Supply in a Market Economy

Richard Jones

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000478129
• Edition: 1
• Topic: Volkswirtschaftslehre
• Subtopic: Wirtschaftstheorie

Originally published in 1976, Supply in a Market Economy was a new kind of introductory micro-economics text which both assesses the usefulness of traditional theory in tackling social and economic problems and compares and contrasts the alternative approaches to the practical problems inherent in the allocation of scarce resources. Richard Jones has succeeded in bringing together the most useful features of a standard microeconomics theory book with empirical and applied material more usually dealt with separately in second year surveys of industrial organisation.

The book gives full coverage to the standard theories of the firm, of production, of cost and scale, and of location, to recent critiques of these theories and to alternative approaches now being proposed. Integrated into this theoretical background is a clear analysis of the relationship of these theories to market structures and the economics of industry, and a 'real-world' examination of markets in action – with individual sections on the control of rents, on the water supply industry, on the effect of taxation on commodities, and on the economics of crime and its prevention.

Supply in a Market Economy would prove to be an invaluable new course-book for first and second year students of microeconomics at the time and particularly for those non-specialists who were impatient to see the relevance and applications of traditional theory to real problems. Now it can be read in its historical context.

Chapter 1 Introduction to the Theory of Supply

The theory of supply is one of the building blocks from which that part of economics known as price theory or microeconomics is constructed.¹ This book is therefore concerned with only one part of a whole which traditionally is examined in its entirety. This approach has both advantages and disadvantages. In particular, much must be taken on trust, for example the demand curve. On the other hand, material which would not, according to established conventions, be contained in one course can be placed in juxtaposition, for example the large body of empirical data which constitutes what may for convenience be defined as industrial economics.²

In this chapter the nature of economic theory and the methodological controversy which has surrounded the so-called received theory of the firm since the 1930s are described.³ The issues examined in this section are of fundamental importance because it is not possible to make a realistic assessment of the value of this branch of economics unless its true nature is clearly appreciated at the outset.

Economics, according to a widely accepted definition, is the science which studies the relationship between ends (uses) and means (resources) which are scarce, in the sense that they are insufficient to satisfy all the alternative uses to which they may be applied.⁴ Economic goods are those which are scarce. In the absence of scarcity no economic problem (in terms of the above definition) can exist, although it is becoming increasingly clear that very few things which are not scarce can be identified. Many economists do not wish to accept this definition of economics, and argue that it arbitrarily restricts and determines the scope of the questions considered by the economist and the procedures applied to problem solving.⁵ Ward argued that the 'idea that means and ends are distinct forms the basis for the positivist approach .... Behind the formal structure of economics lies an attitude toward ethics that is essentially technological, because of the economist's inextinguishable interest in tradeoffs, in appraising situations in which you always have to pay a price of some kind to get something you want'⁶ In general terms, it is argued that the supposedly objective approach of orthodox economic science is in fact value-laden. That is, what is taken as a datum depends in fact upon an implicit value judgment over which men may disagree – for example, negative income tax proposals consider the distribution of a given amount of resources but ignore the question of how large this amount should be; the notion of efficiency relates inputs to outputs yet the basis upon which variables are classified into either category is not necessarily fixed. Ward argued that the ends-means approach is not 'a natural way to look at human problems' and that it would be desirable to find some alternative system which was capable of integrating a consideration of values into economic science.⁷

These objections may be well-founded. No economist would seek to deny that any given problem can be examined by a number of alternative frameworks. Acceptance of the above definition of economics need imply no more than a belief that, by bringing a particular – albeit restricted – viewpoint to bear upon problems, useful results may be obtained. This is a quite legitimate argument. Nor does it necessarily follow that there is 'something wrong with economies' if one group of people who call themselves economists (within the ends-means framework) disagree with another group over what questions are to be considered important and proper subjects for study. The really important points are (i) whether or not the approach adopted enables the economist to achieve the task he sets himself, and (ii) whether or not the insights and knowledge thereby produced are useful in solving society's problems, perhaps in conjunction with other information generated by other branches of science. To apply the so-called ends-means philosophy to questions such as the supply of hospital beds or the housing shortage is not to deny that the problems have other dimensions but rather to believe that some insights into the nature of the problem may be obtained by adopting a restricted viewpoint.

Let us now return to the question of scarcity. Scarcity implies choice, and in the presence of scarcity some mechanism must be found for distributing scarce means between alternative uses. Two systems have developed: in one, some central planning authority assumes the responsibility for deciding what will be produced and how it will be distributed; in the other, the solution is sought in the operation of markets.⁸ A market may be defined as a system of communication between buyers and sellers of particular goods. A market is said to be perfect when all buyers and sellers are in such close touch with one another that only one price can rule at any one time. In a perfect market the price of a good is determined by the intersection of supply and demand curves. In this book the derivation of the supply curve will be examined. The demand curve will be taken as given, and it is assumed that demand curves slope downwards from left to right when price is plotted on the vertical axis and quantity demanded on the horizontal axis of a two dimensional graph. In a market or free enterprise society, goods and services are supplied by individual economic units known as firms and the total supply of a product is the result of the production decisions of these business firms. In order to assist in the analysis of the operation of the market system economists have devised a body of theory known as the theory of supply or the theory of the firm. Some economists have argued that the legitimate focus of interest is the aggregate supply curve and that the reality of the concept of the firm employed to derive that curve is irrelevant.⁹ This position has been challenged and has led, as will be seen below, to a prolonged controversy within economics.

