select
values for himself that will lie on a follower's reaction
curve. The inclusion in the analysis of quasi-agreements
may be said to consist of two steps.
Leadership
First, starting from the leadership model (in this
model the follower firm assumes that the leader firm sets
his own variables and will stick to them regardless of his
behavior and proceeds to set his variables so as to maxi
mize his profits, given the leader's behavior), reaction
functions other than those defined to express the fol
lower's individual profit maximization for given values of
the leader's variables should be included. Follower's
reaction functions are significant only if the leader is
willing to make a selection along them. Any meaningful
solution assumes that the behavior pattern of the rivals
is mutually acceptable.
For the same reason, the second step for the inclu
sion of quasi-agreements consists of allowing for the
possibility that the reaction function of the follower may
be limited to one range of potential values of the leader'
variables (to that range within which the outcome is more
favorable for the follower than in other ranges). Thus,
instead of expressing individual profit-maximization for
alternative leader's values, these reaction functions
express profit maximization, given not only the leader's
values but also given his willingness and power to accept
certain reaction functions and to refuse to accept others.
The inclusion of the idea that an agreement has been made
means that the selection of the leader is made along func
tions sufficiently favorable to him and at the same time
to his rivals to be acceptable to both. If this agreement
covered all areas of the individual firm's operations,
then it would always be true that all firms have an inter
est in maximizing the joint-profit. Market sharing must
be considered incomplete rather than complete because it
67
does not imply the pooling of resources. However, based
on unrealistic assumptions, market sharing without pooling
of resources will result in profit maximization. It must
be assumed that the average total cost functions of all
firms are identical and horizontal in the relevant range,
then given the absence of product and spatial differen
tiation, a simple market sharing agreement will result in
joint maximization. Thus, only under unrealistic assump
tions will joint maximization be the case. Again, maxi
mization of joint profits which results from coordination
of efforts must be qualified. It is not in the interest
of individual firms to maximize industry profits if the
agreement fails to cover all aspects of the firms' opera
tions. With sloping cost curves and/or differentiated
cost functions for the various firms and/or product dif
ferentiation, the maximization of industry profits would
require the firms in the industry to pool all resources
as well as markets.
In oligopoly, there is a tendency to maximize
aggregate industry profits with the distribution of these
profits according to the relative strength of the firms'
bargaining power, but this tendency to maximize, as pre
viously indicated, must be qualified.
68
The profit maximizing principle itself must be
adjusted to allow for a margin of safety against decreases
in the firm's share of the market (downward shifts in
demand) and increasing costs (upward shifts of cost func
tions) . Also, as indicated previously, the long-run profit
is a consideration which will affect the maximization of
today1s prof its.
Specific Oligopoly Qualifications
m
Qualifying factors discussed previously apply to
the monopoly-oligopoly problem in the sense that they must
be taken into account in interpreting the profit incentive
for monopolistic and oligopolistic firms alike. But not
necessarily that they have the same intensity in monopoly
as in oligopoly. Thus, further qualifications must be
applied to oligopoly specifically. All of these qualifi
cations are consequences of the fact that the strength of
the firms in relation to one another changes and is known
to change, but in an unpredictable way. Therefore, it may
be impossible to agree on discounting the future in a way
that would be required for the maximization of joint
profit. As respects the element of uncertainty, F. H.
Knight indicates that the character of competition is
69
changed:
. . . with the introduction of uncertainty, the fact
of ignorance and the necessity of acting upon opin
ion rather than knowledge, into this Eden-like situa
tion (referring to pure competition), its character
is entirely changed . . . with uncertainty present,
doing things, the actual execution of activity, be
comes in a real sense a secondary part of life; the
primary problem or function is deciding what to do
and how to do it.
Oligopolistic firms usually have different ideas
about what action is appropriate to the maximization of
industry profits. The reason why an additional qualifica
tion enters here is that each firm knows that the others
have different appraisals and that they are mutually
ignorant about what the appraisal of their rivals will be.
They may have a fairly good idea as to the rival appraisal,
but still an element of uncertainty is present. Thus, no
firm can be sure whether the action of a rival is toward
a profit maximizing agreement or toward aggressive compe
tition. Also, no firm can be sure how its own actions will
be interpreted. This is where the desire to avoid aggres
sive competition enters as a qualifying factor. The result
of this qualifying factor is likely to be not profit
13
R. H. Coase, "The Nature of the Firm," Economica,
Vol. IV (1937), 386-405, quoting Knight.
70
maximization on the basis of the average appraisal of what
profit maximizing action is but something lying between
this on the one hand and the average guess on the other as
to what the appraisal of the rival is of the policies
appropriate to profit maximization.
Price Rigidity
This qualification (uncertainty as to the meaning
of a rival's actions and uncertainty as to his interpreta
tion of the firm in question's actions) may produce a high
degree of price rigidity. Oligopoly involves rivalry but
not necessarily continuous rivalry, as most oligopolists
will try to keep rivalry or the struggle for position to
a minimum due to the costs to the oligopolist arising out
of the struggle for position. As respects the desire to
avoid rivalry (aggressive) or struggle, Rothschild states,
"Their normal desire will be to enrich themselves in as
secure a position as possible which will enable them to
hold what they hold.""^ Thus, it appears that there may
be a tendency towards price rigidity.
l d
K. W. Rothschild, "Price Theory and Oligopoly,"
Economic Journal, LVII (1947), 299-320.
71
The kinked oligopoly demand curve hypothesis main
tains that oligopolistic firms are likely to believe cor
rectly that their rivals will follow suit in the event of
price reduction but will not follow suit in the face of
price increase. Thus, the oligopolist may see the demand
curve which he faces as being kinked. The idea of the
kinked demand hypothesis is that for fear of retaliation,
olxgopoly price is likely to be rigid. J
Therefore, an additional qualification to the
industry maximization of profits idea is added, in that
uncertainty as to rivals1 intentions and uncertainty as to
how a firm's own action will be interpreted by rivals may
lead to price rigidity. The theory resulting from these
and previous considerations is one of qualified joint-
maximization of profits.
It will be helpful at this point to summarize the
reasons for various qualifications. A simple listing of
these reasons for qualifications will be helpful, in that
future reference to these qualifications will be greatly
15
George J. Stigler, "The Kinky Oligopoly Demand
Curve and Rigid Prices," The Journal of Political Economy,
LV (1947), 432.
72
facilitated. The reasons for the qualifications, then,
are as follows:
a) Unwillingness to pool resources and their earnings
and to agree on interfirm compensation, in order
to maximize profits in the presence of nonhorizon
tal cost curves (if cost curves were horizontal
and identical, there would be no reason for pool
ing resources).
b) Unwillingness to pool resources in the presence
of differences between cost curves of the various
firms.
c) Unwillingness to pool resources in the presence
of product or spatial differentiation, implying an
unwillingness to relocate output between points
with different locations.
d) Incompleteness of coordination or control con
cerning future changes in advertising, product
quality and technological methods.
e) Safety margin considerations, based upon uncer
tainty as to the future.
f) Long-run considerations which relate to the maxi
mization of the present value of the firm.
g) The desire to live and let live (to avoid aggres-
73
sive policies).
h) The existence of a controlling group among owners
whose ideas about profit maximization differ,
which reflected in the N curve as previously pre
sented.
All of these qualifications apply to oligopoly,
and qualifications E, F, and H apply to monopoly as well.
The qualifications as respects oligopoly arise in view of
the fact that changes in the relative strength or bargain
ing power are unpredictable; but relative strength at any
particular moment may be known. Qualifications E, F, and
H may be said to arise because the profit maximizing
principle itself (derived by equating marginal cost and
marginal revenue), given the qualifications resulting from
the interdependence of the firms, requires adjustment as
previously indicated.
A Model for Intermediate Structure
With these qualifications in mind, it is now pos
sible to proceed with a theoretical model which attempts
to consider all the qualifications involved. The qualifi
cations are presented individually and then combined into
the final model.
74
If qualification A is considered, and if the firms
in undifferentiated oligopoly (no difference in their
products or services rendered which are related to the
product) are assumed to be of equal strength as respects
bargaining ability, each firm will produce the quantity
indicated by the intersection of its marginal revenue and
marginal cost curve corresponding to DD in Diagram 5. The
DD curve represents a duopolist's portion of the market
— I
AC
AC
DD DD
HR
Diagram 5
demand curve in undifferentiated duopoly, where the share
results from dividing the market by agreement. This DD
curve implies that the two firms set the same price. The
DD curves can also be used to describe partial as well as
75
full oligopoly. That is, if the industry includes a com
petitive sector (some small firms are not subject to the
agreement between the large firms), the DD curves will
represent the large firm's share of the market less the
sales of the small firms at each price. Then the small
firms will proceed to equate their marginal costs to the
price set by the large firms.
If firms were willing to pool resources (qualifi
cation A being absent), output would be indicated as in
Diagram 6. Thus, with complete pooling of resources, a
COST
•9
9 I *
o
Diagram 6
combined cost curve would apply. The left and right "U"
shaped curves represent individual cost curves which have
been combined. The solid part of the combined curves
create the relevant (combined) cost curve. The combined
curve is drawn on the assumption that there are no inter
plant economies or diseconomies. In this situation, an
oligopolistic pool would be operating along the curve.
