Neoclassical Economics: The Cult of Marginality

When I was in college there was a popular song called Cult of Personality . A couples of lines went: “I tell you one and one makes three, I’m the cult of personality.” I claim that neoclassical economics is a cult of marginality, as it tells students of economics that one and one makes three with its emphasis on marginal costs and marginal revenues. The film The Big Short begins with a display of the statement “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” This was attributed to Mark Twain but appears to be based on a statement by another nineteenth century American humorist whose pen name was Josh Billings. It is an uncomfortable truth that many of the things we think we know, or that we were taught in school, are just not true. For example, my high school history teacher told us that the Civil War was fought because of a disagreement over states’ rights, when the truth is that it was fought over the horrible and evil institution of slavery. Like my high school history teacher, neoclassical economics is just plain wrong about some basic facts. I will show that neoclassical economics is wrong about one of the most basic facts of economics – that supply curves have an upward slope.

There are some basic ideas that people associate with a subject. There is a joke about the chief accountant of a large company. Every day when he arrived at work, he would unlock the top drawer of his desk, look at something inside, then lock and close the drawer. His staff had observed this for years and were curious about what was in the drawer, but never asked him. Upon his retirement, his staff rushed to his office, unlocked the drawer, and saw, taped to the bottom of the drawer, a handwritten note that stated, “debits on the left, credits on the right.” Like many subjects in college you may associate one idea or only remember one idea from a class. I took two basic accounting classes in college, and the basic facts about debits and credits is all I clearly remember about it. If you remember anything at all from Economics 101 in college or have at least a passing familiarity with the subject, you will be aware that demand curves slope downward, and supply curves slope upward. This is the foundation of economics. But what if, as Josh Billings said, this “just ain’t so?”

There are a variety of paradigms in economics, but the current prevailing one is the neoclassical school. Neoclassical economics is based upon a variety of assumptions that are suspect. One of these is that people are rational. When I was in college, one of my neighbors was giving away two Iron Bowl tickets. For those of you who do not familiar with this, the Iron Bowl is the annual football game between The University of Alabama and Auburn University. It is the single biggest sporting event in the state of Alabama. If you have a pair of tickets, you can typically scalp them for hundreds of dollars each, as long as the seats are in good locations. I told my neighbor that I had to assume she did not exist, as I was studying economics, and I learned in my economics classes that people are rational. In retrospect, I was not being very rational either, as I should have taken the tickets and either used them or scalped them myself.

In addition to rationality, another questionable assumption is the idea that people optimize through a sort of internal calculus that focuses on the revenue or cost associated with each additional unit. The revenue or cost of each additional unit is called the margin. Economists assume that corporations seek to maximize profit, which occurs at the unit for which marginal revenue equals marginal cost. They also assume that people experience diminishing marginal utility as they consume more of a given good, and that corporations experience diminishing marginal returns to production. Diminishing marginal returns to production means that as more of an input is applied to production, more is produced, but each additional unit provides less additional output than the previous unit. This means that marginal costs increase with production. In a market with many competing producers, a situation which economists call perfect competition, the supply curve is equal to the marginal cost curve.

I read an interesting book recently titled The Assumptions Economists Make by Jonathan Schlefer, a political scientist. In this fascinating look at how neoclassical economics may have led to the financial crisis of 2008, Schlefer writes “The assumption about diminishing marginal returns… is so central to neoclassical theory that [it] is sometimes called ‘marginalist economics.’” He also cites economist Thomas Palley, an economist not associated with the neoclassical school, as saying the assumption of diminishing marginal returns is one that even progressive neoclassical economists will dare not touch.

This academic theory is very much divorced from reality, particularly as it applies to the market for manufactured goods. There is a phenomenon in manufacturing called the learning curve. Learning in this context means that as more units are produced, the cost of producing additional units, the marginal cost, decreases. It was first discovered in the 1930s in the manufacturing of aircraft and has been documented for a variety of products such as missiles, tanks, spacecraft, calculators, and refrigerators. The general rule is that cost decreases by a constant percentage every time the quantity doubles. This percentage decrease can be as much as 30%. The learning slows as the number of units increases – this decrease occurs over four units between the fourth unit and the eight unit, but 1,024 units between the 1,024th unit and the 2,048th unit. I have never seen marginal units increase in practice, but I have seen it slow down as the distance between doublings continues to increase by a factor of two.

