The Marginalist Defence. by Fred.

Topics: Pricing, Economics, Profit maximization Pages: 5 (1882 words) Published: April 16, 2013
The discussion on price theory during the first half of the 20th century that would later be known under the term “full-cost controversy” had its debut with the publication of the aforementioned article by the Oxford-based economists Hall and Hitch (1939). In their work, entitled “Price Theory and Business Behaviour”, they presented the results of a survey accompanied by interviews among 38 firms, of which 33 were in the manufacturing business. The large majority of the firms were found to set their price in the following way: first, an ex-ante estimate of average costs was derived. On this cost base, two percentage margins were added to arrive at the final price. The first was a mark-up to cover overhead costs which could not be directly attributed to products; the second had the function of a profit margin. The authors called this “full-cost pricing” and insisted that it was a “rule of thumb”, which could only lead to profit-maximizing prices in the neoclassical sense by accident (Hall and Hitch, 1939, p. 113). Furthermore, they asserted that managers did not make any implicit or explicit attempt to estimate demand elasticities or other factors that would reflect the demand situation for the price setting process. Additionally, they included sunk costs (in the form of fixed overheads) into the pricing decision and were reluctant to alter prices if market conditions changed. All these answers Hall and Hitch received from managers seemed - at least at first glance - to be at odds with the postulates of the predominant economic doctrine, namely that prices are determined optimally so as to equate marginal costs and marginal revenues and thus to maximize profits. The results obtained through their survey motivated the authors to develop their own explanation of the price-setting process, the “kinked demand curve”. This theory assumed that firms were, with their current price-quantity combination, situated at a kink on their firm-specific demand curve. A change in prices would have asymmetric consequences: if the firm raised its price, it would be the only firm to do so; its competitors would leave their prices as they were, leading to a substantial loss of demand for the firm that adjusted its price upward. So, the firm demand curve is highly elastic above the current position. For a reduction of the selling price, Hall and Hitch assumed that all firms would follow this move, making the firm demand curve highly inelastic below the kink. As a consequence, the firm was actually situated at a local equilibrium of optimal profits, which was stable over a range of cost- and demand fluctuations, since for small shocks it did not pay off to change the price. This was also the case for all other firms in the market; hence, once the kink was established, there was no price competition in the market. The connection of the kinked demand curve to the full-cost principle was that the optimal price at the kink was arrived at by the full-cost calculation and lay significantly above marginal costs. The concept of the kinked demand curve as proposed by Hall and Hitch was highly problematic. The location of the kink was random, as was therefore the corresponding. Its stability was only possible as a consequence of some form of implicit or explicit collusion. In addition, firms were actually profit maximizing, which was again at odds with the statements the authors recorded from their interviews with managers. Furthermore, the use of a demand schedule in their proposed theory seems to be sharply at odds with their proposition that managers in their survey did not take demand factors into account.

Empirical Evidence
Before we focus on the full-cost controversy that started after the publication of Hall and Hitch’s article, it seems worthwhile to give a short survey of other empirical work that was brought forward in the wake of the debate and that proved that Hall and Hitch’s initial findings reflected a general...
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