’ If interplant economies did exist, the second minimum
point of the combined curves (the "U" shaped curve on the
right) would be lower than the first indicating that as
output of the combined firms increased, total cost would
decrease. In the case of interplant diseconomies, costs
would be higher for the monopolist but not for the oli
gopolist. Interplant diseconomies would be expressed by
the second "U" shaped curve being higher, relative to the
x-axis, than the first.
The monopolist would be operating along the entire
combined curve. However, the oligopolistic firms would
have the choice between operating along this combined
curve and operating along two separate "U" shaped curves,
both of which have their minimum at the level of the lower
minimum (in this case it would be beneficial not to operate
along the combined curve or not to combine resources, as
some inefficiencies result). The oligopolists would then
have the choice as to whether to pool resources and
operate along a combined curve or not to pool and operate
77
on separate curves. For outputs such as that indicated by
point P, combined operations would be preferred because
for such outputs the single-plant cost curve indicates
higher costs than if the plants combine and thus operate
on the second "U" shaped curve, rather than staying on the
first "U" shaped curve.
Thus, the oligopolists' actions with qualification
A and without qualification A or with pooling and without
pooling have been indicated.
The outcome without pooling is determinate in a
sense in which oligopoly results are usually not, because
the firms are assumed to be duplicates of one another in
every respect. Relative strength expresses itself in the
market shares and therefore in the DD curves. However,
given these curves, the equilibrium point is determined
with no regard to relative strength. Relative strength
or bargaining power may enter into the determination of
the equilibrium point, given the DD curves, if it is
assumed that one firm has more bargaining power than the
other. The DD curve of one duopolist would have to be
shifted to the right and the curve of the other duopolist
would be shifted to the left. Thus, one firm would prefer
a different price from the other and in the range between
78
the two prices it would be impossible to show the price
which is optimal for both firms. Diagram 7 will be helpful
in viewing this range. This range is analogous to the con-
R 6i/6«ua.
or
Corr
Diagram 7
tract curve concept where any movement on this line bene
fits one firm but harms the other and outside this range,
both firms can benefit by moving to it. The outcome will
therefore depend upon the relative bargaining power of the
firms concerned. Relative strength in the presence of
unequal market shares will determine both the position of
the DD curves and the price and output.
Maximization of the joint-profit can be determined,
given that no pooling of resources is possible (qualifi
cation A) , and that the two DD curves are determined by
A
$ Rahq
[AC
-AC
■DD
MR
[AO
AIR
DD
79
bargaining power.
In selecting a price in the relevant range one
firm will have an interest in a price lower than that
which maximizes the joint profit, and the other firm will
have an interest in a price higher than the one which max
imizes the joint-profit. The actual bargain may be the
result of two mutually acceptable reaction points, in the
sense that the two firms guage their reactions to tentative
prices and then agree directly on price and quantity or
it may be the result leadership selection (the dominant
firm will decide price and the other will produce the out
put indicated by equating his marginal costs with the set
price). Diagram 7 shows the limits of the price range
within which there will be a conflict of interests and
within which the actual price will be determined by rela
tive bargaining power.
Inclusion of qualification B provides the same
price limits as those in Diagram 7. except that one of the
cost curves would have to be shifted up or down. The cost
inferiority of one firm in relation to the other sets
limits to the proportions in which the profits can be
distributed. However, a new element enters with qualifi
cation B in that while qualification A tends to lose its
80
significance gradually as the number of plants per firm
increases; qualification B does not. However, the signif
icance of qualification B may be decreased if each firm
operates high cost as well as low cost plants. If all
cost curves were horizontal and identical, then all iso-
market (equal market) share demand curves or DD curves
17
would be at the same time iso-profit (equal profit)
share demand curves and they would distribute the market
in the same proportion as that in which profit is dis
tributed.
Combining qualifications A, B, and C, price range
limits still exist, but the meaning of the DD curves
becomes different. The DD curves relating to undifferen
tiated markets assumed identical prices and constant mar
ket shares along the curves. The product produced was
■^Iso-market means that if there are five firms,
each gets 20 per cent of total sales allocated to him by
prior agreement. Pooling of the firms' resources not re
quired. Therefore, their 's will vary depending upon
prevailing cost conditions within each firm.
■^Iso-profit means that the same five firms have
agreed to pool resources (combine costs) and sell in the
market as if one big firm and then distribute the profit
equally. Pooling is necessary, unless they have identical
cost functions; if they do, then an agreement to share the
market will also result in the equal sharing of profits.
81
assumed to be given and advertising was equal to zero,
and the shares were determined by bargaining power. These
assumptions must now be modified in the case of differen
tiated oligopoly. This is because when a product is dif
ferentiated, buyer's preferences will influence market
shares rather than bargaining power.
There are various ways of modifying the undiffer
entiated assumptions.
For oligopoly with product differentiation it can
be assumed that the DD functions imply such price ratios
between the products in conjunction with such advertising
expenditures by the rivals and with such product qualities
as will establish iso-market DD curves or that the DD
functions imply such price ratios between the products in
conjunction with such advertising expenditures by the
rivals and with such product qualities as will establish
iso-profit shared DD curves in accordance with relative
strength or that the DD functions imply a constant price
ratio between the products and given advertising and
product quality. In all three cases, the unwillingness
to pool resources in the sense of qualification C expresses
itself in the fact that brands exist if a producer finds
it profitable to use them, given the brands of the other
producers. Regardless of whether the situation involves
product differentiation, spatial differentiation or both,
the meaning of the DD curves will depend on whether the DD
curves are established in accordance with one or the other
of the qualifications above. In the case of iso-product
curves being established, the agreement should be expected
to establish throughout the course of the iso-profit
share DD curves, that combination of prices at different
quantities, of advertising expenditure and of product
quality which maximize the sum of the profits, given that
there is no pooling of output or earnings and that profit
shares are to be distributed in a definite way. Once the
question of profit shares is settled, and the choice of
the optimum point along the iso-profit share curves is
established, further indeterminateness is eliminated. The
interests of the rivals coincide and the joint profits
as well as the individual profits will be maximized. This
is not the case of the establishment of market share
curves, nor in the case of the establishment of DD curves
based on a constant price ratio between the products and
given advertising and product quality. In the iso-market
case, the optimum is different from the standpoint of
different firms. Each prefers that combination which
83
gives him the highest profit, given his market share.
Therefore, in this case as distinguished from the iso
profit case, the agreement will have to bridge a conflict
of interest with respect to the combination of price dif
ference, advertising and product.quality as well as a
conflict of interest with respect to market shares.
Therefore, profits will not be maximized even in
the qualified sense which takes no pooling and the market
shares as given. The same is true where the DD curves
imply a constant ratio between the products and given
advertising and product quality. It should not be assumed,
however, that agreements typically establish iso-profit
share DD curves for differentiated as well as undifferen
tiated oligopoly because iso-profit curves imply a degree
of indifference concerning contacts with the market.
Thus, iso-market shares are more realistic.
Qualification D expresses itself in the fact that
the market shares established by the original DD curves
need not remain unchanged (they may change because certain
nonprice variables, such as advertising are not part of
the agreement). Improvements in market share need not
result in elimination of profits, but joint-profits will
in any event be reduced below the collusive level and may
84
be reduced absolutely. Joint-profits do not have to be
reduced absolutely because the actions of each firm may
have the effect of increasing sales for the whole industry.
The market may be widened beyond the extent to which costs
are raised and thus relative improvements among the firms
may cancel out. In this case, the joint-profit would be
rising absolutely. However, they would be rising less
than if by coordinated effort only those changes were made
which would have a favorable effect on the joint-profit
and no mutually cancelling intrusions into rival markets
were occurring.
Qualifications E and F express themselves in the
circumstance that the price limit of Diagram 7 are not
truly governed by the intersection points of the marginal
revenue and marginal cost curves but by more complex con
siderations. If price limits were governed by marginal
intersections then points in Diagram 8 would mark these
limits. P2 points would be the points of the maximum
safety margin against downward shifts in demand functions
and upward shifts in average variable costs. The P^
points express compromise solutions between the maximum
safety margin and best guess profits.
Qualification F concerns long-run profit considera-
85
A vc
DD
DO
MR
Diagram 8
tions in which price today affects price tomorrow and out
put today may affect output tomorrow and thus profits
today may affect profits tomorrow. Price limits are not
ultimately set by the values indicated by the DD functions
but by the prices corresponding to the maximum points on
the net worth functions such as N in Diagram 8. As pre
viously indicated, expresses on appraisal of present net
worth is not based entirely on the most probable or
86
expected cost and revenue functions for successive periods
but is corrected for safety considerations. In Diagram 8
the price and output corresponding to the maximum point
on the N function happens to coincide with the price and
output corresponding to the appropriate compromise between
marginal intersection P^ and maximum safety margin P2. In
other words, P3 happens to coincide with the ultimately
relevant P^. Thus, future conditions depend partly on
present decisions.
Qualification G, the desire to avoid aggressive
competition, tends to create downward price rigidity.
Thus Diagram 8, it tends to move P4 to the left of P3 in
the long run.
Qualification H expresses itself in the circum
stance that the N function should be interpreted as the
net worth of the effective interests in the firm. This
may shift P4 to the left of P3 because the absolute share
of old owners may sometimes fall aggregate profits are
increased by the investments of new owners. On the other
hand, the effective ownership interests may be closely
linked with management interests, and these may be favored
by initially high output. This may shift P4 to the right
87
1 8
of in Diagram 8.