A friend and colleague of mine, Douglas (Doug) Howarth, pointed out to me the contradiction between the learning curve as experienced in practice and the concept of diminishing marginal productivity that is central to neoclassical economics (you can find Doug on LinkedIn and Twitter – he is an original thinker with important insights about value in both commercial and government markets for aerospace). Doug has documented several instances of declines in prices as quantity increases, including the Ford Model-T car from the early twentieth century and the price of solar panels over the last 40 years. The Model-T Ford production line ran to 15 million units. Both products exhibited price reductions on the order of 20% every time the production quantity doubled.

However, economic theory has a different take on production. As Paul Samuelson and William Nordhaus write in their best-selling textbook on introductory economics, “One important reason for the upward slope [of the supply curve] is ‘the law of diminishing returns.’” They cite wine production as an example. In their discussion on this so-called law, they write “the land gets overcrowded, the machinery gets overworked, and the marginal product of labor declines.” “Machinery gets overworked” is an interesting phrase. No matter how much I drive my car, I’ve never known it to get tired. To illustrate the law of diminishing returns, they provide an example of corn production. They claim diminishing returns is a “widely observed empirical regularity” and that it “will prevail in most situations.” They do not provide any evidence of it in manufacturing.

The University of Chicago is the leading center of neoclassical economics. Deirdre McCloskey, an economist who used to teach at the University of Chicago, and whose textbook The Applied Theory of Price is based on her lectures in a required graduate course in the economics department there, is a fierce defender of marginality. In her textbook, she calls marginality the “Rule of Rational Life.” “To an economist,” McCloskey writes, “the idea of average cost is pretty much useless…it is no guide on how much to produce.” She also writes that “diminishing marginal returns is, for one thing, a fact directly observable.” McCloskey also provides agricultural examples of diminishing marginal returns.

The notions of demand and supply curves are a part of partial equilibrium analysis. It is called partial because it is assuming other things are held constant. There is another type of equilibrium analysis in economics called general equilibrium analysis. It does not assume that everything else is held constant. I thought perhaps a textbook on general equilibrium analysis might avoid the concept of upward sloping supply curves. I turned to a classic text, Introduction to General Equilibrium Theory and Welfare Economics , published in 1968 and written by economics professors James Quirk and Rubin Saposnik. James Quirk is a retired professor of economics who used to teach at Cal Tech. I took three graduate courses in microeconomics in the early 1990s at Georgia State University that were taught by Saposnik. He is probably retired now, but I cannot find anything online about his current status. In their book, Quirk and Saposnik write “the basic tool of microeconomic analysis is supply and demand analysis, and the same is true of general equilibrium theory.” They provide an example of an upward sloping supply curve for wheat, where quantity is measured as bushels per day.

The examples from McCloskey, Samuelson and Nordhaus, and Quirk and Saposnik all involve agricultural applications. Doug Howarth has also documented upward sloping supply curves in mining. The ideas behind upward sloping supply curves, such as diminishing marginal returns, arise from economic theory from the 19th century, which was focused on agriculture and mining, but not on manufacturing.