A supply curve may be defined as a curve showing 'the maximum quantities per unit of time that sellers will place on the market at various prices'.¹⁰ The aggregate or total supply curve is built up from the production decisions of individual firms.¹¹ These decisions depend in turn upon the costs of production in those firms. These are the relationships examined in this book. Let us assume that both the supply and demand curves have been determined. They may then be utilised to determine market price. Two important questions arise at this point: what set of questions is this set of analytical tools designed to answer, and have the basic methodological underpinnings upon which this structure is based been appreciated?

These two questions are clearly related. A great deal of controversy in economics has been caused by a failure to specify exactly what it is that received theory is attempting to achieve and, consequently, by an inability to achieve consensus on the extent to which these objectives have been fulfilled, or even on what criteria should be employed to determine the appropriateness of the methodology employed in deriving the model.

The first part of this book is consumed by an exposition of the received theory of the firm. This has been extensively criticised over the last forty years and substantial revisions have been advanced. A large proportion of the dissatisfaction with received theory felt by many economists has revolved around methodological issues. It will be appropriate therefore to begin by examining the methodology employed to derive the received theory of the firm. By methodology is meant 'the logic behind a given procedure – the logic which justifies the use of a given procedure to solve a problem'. This should be distinguished from method, which refers to techniques of solution.

At this stage it is necessary to introduce some other terms commonly encountered in economics. The first is the distinction between positive and normative statements. Positive statements are concerned with what is: in Friedman's words, the task of a positive statement 'is to provide a system of generalisations that can be used to make correct predictions about the consequences of any change in circumstances'.¹² A normative statement is, on the other hand, concerned with what ought to be. For example, the statement that 'information in the labour market is a valuable scarce resource and therefore institutions will produce and supply information' is a positive one, whereas the statement that 'information in the labour market should be a free good' is a normative one; the statement that 'if exports of beef increase the home price will rise' is a positive one, whereas the statement that 'exports of beef should be prevented' is a normative one.

Next let us examine the nature of economic theories. A theory is designed to provide explanations of economic activities and events. A theory has two functions which are combined to produce this result: (i) it is a language in that is assigns limited and agreed meanings (definitions) to words; and (ii) it is a system of logic. Theories are characterised by abstraction and simplification. The observations which a theory is designed to explain are part of a complex world; it would be impossible to build a theory incorporating all the variables which have interconnections with the variables under observation. Therefore a theory reflects only those variables which are believed to be most important. All theories abstract from reality by definition, but the fact of abstraction is not the crucial factor. What is important is whether or not the theory abstracts in a way that is helpful in solving the problem it is designed to answer. If crucial factors are omitted the theory may not work. The question of the verification of theories in economics is an important one which will be considered in more detail later, but it can be noted here that even incorrect theories may have some correct predictions and vice versa. It should be noted that this does not mean that economic theories are in some way different from theories in the physical sciences. The crux of this argument is that it is not possible to conduct controlled experiments in the social sciences. It is true that this makes experiment more difficult in the latter field, but it does not alter the fundamental nature of the problem. The difference is one of degree, not one of kind. Theories in the physical sciences abstract in the same way as theories in economics; for example, the law of falling bodies assumes a vacuum. This assumption is false; that is, it is not fulfilled in the real world. Yet the theory is generally accepted and produces some useful predictions. There are, however, circumstances in which the law does not work, and in these cases the falsity of the assumption is important; for example, the law of falling bodies works for tennis balls but not for feathers.

Second, it is frequently stated that economic theory is merely a series of tautologies and is therefore useless. Once again it is true that no more can be drawn out of the original statements (assumptions) of a theory than what were originally stated. If these were properly defined, the implications logically derived from them must be true by definition. This does not, however, mean that the theory is useless because it will enable practitioners to draw out the full implications of the theory – which may not be immediately obvious. The statement that profit-maximising producers expand production up to the point at which marginal cost equals marginal revenue follows inexorably from the assumptions of received theory. However, many implications can be extracted from this theory, for example the implication that, as marginal fixed costs are zero, a change in fixed cost does not affect the output decision of the firm. What does follow from the nature of economic theories is that they have no independent existence or substantive content of their own. Therefore, if the prediction that supply curves are upward-sloping is forthcoming from received theory, it does not necessarily follow that this conclusion holds true in any real world situation; it applies only in those conditions specified in the assumptions of the theory. As has been shown above, this is true of all theories, including those in the physical sciences. All theories are conditional in this way.

The important questions raised by these factors are: How can the validity of a theory be assessed, and under what circumstances can a theory be held to be applicable to the real world? Economists have at different times held alternative views on these issues.

G. C. Archibald suggested that the history of economic thought on this issue can be divided into three parts.¹³ Lionel Robbins argued that the postulates of economic theory are self-evidently correct because they are deducible from 'obvious and indisputable' postulates; hence their testing is of no concern to the economist.¹⁴ This position was attacked by T. W. Hutchinson who insisted that the criterion of testability be rigorously applied.¹⁵ At about the same time as Robbins a group of Oxford economists carried out a number of influential studies, one of which was concerned with the pricing decision of the firm.¹⁶ They advanced two propositions as a test of received theory: (i) price makers must be seen to make some estimate of marginal cost and revenue, and (ii) they must make some attempt to equate these estimates. No such evidence was forthcoming and it was concluded by Hall and Hitch, ...

Table of contents

• Cover
• Half-Title Page
• Title Page
• Copyright Page
• Original Title Page
• Original Copyright Page
• Table of Contents
• Tables
• 1 Introduction to the Theory of Supply
• 2 The Theory of Production
• 3 The Theory of Costs
• 4 The Theory of Markets
• 5 Market Structure and Industrial Organisation
• 6 Revisionist Theories of the Firm
• 7 Markets in Action
• 8 The Spatial Dimension
• Index