Thus, the results of agreements on oligopolistic
pricing and output decisions have been incorporated into
a theoretical model. However, oligopoly is but one struc
ture among many (it may be the most significant in its
representation of reality), thus it will be meaningful to
indicate the results of agreements for the entire family
of market structures of which oligopoly is a member.
In the absence of resource pooling, or with incom
plete pooling, the indifference map concept can be used to
indicate the effect of agreements on market performance.
In the absence of pooling in the sense of taking
into account qualifications A, B, and C, two cases can be
distinguished.
The first is the case where iso-profit share DD
curves are established. For example, in oligopsony the
iso-profit share SS curves (analogous to iso-profit share
DD curves for oligopoly) expresses the fact that the rival
firms buy, at alternative prices, different shares of the
total purchase (of the industry) in such a way that the
profit shares will be the same. These are identical supply
- * - 8Fellner, op. cit., p. 20.
88
functions faced by the oligopolist which are derived by
spontaneous coordination from the supply functions faced
by the oligopolistic industry. In the case of iso-market
share curves (demand or supply) the firms are allowed (by
agreement) to sell equal shares of the total sales. In the
case of iso-market share supply curves, each firm is
allowed to purchase equal shares of the total -industry
purchase at different prices as indicated in Diagram 9.
Diagram 9
If iso-profit share DD curves are established, the points
of tangency of the indifference curves with one another
are connected and thus a contract curve can be derived.
The actual bargain will lie on this curve and will be
expressed by that point on the curve which corresponds to
the agreed upon distribution of the joint-profit. The
aggregate joint-profit is not constant along these con
tract. curves as the contract curve merely satisfies the
condition that the individual profit of both participants
can be increased by moving from any point outside the
curve to some point on the curve, while the individual
profit shares can neither be increased by moving away
from the contract curve or by moving along it. The estab
lishment of iso-profit share curves means that a curve
would be drawn across the corresponding indifference map,
showing the output combinations or price combinations
which distribute profits in given proportions. This curve
can be called a profit share path then. These profit
share paths would become tangent to an indifference curve
of one producer at the point at which they became tangent
to an indifference curve of the other producer. Both pro
ducers have an interest in moving to the point on the
profit share path which expresses maximum joint-profits
for these profit shares, that is, the point of intersec
tion of the profit share path with the contract curve.
More market variables and more firms can be analyzed by
this method. The principles are the same, except that
90
there may be several combinations of price, output, sales
expenditures, and product quality which jointly produce
identical profits.
The second case which may be more realistic than
profit sharing is that of market sharing, again based on
an agreement. In this case, the line which expresses the
agreement cuts across the indifference map and becomes
tangent to an indifference curve of a different producer
at another point on the indifference map. For example, in
the indifference map with output as the variable, the mar
ket share path, corresponding to the market-share DD
curves in oligopoly is the straight line from the origin
as indicated in Diagram 9. The slope of this line shows
the constant market shares. None of the market-share
paths, indicated by the line MM, will become tangent with
the two indifference curves at the same point. Thus, tan-
gencies of the market share line and indifference curves
will be off the contract curve (unless the market share
paths happen also to be profit-share paths, which would
indicate identical cost functions for the firms). Each
firm will be striving for the point of tangency of the
market-share line with its own indifference curve. The
agreement which the firms make will have to bridge the
91
conflict of interest with respect to the shares and the
difference, given the shares, between points of tangency
between points of tangency between the firm's own indif
ference curves and these given shares. Thus, the agree
ment will not maximize the joint-profit as there is a lack
of pooling. Costs are different among firms and the final
market-share going to a firm is not that which maximizes
his profit, because a conflict exists between his profit
indifference curve and his market share.
Thus, qualifications A, B, and C have been taken
into account by way of indifference map analysis for the
family of related market structures. Qualification D can
be included by stating that within the framework of exist
ing agreements, the tangency points of market-share paths
with the indifference curves may change in the passage of
time and the compromise point reached between these tan-
gencies may also change. This is because changes in the
angle of the market-share paths produced by the competi
tive handling of certain variables is permissible in the
agreement. Also, because innovations in production and
marketing may change the indifference curves themselves.
III. SUMMATION
92
In summary, then, a theoretical framework has
been created for the market structures which are inter
mediate between the extremes of pure competition and monop
oly. It was indicated that the oligopolist does not set
up a supply function in the traditional sense, nor can he
define the demand curve he must face because this curve
is not based upon buyer's preferences alone but is affected
by rival's actions as respects pricing and output decisions.
Reaction functions were used to indicate individ
ual maximization of profits, given the rival's actions.
However, since coordination of effort, to a certain
degree, is a major characteristic of oligopoly structure,
the theoretical framework was improved by the use of in
difference map analysis to allow for the inclusion of
agreements which result in some of the relevant variables
being jointly controlled.
The following chapter will attempt to indicate
what empirical evidence has to say about oligopolistic
market structures in terms of efficiency, profit levels
and selling costs. As indicated in the theoretical frame
work presented, innovations in production and marketing
93
will likely not be subjects of an agreement, thus, profits
going to the various firms will vary over time.
CHAPTER IV
EMPIRICAL INVESTIGATION: APPLICATION OF THEORY
Evaluation of market performance and the explana
tion of why such results occurred requires the development
of certain norms for performance. The question arises,
can the structure of a market be relied upon to predict
the performance of the market? Before an attempt to
answer this question is made, it is necessary that a dis
tinction between market structure and market performance
be made.
Market Structure and Market Performance
The concept of structure involves the conditions
which influence the degree of competition between rivals.
Such things as the number of firms in the industry and the
conditions of entry will influence the degree of competi
tion present.
Performance refers to the consequences of the
structure. The consequences involve such matters as cost-
price relationships, efficiency, et cetera; the more com-
94
95
petitive the market, the more nearly will profits resemble
the "normal profit." Joe Bain defines market structure as
follows:
. . . market structure for practical purposes means
those characteristics of the organization of a mar
ket which seem to influence strategically the nature
of competition and pricing within the market.!
Performance is defined by Bain as follows:
. . . market performance refers to the character of
end adjustments to the effective demands for their
outputs which are made by sellers (or adjustments
made by buyers to the effective supplies of outputs).^
I. THE APPROACH
Efforts to verify or elaborate on the theoretical
models involve the consideration of the nature of price
theory and what there is in it to verify. This requires
consideration of the postulates of the theory, the iden
tification of basic motivations in psychology, technology,
and the identification of the resulting market structure.
Such studies involve the question of the nature of hypoth-
^Joe S. Bain, Industrial Organization (New York:
John Wiley and Sons, Inc., 1959), p. 7.
^Ibid., p. 11.
96
eses in the theory in an effort to establish some predict
ability of market performance resulting from its struc
ture. By taking the theory related to structures ranging
from pure competition to monopoly, as presented in the
previous chapter, and attempting to relate it to empirical
studies, the correctness of the assumptions about behav
ior, the relevancy of the description of structure, the
deduced versus the actual performance, may be determined.
The theory could be questioned step by step; for example,
the question could be asked, do firms equate MR and MC?
By determining the answer to this question, the postulate
of price theory that firms maximize profits can be
checked. Thus, one approach that empirical research
could take is to go down the list of postulates in price
theory and attempt to test them in a particular situation.
The Profit Maximizing Objective
What about this postulate of profit maximization;
do firms have as their primary concern the goal of maxi
mizing profits? In other words, can it be assumed that
the large corporation of today will react in a manner
similar to that of the entrepreneur in traditional price
theory? Some studies on the behavior of large corpora-
97
tions indicate that managers are concerned primarily with
such things as salary, power and personal status and that
they see size as being directly related to their goals.
The president of a large corporation might rationally be
more interested in creating a large firm than making it
profitable. He may describe his function as an arbitrator
among various interests in the firm and that of maintain
ing an equitable and working balance among the claims of
the various directly interested groups such as stock-
holders, employees, customers and the public at large.
This seems at first to indicate that maximizing profits
is of lesser concern. However, since profits are important
to growth and growth seems to be a primary concern, the
behavior of large corporations may be very similar to the
behavior which would be forthcoming if the maximizing of
profits was the primary conscious goal.^ This is espe
cially true where long-run growth requires long-run
Therefore, in such instances the behavior of the corporate
3
J. K. Galbraith, American Capitalism: The Con
cept of Countervailing Power (Boston: Houghton Mifflin,
1952) .
^Robin Marris, "A Model of the Managerial Enter
prise," Quarterly Journal of Economics, Vol. LXXVII (May
1964).
98
manager is not sufficiently different from the behavior
of the entrepreneur in price theory to require a new con
cept.
Identification of Structure
After testing the various postulates of price
theory to see if they hold true in a particular situation,
another approach can be taken in the attempt to relate the
theory to empirical findings. Such an effort would involve
the identification of empirical market structures as being
competitive, oligopolistic, monopolistic, et cetera, and
to relate the performance of such structures to their
theoretical performance. In an effort to identify partic
ular market structures, a measurement device called the
concentration ratio has been used. To appreciate the need
for such a measuring device, consider the definition of
oligopoly in price theory. The concept of "few" sellers
is not sufficient when attempting to empirically define
and predict the performance of a particular market struc
ture. For example, an oligopoly consisting of five sellers
may behave (say, arrive at a price) differently than would
an oligopoly consisting of fifteen firms (assuming that
each of the fifteen had an equal share of the market).