Perplexed by this contradiction between learning curves and supply curves, I looked at the two graduate textbooks on microeconomics I own, a popular one by David Kreps, a Stanford economist, and a less well-known one by Miltiades Chacholiades, a professor emeritus of economics at Georgia State University. Neither mentions learning curves. I asked a friend and neighbor of mine, who is a retired economics professor and still an active researcher, about learning curves. He said this topic is not taught in microeconomics. He loaned me a textbook titled Managerial Economics, published in 1976 and written by Samuel Webb, a professor emeritus of economics at Wichita State University, that discusses learning curves. Managerial economics is a subject that teaches basic graduate-level economics to MBA students. The textbook mentions that the learning curve is a “very useful tool that has been employed in industry since the 1930s but has as yet received limited attention by academicians.” It also states that “Economists have long been aware of the existence of economies of mass production and decreasing costs in some industries. Increasing economies are typically said to occur in the early stages of development of an industry followed by a longer (sometimes much longer) period of constant costs that eventually blend, as the industry matures, into a final phase of rising unit costs.” As the economist John Maynard Keynes said famously, in the long run we are all dead. In my experience, once a product reaches a point where learning stops, production also tends to stop as well. At this point, the product is replaced by a newer version or a better substitute.
The counterargument by economists to the learning phenomenon could be that diminishing returns and supply curves are a short-run phenomenon. One of the many criticisms of classical and neoclassical economics is that it ignores the dimension of time. Learning happens over time. However, learning is not a phenomenon that relies upon technology shifts. It is a natural phenomenon that occurs in manufacturing when human labor is involved. I’ve experienced this in my own life. When putting together my son’s toys, the first few times took me a while, but the more I did it, the better I got at it. It now takes me less time to put together something than in the past. When you look at a fixed time period, such as a year, there is a significant amount of learning that occurs as long as there are enough units produced in any fixed time period.

The book Debunking Economics , by Australian economist Steve Keen, provides examples of empirical studies that show declining costs in practice. A 1952 study by two economists asked factory managers to choose which of eight different drawings of cost and output most closely resembled their experience. Of the 334 companies that responded, 95% chose downward sloping curves. Indeed, over 150 empirical studies have been conducted into the relationship between cost and output for corporations. They all report that they have high fixed costs, and either constant or decreasing marginal costs. Keen also mentions that the prominent economist Alan Blinder, who was once the vice-president of the American Economic Association and vice-chairman of the Federal Reserve found a similar phenomenon. In a survey he conducted in the late 1990s of 200 medium-to-large US companies, he found that only 11 percent of economic output was “produced under conditions of rising marginal cost.” Blinder then states that this study “paints an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks.”

An important reason that marginal costs are typically not an increasing function of output is that manufacturing plants are not close to their maximum capacity. The Hungarian economist Janos Kornai, as discussed in Keen’s book, has documented that one of the differences between socialist and capitalist economies was a lack of resources in socialist countries. Another study I’ve seen that looked at four defense contractors over a 17-year period showed that each firm only reached 100% capacity in at most two years over that period. A French colleague of mine, Pierre Foussier, told me that he had seen maximum capacity approached or reached often in his work for private firms in France, including auto manufacturers. As France is a more socialist economy than the United States, this could be the reason for a lack of excess capacity. This standard excess capacity in manufacturing could be a reason for the success of the US economy.

As marginal costs are declining, firms do not price based on marginal cost because in this case, the marginal cost curve is below the average cost curve. Any firm that would price at the marginal cost in such a situation would lose money, as the price would be less than the average cost to produce it. If firms don’t price on the margin, what do they use instead? They use average cost. Despite McCloskey’s claim that “average cost is useless,” that is how government weapon systems are priced, by an average cost for an agreed-upon lot size plus a percentage of the cost for profit. Average unit cost is also the key metric that defense agencies report in measuring baseline performance of cost over time for major programs. A textbook on managerial economics from 2009 ( Managerial Economics by Mark Hirschey, late Professor of Business at the University of Kansas), provides an example of a company that has used average cost as a basis for pricing. Texas Instruments has long been a leader in digital technology. One of their employees invented the integrated circuit in 1958, and they produced the first hand-held calculator in 1967. Early on, they decided to price their semiconductors well below production costs, because they expected to experience learning curves in the 20 percent range. By pricing on the longer-term average costs, they were able to dominate the market and eliminate much of their competition.

Since at higher prices, a firm would be willing to supply more output, you cannot really say that supply curves are downward sloping. Instead, the bottom line is that there is no supply curve, at least in the market for most manufactured goods. Generations of economists have never bothered to look at how goods were manufactured in the 20th century when promulgating the theories of the firm. It is highly ironic that they call the section of their texts dealing with supply the “theory of the firm” when they have no idea how firms actually conduct their business. A cult is sometimes defined as a misplaced or excessive admiration for something. Neoclassical economics is a cult of marginality. The notion that there is no supply curve is still a shocking idea to me, though. I still struggle to fully accept it, even though I now believe it to be true. As the country singer Toby Keith sings “I wish I didn’t know now what I didn’t know then.”