Academic journal article
By Nichols, Mark; Pavlov, Oleg; Radzicki, Michael J.
Journal of Economic Issues , Vol. 40, No. 2
How are prices determined? This is a very basic economic question that many economists have sought to answer. The short explanation from neoclassical economics is that firms, seeking to maximize profits, produce until their marginal revenue equals their marginal cost, thereby generating a supply of goods and services. Consumer demand for these products arises from income-constrained utility maximization. Together, the interaction of firms and consumers, supply and demand, determines price in the market.
Many, if not most, economists will also tell you that this is not literally how things work. However, neoclassical economists will usually invoke the "Friedman defense" (1953), claiming that a more literal explanation is unnecessary because the neoclassical model predicts well. It is as if the firm's only goal is profit maximization, achieved as if it equated marginal revenue and cost. A model's usefulness is judged by its ability to predict firm-level data well, not by its realism. Indeed, extremely simple models, devoid of institutional detail, are to be preferred because their results are not specific to any particular time or place.
Yet even the ability of the neoclassical model to predict well can be questioned. The economy in general, and prices in particular, are not as frictionless as the theory predicts. Studies by Gardiner Means (1935, 1936, 1972), Alan Blinder (1998), Frederic Lee (1994, 1995), and others (see Lee 1999), have demonstrated the inflexibility of prices over long periods of time. Moreover, heterodox economists have long emphasized the simple fact that, when actual decision processes used by managers to set prices are studied, they rarely, if ever, resemble the neoclassical explanation. As a result, institutional and Post Keynesian economists have sought a more literal explanation of price setting, one that is dynamic and open--possibly path-dependent--and that accounts for the historical, social, cultural, and institutional context of the firm, industry, or economy.
The purpose of this paper is to report on the administered pricing subsector of a Post Keynesian-institutionalist-system dynamics (PKI-SD) "core" model that is currently under development by the authors. When complete, the model will be used to examine the dynamics of heterodox economic theory as well as to test the implications of heterodox policy alternatives.
A complete overview of the heterodox pricing literature is impossible in this paper. Rather, what are reviewed here are some of the key studies that are relevant for representing managerial behavior in the goods sector of the PKI-SD model. For a thorough review of the Post Keynesian pricing literature see Lee 1994, 1995, and 1999 and Downward 1999.
According to Downward and Reynolds 1996, one of the key features of Post Keynesian price theory is the focus on the mark-up, where price is set as some mark-up over costs, as opposed to the equating of marginal revenue and marginal cost. The calculation of costs, the sensitivity of price to changes in demand, the dynamics of price over time, and the determinants of the mark-up are all issues that have been explored.
One of the seminal studies in Post Keynesian pricing was conducted by Robert Hall and Charles Hitch (1939), who had the novel idea of simply going out and asking managers how they set prices. Their conclusion is that managers set prices using a rule of thumb they termed full-cost pricing. Hall and Hitch found that firms use direct costs as a base to which is added a percentage for overhead, including selling or marketing costs, and an addition for profits. Interestingly, Hall and Hitch noted that "maximum profits, if they result at all from the application of this rule, do so as an accidental (or possibly evolutionary) by product" (18).
Philip Andrews (1949) introduced the "normal cost principle," where average direct costs are "grossed up" by an amount sufficient to cover overhead costs and ensure a profit under "normal" production. …