99
Of course, if five of the fifteen firms in the second
case had 95 per cent of the sales in the market, there
would probably be little difference in performance between
the first and the second case.
Typically, to compute the concentration ratio so
that these different or similar oligopolies can be iden
tified, the firms are ranked in order of size beginning
with the largest (determined by percentage of sales it has
relative to total sales). Then the shares of the largest
X number of firms are summed. Usually statistics will be
given for the largest four to eight firms in the industry.
Thus, using this measurement, the concentration ratio for
monopoly would be 100 per cent. For an industry to be
designated as competitive, the ratio of individual firm
sales to total sales (concentration ratio) would have to
be about 5 to 10 per cent. However, it is not so simple
as it may appear, to say that this structure is competi
tive and therefore good, or that structure is monopolistic
and therefore bad. The now almost traditional problem
appears; what about those structures having concentration
ratios which are intermediate between the continuum of
10 per cent (competitive) and 100 per cent (monopoly)?
That is, what about oligopoly structure? This problem
100
will be dealt with shortly but first it is important to
understand the nature of the inquiry.
Studies of the relationship of market structure
to performance rest on the view that there is a relation
ship between structure as defined above and performance
as defined above. How close is the relationship? It
might be said that structure definitely determines per
formance. This is true only if the dimensions of struc
ture are defined broadly enough so that no two industries
are alike. There would always be a one to one relation
ship between structure and performance because every
industry would be unique. But of course this approach
would be of no value because it would not lead to general
izations. Only if a few important dimensions can be iden
tified as making a difference is generalization possible.
Therefore, the dimensions of structure must be limited
if there is to be theoretical content to the approach.
Apparently then, the idea of operationalism and theoretical
usefulness are in conflict. The more operational is any
testing process, the more specific the explanation must
be in order to be understood. On the other hand, as a
theory becomes more detailed, it becomes less a theory
because it must lose its abstractness. Thus, the more
101
operational a concept is made, the less theoretical con
tent it has. The point is that, if the concept of struc
ture is to be useful, it must be identified by relatively
few important dimensions.
In the attempt to identify a market structure as
being relatively competitive.or relative monopolistic,
the concentration ratio analysis seems to be a good first
approach. However, as previously indicated, the problem
arises in the range between competition and monopoly. In
an effort to meaningfully indicate how far on the scale in
the direction of monopoly an industry could be and still
perform in an acceptable manner (relatively normal prof
its, reasonable efficiency, et cetera), the concept of
5
workable competition was developed. This concept is
based upon the idea that there is an allowable range within
which performance can deviate from the ideal and still be
acceptable. Six dimensions of performance are developed:
(1) average employment, (2) efficiency of production,
(3) relative stability in the market, (4) rate of growth
5
J. M. Clarke, "Toward a Concept of Workable Com
petition," American Economic Review (June 1940).
102
of output over time, (5) composition of output, and (6)
distribution of income. There is disagreement as to how
each dimension should be weighted. It seems reasonable
to state that the relative importance of the dimensions
would depend upon what industry is being studied.
Generally, then, workable competition is taken to
mean a socially satisfying competition in terms of the
general welfare. If a market is functioning satisfac
torily (making reasonable profits, et cetera), can it be
assumed that the structure is such that deviations from
this, observed to be competitive market, are not possible?
The answer is no. Such performance may be voluntary on
the part of a benevolent monopolist. Therefore, condi
tions in a given market could appear to be relatively com
petitive when in fact they are not compelled by the nature
of the structure to be so. Thus, the objective is for
competition to be such that the benefits (reasonable
prices, output, quality, et cetera) to society come
because the firms cannot avoid giving such benefits,
because the structure of the market forces it. It seems
reasonable to state that even if good performance is
present, it cannot be considered workable competition if
the firms involved are not forced by the market structure
103
to perform in this way.
What criteria could be used, then, as the basis
for determining whether or not the observed competition
is workable? First, high seller concentration in an indus
try generally seems to be a good indication that workable
competition is absent, as far as profits are concerned.
Bain indicates a rule of thumb as follows:
. . . if seller concentration exceeds that in which
the largest eight sellers supply two-thirds to
three-fourths of the output of an industry, there
is a strong disposition toward significant monopo
listic price-raising and excess profits.6
It cannot be assumed, however, that competition would
become more workable if somehow concentration could be
reduced to some minimum level. Again Bain indicates that:
. . . it is not evident from available findings
that market performance in industries with low
seller concentration or relatively atomistic
structures tends to be systematically better or
worse than that in industries of moderate concen
tration. That is, moderately concentrated oli
gopolies seem to tend toward desirably competitive
performance about as well as industries of rela
tively atomistic structures. The important struc
tural distinction is not between atomistic indus
tries . 7
^Bain, op. cit., p. 414.
7Ibid., p. 424.
104
Apparently, if concentration is too low, some inefficien
cies would result.
Secondly, high barriers to entry tend to make the
resulting performance not acceptable. Barriers to entry
may occur due to such things; absolute cost advantage of
existing firms due to technical knowledge not available to
potential entrants, high initial cost in entering, et
cetera. It can therefore be said that moderate barriers
to entry and moderate concentration will probably satisfy
the standard of being workably competitive. On the other
hand, if entry is too easy they may become doomed to a
chronic overcapacity.
A final element of market structure to be viewed
from the standpoint of workability is the degree of prod
uct differentiation. Product differentiation is taken to
mean the efforts by sellers to make their product seem to
be different and superior to other competing products.
It is generally agreed that a certain amount of product
differentiation is desirable so that the potential con
sumer will have a range of choices. High product differ
entiation is not desirable for by definition this is taken
to mean that in the effort to sell his product, the seller
has incurred wasteful (expenditures which are strictly
105
persuasive as opposed to informational) selling costs,
which in turn tend to create high barriers to entry in the
form of product loyalty'.on the part of the consumer.
II. THE QUESTION OF EFFICIENCY
Now that the conditions conducive to workable
competition have been mentioned as to structural requi
sites, it is proper to ask what empirical data reveals
about the workability of efficiency in the American econ
omy. However, before this is attempted, it is important
that some concepts be reviewed.
Economies of Scale
For plants in general there is a relationship of
the size or scale of the plant to its efficiency. This
relationship is determined or measured by unit costs of
production. The relationship is such that increases in
the size of the plant up to the minimum optimal size are
accompanied by reductions in unit cost, but further in
creases in size will neither reduce costs nor increase
them further (this is the case in industries that have
flat-bottomed cost curves). The relative significance of
economies of large-scale plants in different industries
106
can be measured by estimating for each industry the per
centage of the total market output that would be supplied
by one plant of minimum optimal scale and how much unit
costs will be increased for plants of successively smaller
scale. Finally, as firms grow beyond some critical size,
there may be diseconomies of large-scale production.
With these concepts now reviewed, the question of
the incidence and importance of scale economies in American
industry can be dealt with.
Importance of Scale
A first, but only partial, indicator of the impor
tance of plant scale economies in an industry is the size
of one plant of minimum optimal scale (expressed as a
percentage of the total plant capacity needed to supply
the market faced by sellers in the industry). For example,
in the cigarette industry, we would ask what percentage of
market would be supplied by one plant of minimum optimal
scale.
In his empirical research, Bain, found great
diversity among industries with regard to the significance
of large scale economies. In six of the industries
studied, one plant of minimum optimal scale should supply
107
10 per cent or more of the market with the figure running
as high as 20 per cent or more in the cases of the auto
mobile and typewriter industries (the other four industries
are tractors, fountain pens, copper, and gypsum products).
In five of the industries studied, one plant of minimum
optimal scale should supply 5 or 6 percent of the market.
These are the cigarette, soap, rayon fiber, farm machinery
and steel industries. In nine of the industries studied,
the percentage of the market supplied by one plant of
Q
minimum optimal scale would be less than 5 per cent.
As previously stated, the size of one plant of
minimum optimal scale (expressed as a percentage of the
total plant capacity needed to supply the market faced
by sellers in the industry) is only a partial indicator
of the importance of economies of scale in the industry in
question.
A second indicator of the importance of scale is
the extent to which unit costs are higher with plants of
less than optimal scale. Industries which have a flat-
bottomed plant scale curve (this curve relates unit costs
to size of plant), can operate with less than optimal
^Ibid., pp. 346 ff.
plant sizes and incur a relatively slight increase in unit
cost whereas industries with a relatively steep plant
scale curve would incur a large rather than a slight in
crease in unit cost when less than optimal plant sizes are
being used. The steepness or flatness of the plant scale
curve will be determined by the nature of the product
being produced. Thus, plant scale economies are more
important in industries with a steep plant scale curve
than in industries with relatively flat-bottomed plant
scale curves. This is because with the steep curve,
efficiency requirements are met at only the minimum
optimal point near it, whereas with the flat-bottomed
curve the size of plant is of slight importance in overall
efficiency. Therefore, to appraise the importance of
plant scale, the size of the minimum optimal plant and
the effect on costs as the plant is reduced in size must
be considered.
Empirical data indicates that many plant scale
curves tend to be at least moderately flat, so that plants
of half-optimal scale would experience no more than a 2
or 3 per cent elevation in unit costs and plants of
quarter-optimal scale no more than a 5 or 6 per cent cost
elevation. Only in a small minority of the cases studied
109
were plant scale curves fairly steep (an example of such
an industry is the cement industry). Considering both
measures of the importance of scale economies, that is,
the magnitude of the minimum optimal scale of plant and
the shape of the plant scale curve, how important were
scale economies found to be for American manufacturing
industries?
