Gravitation, Full Cost Pricing and Prices of Production

Franklin Serrano (Guest blogger)

Most Sraffians understand that gravitation of market prices to normal prices is much quicker than the slower, but inevitable, adaptation of capacity to demand. But other eminent Sraffians have made some confusion by wrongly identifying classical prices of production with full cost pricing.

Classical prices of production are the centre of gravitation for market prices and are determined by the costs of the dominant techniques (at the level of normal utilization of fixed capital) and the state of distribution. It is a general theory of the structural determinants and limits for the trend of market prices in all types of markets. In spite of the similar name it has little or nothing to do with “normal cost” or full cost pricing which is a generalization of the descriptions given by some firms as to how they actually calculate their own prices based on a markup over their own costs (not those of the dominant technique).

First of all, there is obvious fact that the theory of prices of production was developed in a historical period in which such these pricing rules simply did not exist (see Hicks’ Market Theory of Money, 1989). And prices of production can still explain, in my view, the structural or trend element even in markets with highly flexible prices subject to wild short run fluctuations and rampant speculation, as in the so-called “commodity” markets (in Garegnani’s comment on Asimakopulos he explicitly mentions the importance of explaining the trend of the relative price of copper even though “at any one time copper prices are 50% or more above or below trend”)

Second, even in the so called fix price markets, were firms set the prices of their products directly, the full or "normal cost" that particular firms use to calculate their own price is the actual cost of these particular firms and the markup these particular firms think they can add to prices without trouble. These calculations generate actual market prices or (if stylized enough to have some generality short run theoretical prices) that are not unique even for a single market as the full cost prices can be different for different firms. These prices differ from prices of production because they refer to the actual costs of some firms and not the costs of the dominant technique available. For that particular product that determines a single price of production for that market.

The way prices of production may regulate the full cost prices of firms is by getting them in trouble whenever their actual costs plus their desired markups are too high relative to the costs (including normal profits) of the dominant technique, thereby attracting new entrants or cause some rival firms inside that market not to follow price rises that are due to increase in costs particular to that firm or “excessive” desired markups of these firms.

Professors Fred Lee and Marc Lavoie are both absolutely right and some Sraffians wrong in saying that full cost pricing is NOT the same thing as the classical theory of prices of production. Where I think they are definitely wrong is in thinking that classical prices of production are thus irrelevant for market forms in which firms follow such rules. For, through the power of actual or potential competition, the classical prices of production are the centers of gravitation that regulate even the trend of the prices of firms that practice full cost pricing. The closest analogy between classical prices of production and the industrial organization literature is thus the concept that Sylos-Labini called “limit” prices.

So market prices in both fix and flex price markets gravitate, towards or around classical prices of production. Any theory of full cost pricing can at best be a particular theory of short run price behavior of some firms in particular types of markets. There are old papers by James Clifton that started this confusion many years ago in Contributions to Political Economy and the Cambridge Journal of Economics. It is about time we stop confusing ourselves and our post Keynesian friends on this issue.

References:

Lavoie, M. (2003), “Kaleckian Effective Demand and Sraffian Normal Prices: Towards a reconciliation,” Review of Political Economy, 15(1) available here.

Lee, F. and T-H. Jo (2011) “Social Surplus Approach and Heterodox Economics,” Journal of Economic Issues, 45(4) available here.

Garegnani, P. (1988), “Actual and Normal Magnitudes: A Comment on Asimakopulos,” Political Economy, republished in Essays on Piero Sraffa: Critical Perspectives on the Revival of Classical Theory, Routledge, 1990.

Sraffian economics vs. Post Keynesian methodology

A very nice debate on the nature of heterodox economics took place yesterday in a heterodox conference in Buenos Aires. Sergio Cesaratto and Marc Lavoie (depicted above during the interval) presented alternative views which, in spite of some important differences, agreed that Sraffian economics is part of the broadly defined heterodox Keynesian camp (or Post Keynesian if one prefers the term). The question of the relation of Sraffians, and more broadly all of those that believe in the importance of the old classical political economy school (from Petty to Marx, including Quesnay, Smith and Ricardo), with non neoclassical Keynesians, that is, those that believe that unemployment does not result from some rigidity or imperfection (be that of the price, wage or interest rate), has been difficult to say the least.

