In a provocative post on his Substack last month, [*] Arnold Kling proclaimed that the marginal revolution is dead. However, Kling is wrong. Some of the things in his post are correct, some may be correct but are overstated, but others are just plain wrong.
Before we get that far, it is worth reviewing a few key points. Market power is the ability of a firm to influence the market price. For most firms, this means that they have the freedom to set their own price. As students are taught in pretty much every introductory economics course, the firm with market power aims to maximise profits, and does so by selling the quantity of the good or service where marginal revenue is exactly equal to marginal cost (for an example, see this post). The price that the firm sets is not equal to marginal cost, and it is not equal to marginal revenue. It is equal to average revenue, but average revenue is always higher than marginal revenue. So, the firm with market power will set a price that is greater than marginal cost.
Now, looking at Kling's post:
But marginalism went too far. Economists said that profit-maximizing firms will equate marginal revenue with marginal cost. In a perfectly competitive market, or so they said, price will equal marginal cost. (In a less than perfectly competitive market, as the firm expands output, it has to lower its price. Taking its demand curve into account, the firm sets marginal revenue—a number that is less than the price that it charges—equal to marginal cost.)...
In the twenty-first century, marginalism does not apply to pricing or to wage-setting. To understand the contemporary economy, we have to think in terms of overhead. Real-world business is often dominated by overhead.
Overhead, or fixed cost, is all of the cost that a firm incurs even if it sells no output. You need to pay for tax compliance. You need a business license. You have advertising and marketing expenses. You need to develop and refine your product. You need IT infrastructure. As you get bigger, you need middle managers, a human resource department, finance and accounting, a legal department, janitorial staff, security guards, and on and on...
For many businesses, the marginalist approach would suggest a price that is too low to cover overhead. In fact, the marginal cost is often zero. The marginal cost is close to nothing for:
—an airline with empty seats to carry another passenger
—a telecom firm to provide the bandwidth you need for a phone call or to view this web page
—an app to serve an additional user
—a college to allow an additional student to take classes
In all such cases, if the seller were to follow the marginalist principle, its price would not be high enough to cover overhead. It would lose money and go out of business.
A better pricing rule would be to set price equal to or higher than expected average cost, which is based on a projection of the number of users.
The first paragraph of the above quote is fine. The firm sets a price where the quantity that it sells will lead marginal revenue to be equal to marginal cost. The next bit about fixed costs is fine too. However, then things go wrong. By itself, the presence of fixed costs does not necessarily lead a firm to set a price that would not cover the fixed costs. As one example, see this post. A firm with high fixed costs and low marginal costs has economies of scale. That firm can set a price that is above average cost, by setting the price at the quantity where marginal revenue is equal to marginal cost.
Kling seems to be assuming that the firm is pricing equal to marginal cost. But that is only true of firms with no market power - firms in perfectly competitive markets. None of the examples he provides are of firms in perfectly competitive markets. Even if marginal cost is equal to zero, that doesn't mean that the profit maximising price (set at the quantity where marginal revenue is equal to marginal cost) is zero. Overall on this point, which seems central to Kling's argument, he is very much wrong.
Later in the post, he writes that:
An even better pricing strategy is to come up with a way to charge more to customers who are willing to pay more (inelastic demand), and to allow other customers (elastic demand) to pay less. That way, both types of customers contribute to covering your overhead, with the inelastic customers paying more.
There are many examples of price discrimination in practice. If Disneyland charges an entrance fee plus a per-ride ticket fee, it gets the most out of both types of customers...
One of my catch-phrases is price discrimination explains everything. By that I mean that most of the strategic decisions that firms make in marketing their products are attempts to implement price discrimination. This in turn helps them to cover overhead.
Business strategy ignores the marginalist rules. Managers put a lot of effort into coming up with ways to implement price discrimination. They don’t put effort into making marginalist calculations.
Conversely, economics textbooks ignore business strategy. They devote little attention to price discrimination. We need The Overhead Revolution.
I like that Kling is a fan of price discrimination. I am too. Once you know what to look for, you start to see price discrimination everywhere (like in this post from earlier in the week). However, he uses it as a counter-example to decision-making at the margin. Unfortunately, price discrimination relies on firms setting profit-maximising prices for multiple groups of consumers. In turn, that relies on setting a price at the quantity where marginal revenue is equal to marginal cost in each submarket (for examples of this, see here and here). His Disneyland example is not price discrimination at all - it is two-part pricing (as described here, or here).
For the most part, Kling is correct that economics textbooks ignore business strategy. But that doesn't mean that business strategy is not taught in economics courses. I devote a substantial proportion of my ECONS101 class to business strategy (and the lack of supporting textbook resources is part of the reason why there are so many applied examples for my students on this blog), and business strategy comes up in almost every topic. That should be what students expect from a paper called Economics for Business and Management.
Not all business strategy is price discrimination though. For example, in my ECONS101 class, I also cover bundling, cost-plus pricing, two-part pricing, block pricing, limit pricing, loss leading, customer lock-in, and more. Many firms actually use a combination of these strategies (often combined with price discrimination, to be fair to Kling).
Kling's post isn't all wrong. He is mostly right about the labour market, which may be better characterised by a search model (for example, see here), than by a model that relies on wages being set equal to the value of the marginal product of labour. However, most economists already recognise the limitations of a neoclassical model of the labour market.
So, Kling is only right in terms of the labour market. By itself, that isn't enough to mean that economists should give up on marginalist thinking in business applications. At the margin, I think that Arnold Kling needs a refresher course on introductory economics.
[HT: Marginal Revolution]
*****
[*] Provocative to (neoclassical) economists, anyway. Most average people wouldn't care much, either way.
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