Two industries had very important plant scale
economies in the sense that minimum optimal plant exceeded
10 per cent of total market capacity, and that unit costs
would be elevated by 5 per cent or more at half-optimal
plant size (these were automobile and typewriter indus
tries) . Five industries had moderately important plant
scale economies in the sense that minimum optimal plant
scale was in the neighborhood of 4 to 6 per cent of total
market capacity, and that unit costs would be elevated by
at least 5 per cent at half-optimal plant scale (these were
cement, farm machinery, tractors, rayon and steel). Nine
industries had unimportant plant scale economies, either
because the minimum optimal scale was small, or because
the plant scale curves were relatively flat or for both
reasons (these were the cigarette, liquor, petroleum prod
ucts, soap, rubber tires, shoe, flour, meat and canned
110
goods industries).
To what extent then, are plants and firms big
enough for efficiency in the sense that they are at least
of minimum optimal scale?
It was found that the bulk of industry output in
each industry was supplied by plants of reasonably effi
cient scale, that is, by plants either of at least minimum
optimal scale or smaller by only such an amount that their
unit costs were not significantly above the optimal level.
The proportion of industry output supplied by such effi
cient plants ranged from about 70 per cent at the minimum
to 90 per cent at the maximum. Also, a few of the largest
plants in most industries were of substantially greater
than minimum optimal size because large firms had dupli
cated efficient plant units at one location. However, it
was found that these very large firms were not either more
or less efficient than plants close to the minimum optimal
scale. As mentioned above, 70 to 90 per cent of the
industry output was being supplied by relatively efficient
plants; therefore, 10 to 30 per cent of the output was
being supplied by inefficient fringe firms.
A logical extension of the analysis would be to
ask, to what extent the actual scales of existing firms
Ill
are greater than necessary for purposes of efficiency?
The incidence of multi-plants (in the sense that
the firm has reached a scale which is a substantial multi
ple of the scale of one minimum optimal plant) was found
for the four largest firms in a large majority of the
industries studied.
In six industries, the average size of the first
four firms was such that each could control from nine to
twenty-five plants of minimum optimal scale. In nine
industries, the average size of the first four firms was
such that the firm could control from three to nine plants
of minimum optimal scale. In five industries, the size
of the first four firms was such that each could control
from one to three plants of minimum optimal scale. (The
size of the first four largest firms in each is expressed
as a multiple :>of the size of one plant of minimum optimal
scale in the same industry.)
It appears then, that the size of the leading
firms in most of the industries studied is substantially
greater than is required for efficiency. Also, seller
concentration in most of the industries was found to be
either moderately higher or much higher than required for
efficiency.
112
It may be concluded that in at least half or more
of all manufacturing industries the leading firms are in
a significant degree larger than necessary from the
standpoint of efficiency. What then can be said about
the relationship between market structure and efficiency?
About the only positive association between struc
ture and efficiency in plant and firm scale is that indus
tries with the largest fringes of inefficiently small
firms (therefore the industries whose output is produced
inefficiently by about 30 per cent of the firms in the
industry) are usually industries with high degrees of
product differentiation. Thus, apparently, strongly
developed consumer preferences for various company names
and brands affords a number of inefficiently small firms
a market at prices high enough to more than cover their
higher costs which result from their inefficiency. The
major reason for the survival of these small firms is
probably attributable to two things: (1) the ability of
these firms to make normal profits in competition with
larger rivals who set their prices so as to earn consid
erable excess profits, and (2) unwise entry of these small
firms which in turn go broke but are quickly replaced by
other unwary entrants, thus maintaining the inefficient
113
fringe. Thus, monopolistic pricing policies by large
firms and excessive or unwise entry by small inefficient
firms are seen to be important factors in maintaining the
inefficiency.
On the other hand, inefficiencies due to plants
being too large rather than too small, and thus creating
excess capacity in relation to demand were found in the
cement, flour, and shoe industries. This type of ineffi
ciency is most likely to occur in industries with rela
tively low barriers to entry and where sellers develop
enough concentration to make oligopolistic price-raising
possible. The oligopolist may reason that it would be
unwise to set prices low enough to prevent new entry and
wise instead to raise prices enough to induce excessive
entry and excess capacity.
Summation
In summary, it may be stated that there is not any
significant relationship between efficiency in scale of
plant or firm to market structure of an industry, other
than that apparently fewer and larger small firms would
lead to improved efficiency.
114
III. THE QUESTION OF PRICE-COST RELATIONSHIPS
A second important aspect of market performance
involves how the selling price of a firm's output is re
lated to its unit costs of production. The appropriate
question for this area is, how does American industry per
form as respects excessive profits? However, before an
attempt is made to suggest an answer to this question, it
is important that a few basic concepts be reviewed.
Economic versus Accounting— The Concept of Profit
A distinction is made between profit as a concept
in economics and profit as a concept of accounting. Profit
as a concept in economics is defined as the residual
received by the firm, of the sales revenue less the costs
incurred to earn the revenue. These costs incurred include
all expenditures for goods and services acquired to pro
duce the output or what is the same thing all payments
going to outsiders other than the owners of the firm. To
these costs must be added an imputed cost which is equal
to the values in the best alternative market, of goods
and services used to produce the output which are supplied
directly by the owners of the firm and therefore not pur
chased. Thus, the critical difference between profit in
115
the economic sense and profit in the accounting sense is
that in economics, account is taken on the cost side for
the next best use of the factors of production owned by the
firm. This is not so in accounting.
The question might be asked, why are profits impor
tant from society's point of view and how large or small
should profits be to be acceptable to society?
Basically, all firms in an industry should receive
over the long run, a profit rate at least equal to the .
basic interest return or cost on owner's investment, if
efficient production under the price system is to be
forthcoming. That is, in the long run, accounting profit
should be equal to or greater than the interest charge on
owner's investment. Thus, Kenneth Boulding describes the
economist's concept of profit as follows:
The economist is interested in measuring supply
price, that is, the price that will just be suffi
cient to persuade factors to cooperate in the pro
duction of a given amount of a commodity. The econ
omist's concept of cost therefore includes a normal
profit, that is, that sum which is just necessary
to pay to the owner of the capital employed in order
to persuade him to keep his capital in this particu
lar occupation. Similarly, it includes the wages
which are necessary to persuade the workers to work
in this occupation, and payments to other factors
necessary to persuade their owners to supply them
to this occupation. The concept of average cost
as including normal profit has the great advantage
116
that it is equal to the supply price of the pro
ducer's output in the sense that if the price of
the product falls below the average cost, its pro
ducer will go out of business.9
However, it should be stated that this is a necessary con
dition only in the long-run sense and for a substantial
group of firms averaged together. Thus, efficient capital
ism can be maintained where there are short-run losses to
individual industries or even the whole economy, provided
that these losses are balanced in the long run by subse
quent short-run excess profits which bring the long-run
average at least up the normal. It follows also that some
individual firms in an industry can suffer persistent
losses (thus go bankrupt and leave the marked), provided
that other more successful firms can make compensating
gains, thus counterbalancing these losses.
Therefore, short-run losses and persistent (long-
run) losses for some firms or industries are consistent
with the long-run average ability of the enterprise system
as a whole to earn a normal profit. Thus, production will
be maintained if a basic return equal to a normal interest
^Kenneth Boulding, Economic Analysis: Microeconom
ics , Vol. I (New York: Harper and Row, 4th ed., 1966),
p. 250.
117
rate is gotten on the average and in the long run.
It should not be assumed that it is desirable that
all short-run or long-run losses be counterbalanced by
profits in the future. Some persistent losses serve to
eliminate inefficient firms from the market and to remove
excess capacity (thus, wasted resources) from an industry.
Thus, ideally, losses serve as a penalty imposed by the
market to force an efficient adjustment of supply to
demand.
However, losses (long-run) are undesirable when
two conditions exist: when losses are persistent over
long periods and in spite of this, a desirable adjustment
of supply to demand is not forced through the removal of
the losing firm or the reduction of the excess capacity
of the losing firm or industry. Thus, the market mechanism
has failed to force an elimination of oversupply, which is
usually the result of immobility of resources from one use
to another.
Also of interest in the area of profits is the
other extreme which involves excess or supernormal profits.
As in the case of losses, short-run excess profits are
usually justifiable for an industry in boom times which
alternate with slumps in business activity. Excess
118
profits may serve to increase a supply which is less than
demand in a particular industry, which is a desirable
function. Such profits, however, may have undesirable
effects on income distribution by diverting a larger share
of the national income to enterprise owners and a smaller
share to the workers. But this situation may be desirable
to the extent that such payments are necessary to induce
some useful response by enterprises. Another possible
undesirable effect of prolonged excess profits is the
effect on the allocation of resources. That is, where
chronic excess profits are earned by some industries but
not by others, the relationship of price to average cost
will differ; of course, this is true by definition.
The result being that industries with the higher
excess profits are restricting output below a competitive
level (a larger output could be sold at a price equal to
average cost), whereas the industries with lower excess
profits are not restricting their output. Thus, rela
tively too little of some outputs are being supplied where
excess profits are high and relatively too much outputs
relative to the makeup of the total output which would
maximize consumer satisfaction, are being supplied where
profits are below normal.