Marc presented first. A version of the paper is here. Taking aside obvious confusions, and sloppy scholarship of the type that suggests that Sraffians accept Say’s Law, because in the determination of normal prices quantities are taken as given (the fact that those quantities are determined by demand in accumulation theory is, apparently, not understood by these critics), the main line of critique of Sraffians comes from what Marc refers to as Post Keynesian methodologists. For him, “the influence of methodologists ... felt through the study group around Tony Lawson at Cambridge ... that [argues that] proper economics should be based on critical or transcendental realism and ‘open’ systems” and that has led to an “‘open systems’ criterion to judge whether a model can be given a post-Keynesian stamp of approval” (Lavoie, pp. 6-7).

Marc correctly dismisses this supposition that from a methodological point of view the Sraffian approach is limited to closed models. As he clearly notes the Sraffian price equations require that one distributive variable (real wages or rate of profits) are determined exogenously outside of the system by historical and institutional circumstances, which by definition makes it an open system, that is, one in which there is an exchange with its environment. Marc, in fact, suggests that the strong case for a Sraffian-Keynesian interaction is based on the fact that the determination of the rate of profit by the exogenous short term rate of interest set by the central bank provides an obvious link to Post Keynesian endogenous money literature (Pivetti and Panico’s work in that area, among others, shows that Sraffians do have a lot to say about money too, by the way).

Marc notes that the main reason, however, why Post Keynesians reject the Sraffian approach is there is “little enthusiasm for any notion of long-period ‘prices of production’ as centers of gravity towards which short-period or market prices are supposed to tend” (p. 14). However, as Marc suggests there is little difference between prices of production and full cost pricing. Full cost pricing, in my view, should be connected to the Oxford Economists Research Group (particularly P.W.S. Andrews, a tradition that through Andrews’s disciple Wynne Godley influenced Cambridge Keynesians). In other words, I see full cost pricing as compatible with the normal prices in Sraffa, both being determined by a mark up, which represents the social conflicts that allow one class to subtract surplus from another, over costs, which are determined by the technical conditions of production.

My main disagreement with Marc’s exposition, then, is related to his argument that “if one wishes to connect Sraffian economics with the other strands of post-Keynesian economics, one needs to examine production prices in a different light, not as long-run or long-period centers of gravity to which market prices tend” (p. 15). This is also complicated by the incorrect notion that gravitation requires the use of marginalist principles in order to obtain that market prices converge to normal long term prices, which is not the case [I’ll leave the details of that for another post though]. It seems to me that Marc believes somehow that full cost prices are somehow not fully adjusted prices, and that firms do not use their normal costs rather than their short run costs when computing prices.

Sergio counter presentation (not available, but you can check some of his extensive publications here), was narrower in scope, and dealt with the difference between certain Post Keynesian growth models (in particular the so-called Neo Kaleckian school) and Sraffians (he also distinguished among certain Sraffian groups). I should note that Cesaratto agreed with Marc in his rejection of the critique of the so-called Post Keynesian methodologists, and suggested that their lack of understanding of the capital debates and its consequences, reduces the significance of their views. He correctly points out that the capital debates produced the only occasion that forced neoclassical economics to openly recognize its flaws, and, I would add, led to a significant change in the way they do economics, forcing the change in the notion of equilibrium and the development of disaggregated intertemporal short term models (i.e. without a uniform rate of profit, something first noted by Piero Garegnani).

Sergio notes that when dealing with models of accumulation there are three features that most heterodox groups would want to incorporate in their models, namely: (A) the Classical (or in general exogenously given) income distribution, (B) the Keynesian Hypothesis of an investment rate independent from an exogenously given rate of savings, and (C) normal accumulation paths, with the traditional corollary of a long run normal degree of capacity utilisation. Between these three features one obtains what Sergio refers to as the Magical Accumulation triangle.

