profit seeking and sales constraints - response to Jim Devine

[Peter Skott <ecoskott@xxxxxxxxxxxxxx>]

In his detailed reply to my earlier comments JD raises a number of
points and clarifies some issues. However, I have difficulty understanding
some of his arguments.

JD accepts the premise of profit seeking behaviour: firms choose a
price-output combination which they believe will maximize profits
subject to production and cost constraints and the conjectured demand
conditions. This may seem trivial but I think it is important for
JD's discussion of sales constraints. Before I get to this, however,
let me say that I agree with JD - and, I now think, Paul Davidson - on the
need to consider the implications of non-fulfilled expectations; it
may be misleading to analyse an economy as if it were always in short
run equilibrium.

Most of my difficulties with JD's argument relate to his
discussion of quantity/ sales constrained firms. He writes (in part 1):

>For given nominal wage and
>price, the unconstrained atomistic firm hires according to w/p = f'.
>But (unless w/p is very high), the quantity-constrained firm cannot
>sell all of the extra product produced by hiring according to this
>rule at the given w/p.  So the firm will hire fewer workers than the
>unconstrained firm (unless w/p is very high). In addition to the
>technological constraint represented by the production function (f),
>there is a sales constraint based on the effective demand for
>products.

This introduction of sales constraints for a firm in atomistic
competition seems to involve a contradiction. How can a firm
be quantity constrained and at the same time face atomistic competition
and a given w/p ? Atomistic competition, as normally defined, implies
that a marginal reduction in price removes the firm's sales constraint
completely. Why then would the firm want to maintain the price
at the "given" level?

The issue comes up again in part 2:

>JD: If I understand it correctly, the difference between PD and
>myself might be thought of for two cases. (A) In the case of total
>and utterly atomistic competition, the difference is that PD assumes
>that when aggregate demand is below the full-employment level, firms
>hire according to w/p = f'. Now, I see that as *one* possible result
>(for high w/p), either when the sales constraint is non-binding or
>at the point that Keynes emphasized, what I'll term the "kink"
>(where both the sales constraint and the production function are
>binding). There are also the situations with low w/p < f', including
>the case where w/p equals its FE equilibrium level.

This time, however, JD goes on to observe that

>In either the kink case or this latter case, the idea of atomistic
>competition as involving universal price-taking becomes more
>nonsensical than usual, since _firms can't sell all that they
>produce at given prices_. The realized gap between f' and w/p is
>"too high" relative to the f' = w/p kink. (I'd forgotten that the
>firm's inability to sell all they can produce at the given price --
>and the textbook image of perfect competition -- went out the window
>at Keynes' kink. But it does.)

I don't think this last claim is correct. "Keynes's kink" is perfectly
consistent with atomistic competition and price taking firms: firms
sell all they wish to produce at the given prices. But short run equilibrium
with a strict inequality, f'>0 , does contradict the assumptions of
atomistic competition and profit seeking firms. Having stated the problem,
however, JD seems to dismiss it again:

>However, it is reasonable, given uncertainty and the normal absense
>of complete information, that firms would follow a mark-up-style
>"rule of thumb" in setting prices, even in atomistic markets, even
>at FE. (Under atomistic competition, the mark-up on variable costs
>would be high enough to cover both fixed costs and normal profits.)
>At less than FE, in a situation where general equilibrium does not
>apply, such pricing rules also apply. Given the absence of
>diminishing returns to a fixed factor, i.e., excess capacity
>coinciding with unemployed labor, and given a money wage, we might
>model prices as p=(1+m)w/APL -- where m is the mark-up and APL is
>the (constant) average product of labor. It seems quite likely that
>atomistically competitve firms would keep the same mark-up as they
>did at FE. After all, being atomistic, they don't know what's going
>on.

I don't understand this argument. Atomistic firms may not know or
care about what happens in the economy at large. In fact, all they
need is information about the position of their own demand curve, but
of course they may also have imperfect information about their own
future demand. Since short run equilibrium is characterized by the
fulfilment of short term expectations, a quantity constrained
short run equilibrium would seem to imply that the quantity constraints
were expected. How can a firm expect quantity constraints and still be
in atomistic competetion?

Imperfect information doesn't mean that firms stop being profit
seeking, and if a profit seeking firm believes that an arbitrarily
small price cut will remove the sales constraint then why does it maintain
price above marginal cost? Atomistic firms, in my vocabulary, do have
a horizontal conjectured demand curve. Hence my problem. -- Do we
define atomistic differently?

JD seems to suggest that firms can be in a situation where (a) they
have "no price-setting power" and (b) face a sales constraint. The
only possible reconciliation (that I can think of) of these two
assumptions involves a very special conjectured demand curve: let
the conjectured demand curve be kinked with a horizontal segment
p=p0 for q less than q0 and a vertical segment at q=q0 (p less than p0).
If this conjectured demand curve is combined with the assumption
that firms feel uncertain about the position of q0 but confident in
their assessment of p0, then the Benassy-Dreze-Malinvaud fix-price
model can be rationalised in terms of profit seeking behaviour. But
this is a very special structure of conjectured demand and not one
I would want to build my theory on. However, if one assumes that this
is the structure of conjectured demand, then I don't think anyone
would disagree with the proposition that f' could exceed w/p in
short run equilibrium. -- Is this the conjectured demand structure you
have in mind? Or do you see some other way of reconciling profit
seeking behaviour with fixed prices and an accommodating ratio of
price to marginal cost?


Cheers,
Peter Skott
University of Aarhus
ecoskott@xxxxxxxxxxxxxx