119
In summary, then, we can indicate certain norms
for desirable profit performance. First, long-run average
profit for an industry should approach a basic rate of
interest on owner's investment, being neither persistently
larger nor persistently smaller. Secondly, sporadic excess
profits and losses are acceptable where due to normal
adjustments to demand conditions in the market.
Thirdly, excess profits over a period of time should be
suspect of resulting from monopolistic restriction of out
put and therefore undesirable.
Profit Performance
Given this review of some important basic concepts
relative to profits, it is now appropriate to inquire as
to how American industry performs in this area of profits.
The empirical data is based on Bain's findings in a study
of forty-two manufacturing industries in a five-year
period from 1936 to 1940 and a separate study of twenty
manufacturing industries in two five-year periods, 1936 to
1940 and 1947 to 1951.10
There appears to be a definite relationship of the
"^Bain, op. cit., p. 413.
120
degree of seller concentration to the size of the profit
rate, in that higher seller concentration tends to be
connected with substantially higher rates of excess
profits than does moderate of low seller concentration.
There is some critical degree of seller concentration
above which industry profit rates are higher and below
which they are lower. Thus, industries fall into two
groups.
In the forty-two industries studied from 1936 to
1940, the dividing line between the two groups falls at
about 70 per cent control of the market by the largest
eight firms in the industry. In twenty-one of these indus
tries, in which the largest eight sellers supplied more
than 70 per cent of total industry output, average annual
profit rates were higher (11.8 per cent on equity was the
average) than in twenty-one industries in which the largest
eight sellers supplied less than 70 per cent of the total
output (average industry profit rates being 7.5 per cent).
In the high concentration group the percentage controlled
by the largest eight firms ranged from 71 to 100 per cent
and in the lower concentration group it ranged from 6 8
down to 8 per cent; however, within the groups, the profit
rate was found not to be significantly related to concen-
121
S'
tration. Industries with 80 per cent control by eight
firms did not have significantly different profit rates
than those with 95 per cent control by eight firms and
industries with 60 per cent control by eight firms did
about as well as those with 30 per cent control.
The study of twenty industries in the period from
1947 to 1951 indicated that the same general relationship
continued, that is, above some critical concentration
level (approximately 70 per cent control by eight firms)
industry profits were significantly higher than they were
below this level of concentration.
What then can be determined from this study? Be
cause a significant relationship was found to exist
between profit rates and the degree of seller concentra
tion (excess profits on the average occurred mainly in
highly concentrated industries) indicates that these high
excess profits are in large part due to monopolistic con
trol. A second indication is that there may be two types
of oligopoly involved. These are those where concentra
tion is sufficiently high so that monopolistic pricing
policies are used to produce high excess profits, and
those sufficiently unconcentrated so that they are rela
tively competitive and thus approximate the competitive
122
price and competitive profit. Also, the condition of
entry was found to be significantly related to the profit
rate. That is, industries with high entry barriers (such
that established forms might raise price above minimum
average cost by 10 per cent or more without attracting
entrants) had higher profit rates than industries with
lower barriers to entry. Industries which had high seller
concentration as well as high barriers to entry also had
very high product differentiation (such industries were
the automobile, liquor, cigarette, typewriter, and fountain
pen industries). This high product differentiation may
make competition less workable rather than more, but this
remains an open issue.
Summation
In summary, then, it can be said that where high
seller concentration and high entry barriers are present
in an industry, prices, and therefore profits, are prob
ably under monopolistic influences. However, the adverse
consequences of high seller concentration (monopolistic
pricing tendencies) may tend to be reduced in the presence
of low barriers to entry. Therefore, under these circum
stances, competition will probably qualify as being work-
123
able.
IV. THE QUESTION OF SELLING COSTS
A third area of concern in relation to market per
formance in American industries is that of selling costs.
Are resources being wasted, in that perhaps too large a
percentage of the labor force is involved in promotional
activities? Are prices unnecessarily high because firms
spend too much for advertising? Such questions are proper
in an effort to determine whether or not this area of
market performance meets the standard of being workable.
However, before we attempt to answer the question as to
workability, it is important that a few concepts be re
viewed.
Selling Costs versus Production Costs
Selling costs can be defined as expenditures in
curred by firms in order to stimulate demand for their
output. Kenneth Boulding makes some important distinc
tions as follows:
. . . The process of persuading the buyers to buy
more at each price is called sales promotion. The
total of expenses plus normal profit involved in
sales promotion is called selling cost. Those ex
penses (plus normal profits) which are not specif-
124
ically connected with sales promotion are called
production costs.H
Sales promotion accomplishes two things to a
greater or lesser extent, that is, it informs and it per
suades. This greater or lesser extent to which sales
promotion passes along information and/or persuades is
the key question in determining the workability of the
costs incurred by firms as the result of these promotional
activities.
How, then, should selling costs be measured in
order to determine whether or not they meet the standard
of workability?
The ratio of selling cost to sales revenue is a
good measure. But, how should these ratios be evaluated
or what standards should be used in passing judgment as
to the acceptability of selling cost levels?
First, it must be said that a certain amount of
selling cost devoted to informational purposes is cer
tainly desirable and necessary. However, selling activity
which is purely persuasive rather than informational, can
not be justified from the standpoint of economic welfare
l-*-Boulding, o£. cit., p. 584.
125
as such activities represent a diversion of resources
which could be otherwise devoted to producing a larger
volume of goods and services. This is not to say of
course that a certain amount of choice as respects similar
products does not increase the total welfare of a society.
Again, it is very probable that the type of promoticpnal
activity (persuasive only) referred to here is not only
wasteful from a social standpoint, but is in general not
even beneficial to the firms (other than for defensive
purposes) since such activities may tend to be self-cancel
ling. Bain indicates that a great proportion of selling
costs tend to be persuasive, as he states:
. . . a substantial portion of all sales promotion
costs probably are socially wasteful in character,
and this wastefulness is probably acute in industries
in which selling costs are relatively high in pro
portion to sales revenue.I2
Empirical Findings
Empirical study has led to tentative conclusions
concerning advertising costs. First, in different manu
facturing industries, the ratio of sales expenditures to
sales revenue varied from a fraction of 1 per cent at the
1 2
Bain, op. cit., p. 389.
126
low end to 10 per cent or more at the high end. Secondly,
a major proportion of manufacturing industries had adver
tising costs at a rather low absolute level, whereas a
small proportion of these industries had advertising costs
at a high absolute level. In Bain's study of twenty indus-
1
tries, three-fifths of the industries observed had adver
tising costs at or below 2 per cent of sales and only one-
fifth had advertising costs which were 5 per cent or more
of total sales. In the one per cent category were indus
tries such as the copper, cement, steel, and tin can indus
tries. In the 5 to 6 per cent category were industries
such as the cigarette, liquor, and fountain pen indus
tries. The soap industry had the highest advertising
costs as a per cent of sales with a ratio of 10 per cent.
Thus, it appears that producer goods industries in general
have relatively low advertising costs. Almost all indus
tries with sales costs of 5 per cent or more of revenue
were consumer goods industries. A common element in these
industries was that a high degree of seller concentration
was found and that strong product differentiation created
by advertising was very common. This advertising tended
-^Ibid. r pp. 387 ff.
127
to be more persuasive than informational.
A tentative suggestion is that most of the indus
tries with relatively high advertising costs should be
suspect in that they probably do not meet the standard of
workability as respects selling costs. Of course, it is
difficult to draw the line as to exactly how much adver
tising is desirable, but it can be said that there is a
reasonable range and that some industries have gone beyond
what is reasonable.
In summary, then, it may be said that with respect
to selling costs, it appears that there is a significant
minority of industries in which selling costs are exces
sive to an important degree and thus, the market perform
ance in these industries must be considered to be unwork
able .
V. SUMMATION
Briefly then, what does empirical research tell
us about market performance in matters of efficiency, cost-
price relationships and selling costs?
In the matter of efficiency in scale and utiliza
tion of capacity, it appears that efficiency performance
is generally workable. However, there is usually a sig
12 8
nificant fringe of inefficiently small plants and firms
in individual industries.
In the matter of cost-price relationships or
profit rates, the overall average profit rate for all
firms and industries studied, approaches the competitive
norm. However, again there is a significant minor frac
tion of industries in which long-run excess profits are
realized and these profits are probably the result of
monopolistic output restriction and price raising.
Finally, there is an indication that a significant
fraction of industries incur selling costs which are ex
dess ive.
An attempt has been made to indicate some empiri
cally observed conditions in American industry. In the
next chapter consideration will be given to the laws that
have been enacted in response to certain conditions found
in various industries, in an effort to create a more
workable situation.
CHAPTER V
7o$*Ugs
— *-- THE IMPACT OF THE ANTITRUST LAWS ON PRICING
It was indicated in the previous chapter that
monopoly elements are present in American industry. In an
effort to reduce these elements of monopoly, and thus
create a more competitive environment, various Federal
laws have been enacted. The intent of these laws is to
correct the imbalance as respects the proper allocation
of resources among industries or to make competition more
workable. The imbalance of the allocation of resources
arises from the fact that price, which is the allocator
of resources, is to some degree, not subject to competi
tive forces.
The concern of this chapter will be to indicate
those laws which have as their objective the control of
monopoly elements. The most relevant laws are presented
and their effect upon the monopolist's or oligopolist's
ability to set price is indicated.