Neo Kaleckian (NK) models (some of Marc’s models, particularly in his Foundations of Post Keynesian Economic Analysis are of this type, but not the ones in his book with Wynne Godley) tend to assume A and B, but not C. The absence of the notion of normal (or fully adjusted) positions, as we saw above with regards to prices, is the main difference between the NKs and what Sergio calls the supermultiplier Sraffians (which have A, B and C). The supermultiplier models (which are in a sense Kaldorian, on Kaldor and Sraffa see this paper) implies that long term capacity output (not optimal in the sense of full employment) is determined by the exogenous components of demand, and investment is derived demand (as noted by Sergio the key contribution here is Franklin Serrano’s PhD thesis).

Here it is important to note why long term normal positions are important. It has little to do with a belief that economic systems are stable and tend to optimal levels, since the normal positions are tendencies, and are, generally, below full capacity, and crisis are the norm. Normal positions are important because they show that the regular functioning of capitalist economies does not produce efficient allocation of resources. Without suggesting that those that deny the relevance of long term positions are imperfectionists in the same sense that neoclassical authors that believe that an accumulation path below full employment is due to price, wage or interest rate rigidities, the argument still relies on an inability of capacity to adjust fully to the exogenous growth of the autonomous components of demand. The question then is why would a business not invest enough to keep its capacity growing in line with the growth of its demand? Here, I believe, lies the fundamental difference between classical-Keynesians (or supermultiplier Sraffians) and Neo Kaleckians.

By the way, as I noted before in the blog, the use of the term Kaleckians for the NKs is a bit of a misnomer, since the models derive really from Joan Robinson (and as noted by Sergio, Harrod and Steindl too). In part, I think, for her role in the rejection of normal positions and her views on history versus equilibrium, Sergio suggested that Robinson played a negative role in these debates.

There are several other things to discuss about this topic (the role of Joan Robinson among the important ones), brought about by the interesting, controversial, but very friendly debate between Marc Lavoie and Sergio Cesaratto which I’ll leave for other posts.

MMT and its discontents

The Washington Post had a substantial profile on what is now termed Modern Monetary Theory (starts with Jamie Galbraith, and then goes on to the Kansas version of post Keynesian economics). A few reactions in the blogosphere. Two worth noticing are by Dean Baker and Jared Bernstein that provide qualified support.

Dean suggests that beyond fiscal deficits stimulus should also come from monetary policy (lower interest rate), and a more depreciated dollar. My guess is that, at least the Kansas MMTers would be fine with both, but suggest that lower rates of interest are not much in play now. But from what I understand a depreciated dollar has been seen as part of a solution by most progressive economists. Randy Wray, for example, is certainly less concerned with the size of a trade deficit than Dean, since the US is the issuer of the key currency [I have less confidence on flexible exchange rates as a way of solving balance of payments constraints in developing countries, but I'll leave that for another post].

My concern with Dean's notion of a more devalued dollar, which is generally fine and will not lead to the demise of the dollar in the near future, is that for the workers with low wages that depend on cheap imports at Walmart it implies higher prices and lower real wages. A boost to increase real wages would be necessary [see Jamie on that here]. So better income distribution should be the most important channel to boost consumption on a sustainable way.

Jared Bernstein fundamentally adds that taxes on the wealthy should be increased. Which he argues from a political standpoint, and I think it is quite reasonable, since that is one way (besides hiking minimum wages, and repealing right to work and other anti-labor legislation) to improve income distribution.

On a more personal level, my problem with the WaPo piece, and the general discussion of MMT, is that for the most part it sees MMT as just a policy program (the Kansas one is, for example, an Employer of Last Resort of some type, which is fine with me, by the way), and does not separate the theoretical discussions from the policy stuff.
Endogenous money, chartalism, and functional finance, are relevant because they fit the theoretical framework of a coherent heterodox alternative to the mainstream based on Keynes' Principle of Effective Demand [for a full alternative you need also long term pricing; in Kansas your man for that would be Fred Lee]. For my views on that go here. I think, hence, that a coherent alternative to the mainstream, beyond Keynesian economics, requires a good dose of the old and forgotten methods of classical political economy.

