The Neoclassical Supply Curve, the Iron Bowl, and Reality

The Iron Bowl is the annual (American) football game between the University of Alabama and Auburn University. When I was in college, one of my neighbors told me that she had two tickets to this game she could not use, and wanted to give them away. I was taking my second class in microeconomics at the time and had just learned the key principle that people act rationally. As the Iron Bowl is the single biggest sporting event in the state of Alabama each year, I told her that her behavior was irrational so I had to assume she did not exist. That was the first time I learned that economic theory sometimes clashes with reality.

More recently, I have learned of other instances where economic theory is not supported by reality. One of these is the basic notion of the supply curve. In the standard theory of the firm businesses act to maximize profit. The profit equation is the difference of the revenue and cost. The marginal revenue is the additional revenue obtained by selling an additional unit and marginal cost is defined similarly. With the application of basic calculus, you can derive that this equation will reach its maximum when the marginal revenue is equal to the marginal cost.

In a perfectly competitive market, the marginal revenue curve will be a horizontal line. Due to what economists call the ‘law’ of diminishing returns, the marginal cost curve will slope upward. Typical textbook average cost, marginal cost, and marginal revenue curves are depicted in the graph below. The red circle is the intersection of the marginal revenue and marginal cost curves and the highlighted area represents the supply curve.

As a profit maximizer, the firm will produce along the marginal cost curve. However, if the prevailing market price (equivalent to the horizontal marginal revenue curve) is less than the average cost, the firm will lose money so it will not produce at all, which is why the quantity is zero for prices below the average cost curve.

Standard economic theory typically depicts the average cost curve as U-shaped and continuous. When this is the case, the marginal cost curve will intersect the average cost curve at its minimum (can be shown with some calculus). Thus, standard neoclassical theory claims that firms operate in conditions of increasing average and marginal costs. However, this is not supported by data in most industrial manufacturing. Three examples include:

1. In the short run, production rate analysis for aerospace and defense manufacturing indicates that average cost decreases as a function of quantity. I’ve seen studies for missiles, spacecraft, and other commodities.
2. A 1950s survey of 334 U.S. companies found that 95% operate in conditions of declining average costs.
3. A 1990s survey of 200 U.S. businesses found that 89% operate in conditions of declining marginal costs.

In such a situation, where firms operate in conditions of declining marginal and average costs they are not pricing at the marginal cost since they would lose money. Rather, firms are likely pricing by placing a mark up on their average costs. In such a situation, there is also no equilibrium and firms are not seeking to maximize profit. This is not a novel observation – the late economist William Baumol, in doing consulting work outside of his traditional professorial duties at Princeton, noticed that in reality businesses did not seek to maximize profit. Instead, he found that they seek to maximize revenue subject to a minimum profit constraint. There are other problems with assumptions made in the textbook theory of economics (e.g., perfect competition), but the point is this – if the assumptions lead to models that are not supported by the facts, you need to start over. Economic theory is one area that has issues, but it is not alone.