The Sherman Act of 1890
Section I of the Sherman Act makes it illegal to
130
actively conspire by formal agreement to reduce competi
tion among rivals. Section I reads as follows:
. . . Every contract, combination in the form of
trust or otherwise, or conspiracy, in restraint of
trade or commerce among the several states, or with
foreign nations, is hereby declared to be illegal.
Every person who shall make any such contract or
engage in any such combination or conspiracy,shall
be deemed guilty of a misdemeanor. . . .
Section II of the Sherman Act indicates that it is
illegal to monopolize, not that monopoly power in itself
is illegal. Section II reads as follows:
. . . Every person who shall monopolize, or attempt
to monopolize, or combine or conspire with any other
person or persons, to monopolize any part of trade
or commerce among the several states, or with for
eign nations, shall be deemed guilty of a misdemeanor.
• • •
Thus, the Sherman Act forbids conspiracies in restraint
of trade, attempts to monopolize, and actual monopoliza
tion, which is defined as possession and use of power in a
way that has adverse effects upon those against whom the
power is used.^
The Federal Trade Commission Act of 1914
The Federal Trade Commission Act established the
■^Corwin D. Edwards, "Public Policy and Business
Size," The Journal of Business of the University of
Chicago, Vol. XXIV (1951).
131
Federal Trade Commission, which has the power to investi
gate the practices of firms engaged in interstate commerce.
A major objective of this commission is to uncover unfair
methods of competition.
The Clayton Act of 1914
The Clayton Act makes price discrimination illegal
when such discrimination tends to lessen competition.
Price discrimination as indicated in Chapter III means
charging a different price to different buyers for the
same product or service. This prohibition of price dis
crimination is found in Section II of the Clayton Act.
Section III makes it illegal for a seller to require a
buyer to buy his product and not to buy the product of a
rival, where such restriction would tend to create a
monopoly.
As respects the elimination of competition by com
bining or merging operations, Section VII makes such com
bining illegal if the results will have the effect of
substantially lessening competition. Thus, Sections III
and VII, in effect, try to stop potential monopoly power
before it is established.
These three acts and the amendments to them repre-
132
sent the core of law which attempts to remove the undesir
able elements of monopoly power from the price system. Of
course, their effect on pricing and output results cannot
be determined by taking these laws at face value; the
interpretations which have been made as respects the
meaning and intent of the laws become the important fac-
tors. However, the purpose of this chapter is not that
of delving into the body of antitrust law, but rather to
indicate the effect this body of law has upon curbing
monopoly power.
I. THE EFFECT OF THE LAWS
]
The effect of this body of law is not as good as
it could be, in that the approach to the problem of the
control of monopoly power tends to be inconsistent. This
inconsistency manifests itself in the mass of federal
legislation that grants various kinds of special exemp
tions, without careful consideration of the impact of it
2
Corwin D. Edwards, The Price Discrimination Law
(Washington, D.C.: The Brookings Institution, 1959).
133
■3
on the general policy of maintaining competition.
This exempting legislation has been passed pri
marily to permit the limitation of competition in indus
tries where technology precludes monopoly and where compe
tition comes close to being atomistic. This has been
done supposedly to prevent competition from destroying
the firms involved or to protect small business from
predatory actions by large rivals. Thus, the law has the
effect of removing the competitive process. This will
allow the inefficiently operated small business to sur
vive, protected by law. Thus, there seems to be somewhat
of a contradiction of goals as respects the elimination
of monopoly elements. The whole area of resale price
maintenance policies is an example of this type of contra
diction .
Conglomerate Organization
In an effort to avoid the antimerger interpreta
tions of the Celler-Kefauver Act (amended by the Clayton
Act), corporations have gone into quite dissimilar lines
of production. Many large firms are simultaneously
^W. Adams and H. M. Gray, Monopoly in America (Mew
York: Macmillan Co., 1955).
134
involved in such diverse activities as meat packing, paint
manufacturing, soft drinks, lumber and other activities.
The term conglomerate may be used to describe this type
of organization.
It is difficult to see how such an organization
can reduce competition because the merging of operations
still leaves the same number of competitors. However, a
problem may arise in that a financial empire may be created
by such organization. It is conceivable that in such an
empire the potential for monopolistic control of price may
be present.
The Federal Trade Commission has recently decided
that investigation into the conglomerate organization may
reveal elements of monopoly power. Thus, such an organi
zation may not be conducive to a healthy competitive
4
economy.
The Economic versus the Legal Approach
Perhaps the underlying cause of the apparent con
flict as respects the goal of antitrust law, is to be
^C. D. Edwards, Big Business and the Policy of
Competition (Cleveland: The Press of Western Reserve
University, 1956).
135
found in the fact that the economic approach and the legal
istic approach to monopoly power are different in nature.
In the legal sense, monopoly power has been inter
preted in terms of restrictive or destructive practices,
whereas in the economic sense, monopoly is seen to exist
where one or a few firms control the market in terms of
pricing and output. Legally, free competition has been
interpreted as a situation where no competitor is limited
in his action by an agreement or by harmful tactics by
larger firms. The economic view is that of pure competi
tion (as opposed to free competition) where no buyer or
seller can by his individual action influence the price
5
of goods bought and sold.
It would appear that no definite statement as to
the effect of the antitrust laws on monopoly elements can
be made, in that the goals of this legislation are not
always clear. However, some general effects can be noted.
The existence of such a body of law tends to dis
courage the obvious monopoly situation. In the area of
oligopoly, it seems reasonable to say that the antitrust
5
Edward S. Mason, "Monopoly in Law and Economics,"
Yale Law Journal, Vol. XLVII (1937).
136
laws have a positive effect in curbing monopoly elements,
in that there exists a certain amount of uncertainty in
the minds of businessmen as to how their actions will be
interpreted and thus, they may be restrained from making
moves which they think might be interpreted as a violation
of the law. This uncertainty arises in part because the
laws are dynamic or are subject to interpretation over
Summation
In summary, then, the antitrust laws tend to
greatly discourage pure monopoly and to reduce the use of
monopoly power in the oligopoly situation. Of course, a
certain amount of power to raise price and restrict output
exists in the oligopoly situation which is not used and
thus cannot be easily detected. This raises the question
of whether laws should be passed banning certain inter
mediate market structures, which is a subject in itself.
In the following chapter, an attempt is made to
integrate the various influences upon price with the view
toward answering the question of whether the price which
is determined, adequately serves in its traditional role
as the allocator of resources, and to present an approach
time
137
to be used in studying reality.
CHAPTER VI
CONCLUSION AND PROJECTION
The objectives of this paper were indicated in
Chapter I and at this point in the presentation, most of
the objectives have been met. That is, in Chapter III it
was indicated that a realistic inquiry into the function
of price in the American economy requires that the tradi
tional theory be adjusted if it is to offer an approach to
reality. The assumption that each firm (seller) sets up
a supply function or faces a demand function, or does both
and that these demand and supply functions can be derived
from utility and engineering data alone was shown to be
unrealistic because a significant proportion of real mar
kets fall between pure competition and monopoly. These
intermediate markets were shown to be identifiable by the
fact that in such markets certain buyers and/or sellers
buy or sell large fractions of the total market volume so
that other sellers and/or buyers are affected by what
others are doing. Thus, the major characteristic of the
relevant structure was seen to be that of oligopoly.
138
139
As was indicated, the oligopolist attempts to
select a definite price to charge and a definite output to
produce rather than setting up a supply function. Inter
dependence was shown to exist in that the output the oli
gopolist is able to sell at any given price depends on the
prices his rivals are charging. Recognizing their inter
dependence, such firms have-.a tendency toward making
agreements among themselves in order to avoid competition.
.In line with this, it was shown that there is a tendency
towards the maximizing of the joint-profit. However, this
is only a tendency, as some of the relevant variables
(such as production processes, advertising, product varia
tion, et cetera) may not be subject to the agreement.
A model was developed as an approach to reality.
That is, the model constructed allows for various realities
to be considered as affecting the final price and output
which will result from the firm's relationships to one
another. This model does not in itself represent any
particular market or industry structure from reality but
serves to indicate the considerations which must be made
in approaching reality.
Chapter IV was included in order to bring in some
empirical research in an effort to indicate what a portion
140
of reality was found to look like. Chapter V was included
in order to indicate some institutional restraints upon
the price system. This inclusion of antitrust law is seen
as having the effect of establishing a boundary for the
extremes of monopoly elements. Its effect on the approach
to reality is to narrow the area for consideration or
exploration, in that those market structures very near the
monopoly end of the continuum between pure competition and
monopoly tend to be eliminated by legal action.
With all the elements of adjustment for the theory
thus considered, the question of the exact approach to
reality can be dealt with.
I. THE APPROACH TO REALITY
It can be taken as given that under conditions of
pure competition, resources will be properly allocated
among industries, that profits will not be excessive, and
that there will be no selling costs which will affect
price because the product is homogeneous.
To be realistic, as was indicated in Chapter III,
it must be recognized that real markets do not consist of
a sufficient number of sellers so that price cannot be
affected, at least in some manner, by their actions. In
141
real markets, products are not usually homogeneous, but
are differentiated so that a price above that of a rival
can be charged over time. In real markets, there is not
necessarily free entry and exit, so that the price charged
and the output produced is not that which would be forth
coming in the presence of competition.
With these considerations in mind, the relevant
question becomes how large a disparity between the theo
retically indicated results and the actual results as
respects matters such as efficiency in production, profits,
and selling costs is allowable in terms of workability.
Workability is defined as the allowable divergence from
the ideal or theoretical results so that the nature of the
system remains similar in kind but different in degree.