PS: My point about theoretical versus policy matters is driven by the fact that on certain policy issues, like the need for further fiscal stimulus, New Keynesians like Krugman and DeLong would be fundamentally in agreement with MMTers.

Keynes's General Theory: Seventy-Five Years Later

This volume, a collection of essays by internationally known experts in the area of the history of economic thought and of the economics of Keynes and macroeconomics in particular, is designed to celebrate the 75th anniversary of the publication of The General Theory.

The essays contained in this volume are divided into four sections. The first section contains three essays that explore the concept of fundamental uncertainty and its unique role in The General Theory. The second section contains five essays that examine the place of The General Theory in the history of macroeconomics since 1936. The third section contains three essays that explore the interrelationships among Keynes, Friedman, Kaldor, Marx and Sraffa and their approaches to macroeconomic theory and policy. The final section contains four essays that provide several new interpretations of The General Theory and its position within macroeconomics.

Keynes's General Theory is intended for those students and scholars who are interested in the economics of Keynes and the rich variety of approaches to macroeconomic theory and policy.

The Euro Imbalances and Financial Deregulation

New paper at the Levy Economics Institute. From the abstract:

Conventional wisdom suggests that the European debt crisis, which has thus far led to severe adjustment programs crafted by the European Union and the International Monetary Fund in both Greece and Ireland, was caused by fiscal profligacy on the part of peripheral, or noncore, countries in combination with a welfare state model, and that the role of the common currency—the euro—was at best minimal.This paper aims to show that, contrary to conventional wisdom, the crisis in Europe is the result of an imbalance between core and noncore countries that is inherent in the euro economic model. Underpinned by a process of monetary unification and financial deregulation, core eurozone countries pursued export-led growth policies—or, more specifically, “beggar thy neighbor” policies—at the expense of mounting disequilibria and debt accumulation in the periphery. This imbalance became unsustainable, and this unsustainability was a causal factor in the global financial crisis of 2007–08. The paper also maintains that the eurozone could avoid cumulative imbalances by adopting John Maynard Keynes’s notion of the generalized banking principle (a fundamental principle of his clearing union proposal) as a central element of its monetary integration arrangement.

Read the rest here.

Paul Davidson on Obama's job speech

Here is a link to an interview with Paul Davidson. He makes it clear why a payroll tax cut and other incentives to hiring will not be enough to create new jobs. Lower costs will not lead to hiring if there is no demand. It's not just basic economics, it's simple logic.

What is the correct Keynes solution

Paul Davidson at Triple Crisis.  Most of the post is about Keynes' views on money, and how, contrary to the mainstream, for Keynes money is not neutral. He says:

"In Keynes’s solution to our global economic problems, the primary function of well organized and orderly financial markets is not to optimally allocate capital. Instead it is to provide liquidity so that holders of financial assets traded on such markets “know” he/she can make a fast exit and liquidate their portfolio position at a price close to the previous market price at any time he/she fears something bad is going to happen in the future. For business firms and households the maintenance of one’s liquid position is of prime importance if bankruptcy is to be avoided. In our world, bankruptcy is the economic equivalent to a walk to the gallows."

True, but the important point now is that we are at an Eccles' moment.  In other words, monetary policy is like "pushing on a string."  We need fiscal policy, and to understand that deficits and debt are not a problem, they are the solution.

Monetization of debt: what does it do? Krugman and Rognlie on MMT

Again in a previous post I suggested I would deal with the issue, which seems to be apropos, since there has been a certain discussion in the blogosphere about the so-called Modern Monetary Theory (MMT) approach (see here, here and here). First, I should clarify that the discussion to which I refer tends to conflate two different issues. One is the question that I will deal here, what are the constraints faced by the government in managing its budget, and the approach associated with MMT in this case is basically what used to be called functional finance, a tradition that harks back to Abba Lerner and Evsey Domar, and to which Keynes eventually agreed.

The other issue is related to the causality between money and economic activity, and is part of what in more modern times has been called endogenous money. The debates on this issue are older than the Bullionist/Anti-bullionist and Currency/Banking schools, and in modern times the endogenous money (anti-bullionist-banking) view was developed by Nicholas Kaldor and Basil Moore among other names. The reason the two issues tend to be conflated is that printing money is one way to finance government spending, and there is a traditional connection between sound finance and monetarist (exogenous money) views.

First, it is clear that if debt is denominated in domestic currency default per se is NOT possible, simply because the government can always monetize the debt. So the question is not whether the government has a budget constraint (what’s the meaning of a constraint if you can print money anyway), as Matt Rognlie says (he gets worked up by this, and affirms that: “MMT is wrong on money … The government does have a budget constraint”). Unless he denies monetization of debt is always possible (there might be political problems, but it is technically possible) in domestic currency, he needs to explain what is the constraint. Otherwise the question is really related to the consequences of monetization. By the way, that is the same confusion made by Krugman. He says:

“As I understand the MMT position, it is that the only thing we need to consider is whether the deficit creates excess demand to such an extent to be inflationary. The perceived future solvency of the government is not an issue.”

Again, what could be the solvency issue if the debt is denominated in a currency that the government controls? He may have issues with the consequences of printing money, but not with the fact that money can be printed. So solvency is NOT, and cannot be an issue. What are the consequences of monetizing debt then?

Long ago the authors of the Banking school (e.g. Thomas Tooke) noted that if more money is pumped into the system agents would spend the money or pay their debts (the second case is known as the reflux mechanism). If they pay previous debt, the money has no effect on the level of activity. On the other hand, if they spend and firms have extra capacity output must increase. Note that firms normally have extra capacity, and can produce more at the same price, contrary to the textbook (U-shaped) cost curves.

But what if the economy is at full capacity? Then it is clear that excess demand may have an impact on prices (or, if instead of monetization, the government prints more debt agents may demand higher rate of interest to hold it). The question then is whether the economy is at full employment and what determines full capacity, not whether monetization is always inflationary (which clearly would only be the case if the economy was always at full capacity; unless Krugman and Rognlie agree with Lucas, this could not be the case for them).

However, note that it has been accepted that the supply constraint is variable (the mainstream refers to it as the Time Varying Non Accelerating Inflation Rate of Unemployment or TV-NAIRU). The important question regarding monetization is what determines this supply constraint that imposes an inflation barrier to demand expansion, what Friedman referred to as the natural rate of unemployment (note that natural was meant to suggest that policy cannot affect it).

Here it is also important to note that one component of demand, investment, does have an impact on the supply side. In other words, investment has a dual effect, it is a component of demand (more sales of equipment) and it creates more supply capacity in the future (when the equipment is installed). So, as the economy grows, firms try to adjust their capacity to demand, so as to keep up with the economy, and avoid loosing market share to competition. This suggests that one of the reasons for the variation of the supply constraint is the expansion of demand itself.

It should be noted that this does not mean that the supply constraint is never reached, but it is clearly a rare phenomenon. The graph below shows unemployment in the United States from 1929 to 2011. Only in four occasions did the annual average unemployment fall below 4%, in the mid-1940s, the early 1950s, the late 1960s and the late 1990s (all during Democratic administrations, by the way, with the exception of 1953).

Inflation did accelerate in the first three, when the economy, because of war efforts (WW-II, Korea and Vietnam), was most likely close to full employment (I’m more skeptical about the 1960s, since inflation really picks up in the 1970s, and oil shocks where more important than full employment), but not in the last. Even in those cases, only in the first public debt was actually growing, and the size of the deficits (more than 20%) was incredibly large.  Interest rates did not increase significantly in any of these episodes either (this seems to be Rognlie bone with MMT).

This is the evidence that is used to suggest that governments have a constraint and beyond that inflation ensues? And that is taken as serious thinking on money and deficits! I would agree with Robert Vienneau that this is “unjustifiably arrogant” dismissal of MMT, to say the least.  Part of what I have referred to as the incredible persistency of monetarist views (even among more progressive economists).