That is, if in reality, prices are so controlled that
their theoretical function has been legislated away by
institutional controls, then it becomes meaningless to talk
about the workability of results because workability be
comes what a planning committee says it is.
However, before judgment can be passed upon the
workability of the results produced by the "adjusted
price" (price which results from considerations indicated
in Chapter III), a method of approach as respects the
142
tying of the adjusted theory to real structures must be
indicated so that the researcher may place actual results
found next to theoretically indicated results and compare
the two. It can be assumed that such an effort is meaning
ful in that the theoretical functions of price have not
been taken away by legislative order, except of course in
those known to be noncompetitive areas (public utilities).
With the goal in mind of being able to make a
statement as regards the pricing of products (in relation
to the costs of production) as being near or far from the
theoretical price and thus providing or failing to provide
for the distribution of resources between industries on
a workable basis, an approach is suggested. However,
before the details of the suggested approach are given,
it will be meaningful to indicate briefly the problem
created by the improper allocation of resources.
If high excess profits are being earned by some
firms, industries, or sectors of the economy but not by
others, the relationship of price to average cost differs
between these firms, industries, or sectors. Thus, the
firms, industries, or sectors with high excess profits
are essentially restricting their outputs below a desir
able level as a larger output could be sold at a price
143
equal to average cost. Those firms, industries, or sec
tors with lower or no excess profit are not similarly
restricting outputs. Thus, relatively too little output
is being supplied by those firms, industries or sectors
with high excess profits and relatively too much of other
outputs relative to the makeup of total output, which
would maximize buyer satisfaction.
The Suggested Approach
Since there are a great number of industries and
many more firms in the American economy, the tools pro
vided by statistical analysis are suggested.
The first step is to sample various firms in
various industries within a particular sector of the econ
omy. By sectors is meant all those industries engaged in
a particular type of endeavour. For example, the whole
sale and retail trade, the manufacturing, the finance,
the construction, et cetera, sectors can be distinguished.
Diagram 10 will be helpful in emphasizing the relation
ships in the American economy between the firm, the indus
try, and the sector. As indicated, the first step is to
sample various firms (designated by letter A in all sec
tors) in order to determine the average profit rate over
144
w
B *f
Bh
Diagram 10.
Intra-sector industry comparison
i t t > i i V M-M-- Industry comparison between sectors
• » • > * * Firm comparison between sectors
Area, R S T U — The American economy
W X Y Z — Sectors
B — Industry
A — Firm
145
a given period of time. (Such information can be derived
from the Treasury Department's annual report on corporate
incomes.) This will give the industry (designated by
letter B) average profit rate for the given period. The
same procedure should be followed for each sector (desig
nated by letters W, X, Y, and Z). When the average profit
is determined for each sector then the average profit rate
for all sectors can be determined; thus, the average profit
rate for the economy as a whole can be determined. Of
course, knowing the average profit rate for the economy as
a whole is not very valuable information when the purpose
of the investigation is to determine if price is function
ing as it should, because in this case the important ele
ment is the relative profit rate between the firms, indus
tries, and sectors.
The relationship between industry and in
sector or industry B^ and B^ in sector X, as respects
profit rates, is seen as the more relevant relationship
than just saying that the average profit rate for the
American economy is so much. If as the result of analysis
profit rates are found to be very high in industry B-^ and
close to normal in industry B^/ then the allocation of
resources will not be satisfactory.
146
Again, the major value of this firm-industry-sector
model is that it provides a structure for inquiry.
The model structure can be varied, depending upon
the purpose of the particular inquiry. For example, if
a quick estimate of comparative profit rates between XB^
and XB2 is desired, the method of taking averages, as pre
viously indicated, can be used. Building such a structure
of relationships based upon averages should serve to reveal
areas that will require further study (averages should
reveal relative differences). Once the problem industry
is tentatively identified, and thus further study is indi
cated, an alternative method of arriving at the "A" values
will be required. For example, if it is found, by the
averaging method, that WB3 is making substantially higher
profits than WB-^, this will be the signal that perhaps B^
and B^ should be looked at to determine possible reasons
for variation. This further study will require that the
respective "A" values be replaced (averages are no longer
a reliable enough measure) in some manner which will
reveal more nearly the true value (profit rate, selling
cost, et cetera) under consideration. For example, rather
than just sampling from the total population of all the
firms in industry B^ and coming up with an average value
147
(say in this case an average profit rate), it would be
necessary to choose from B1 the five or six largest firms
(in terms of sales in the relative market) and then look
for conditions of market structure, as described in Chapter
IV, which may be responsible for the high excess profit
rate.
This procedure could be gone through for the entire
economy for whatever variables are considered relevant to
the researcher's particular study (that is, the "A" values
could designate: profit rates, levels of selling cost,
efficiency in terms of excess capacity, et cetera). Com
parisons could be made between WB^ and YB^ or WB^A^ and
AB3A2 (see Diagram 10, firm comparisons between sectors).
Thus, there is almost an infinite number of comparisons
which can be made, again the comparisons made will depend
upon the purpose of the particular study.
Thus, a methodology for the approach to reality
has been indicated. The adjusted model presented in
Chapter III becomes useful after an inquiry such as the
one suggested above has been made. The gap between theory
and reality cannot be spanned by continually adding to the
model presented in Chapter III, as this results in adding
theory to theory. Thus, reality can only be reached by
148
introducing an intermediate step such as the structure
suggested above; this is why it was stated that the model
presented in Chapter III becomes useful after rather than
before the reality of the conditions in a particular mar
ket are determined. The model in Chapter III is useful
in that it indicates possible reasons why the "A" values
in a particular industry are what they are.
As indicated in Chapter IV, which represented a
level B inquiry (study of industry relationships within
the manufacturing sector), pricing in that sector (price
as influenced by conditions of efficiency, selling costs,
and so on) results in a reasonably good allocation of
resources.
II. THE FUTURE ROLE OF PRICE
John Kenneth Galbraith1s The New Industrial State,^
holds a rather pessimistic outlook in regard to the future
of the price system. Galbraith sees the business segment
of the economy merging with the government segment in
Ijohn Kenneth Galbraith, The New Industrial State
(Boston: Houghton Mifflin, 1967).
149
response to the technological environment which creates a
great need for centralized planning and controlled prices.
Since the large corporation cannot do the complete job
in all areas of planning such as the education of highly
specialized man-power technological research on a vast
scale, it will tend to become partners with government,
thus the state and the corporation will merge.
It is believed that Galbraith's presentation is
exaggerated, with the purpose in mind of stimulating the
American society out of its complacency.
It can be said that the price system has proven to
be the best known system for the efficient allocation of
resources among producing units and for the efficient
coordination of the factors of production within the pro
ducing unit. An indirect proof of this allegation is
seen in that in socialist countries, artificial prices are
being put on the various factors of production in an effort
to efficiently combine these factors in producing final
products. Artificial profit goals have also been estab
lished in an effort to provide direction for the flow of
resources.
In summary, it can be said that the price system
will not be replaced by centralized planning because it has
150
proven to be too valuable a system. However, this is not
to say that periodic examinations of its functioning and
adjustments to it will not be necessary in order to main
tain its proper functions.
III. SUGGESTION FOR FURTHER STUDY
Given that periodic adjustments to the price sys
tem will be necessary, it would then be a meaningful under
taking to analyze the whole of the American economy, with
the view of comparing the functioning of price as found
by research, to its theoretical functions. Perhaps the
methodology suggested in this chapter could be used.
BIBLIOGRAPHY
BIBLIOGRAPHY
A. BOOKS
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• >
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152
153
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Oser, Jacob. The Evaluation of Economic Thought. New
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Stigler, George J. The Theory of Price. New York: The
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Tawney, R. H. Religion and the Rise of Capitalism. New
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B. ARTICLES
Allen, R. G. D. "A Reconsideration of the Theory of
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154
Apel, H. "Marginal Cost Constancy and Its Implications."
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v
Backman, J. "The Causes of Price Inflexibility."
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Bain, J. S. "A Note on Pricing in Monopoly and Oligopoly."
American Economic Review, XXXIV. 19 49.
________ . "Market Classifications in Modern Price Theory."
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Bliden, V. W. "The Role of Trade Associations in the
Determination of Prices." Canadian Journal of
Economics and Political Science, IV. 19 38.
Bober, M. M. "Price and Production Policies." American
Economic Review, XXXII. 1942.
Bronfenbrenner, M. "Price Control under Imperfect Compe
tition." American Economic Review, XXXVII. 1947.
Burns, A. R. "The Organization of Industry and the Theory
of Prices." Journal of Political Economy, LVI.
1948.
Cassidy, R., Jr. "Maintenance of Resale Prices by Manu
facturers." Quarterly Journal of Economics, LIII.
1938.
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American Economic Review. (June 19 40).
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Journal,Vol. LV (April 1945), pp. 112-113.
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1937. Pp. 386-405.
Cooper, W. W. "Theory of the Firm: Some Suggestions for
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XIV. 1946.
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Edwards, Corwin D. "Public Policy and Business Size."
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Creator Ballard, Raymond (author)

Core Title Price in the American economy: A theoretical inquiry

Degree Master of Arts

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag economics, general,OAI-PMH Harvest

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Advisor Phillips, E. Bryant (committee chair), Pollard, Spencer D. (committee member), Wang, George (committee member)

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