Alternative PK microeconomic foundations

1. Alternative PK microeconomic foundations The firm: Costing and pricing

2. Realistic features • The modern firm operates in oligopolistic industries. • Oligopolies are dominated by megacorps, i.e., Galbraith's technostructure, usually of the M-type, with multidivisional structures. • Unit costs are NOT U-shaped. • Cost-plus pricing is a pervasive phenomenon. • Prices set by firms in the short run are not market-clearing prices, i.e., prices are not such that they equate demand to supply.

3. Different approaches to pricing and markets

4. Power through growth • "The basic goal of those in charge of the firm is to cause sales revenue to grow as rapidly as possible.... But I do not agree with Marris that this pattern of behaviour is caused by the separation of ownership from control. Instead, I believe it to reflect the fact that (in so far as the two conflict) the urge for power is stronger than the urge for money. As a result, growth maximisation is a phenomenon which is to be observed in (all except the smallest) unincorporated firms and in closely owned companies as well as in large quoted companies with widely dispersed ownership" [Wood 1975 p.8].

5. Kalecki’s principle of increasing risk • «...The expansion of the firm depends on its accumulation of capital out of current profits. This will enable the firm to undertake new investments without encountering the obstacles of the limited capital markets or `increasing risk'. Not only can saving out of current profits be directly invested in the business, but this increase in the firm's capital will make it possible to contract new loans » [Kalecki 1971]. • "Finance raised externally -- whether in the form of loans or of equity capital -- is complementary to, not a substitute for, retained earnings'(Kaldor 1978).

6. Managerial capitalism vs finance capitalism • Managerial capitalism is sometimes said to be over. • However, there has always been a finance constraint on firms. • Managers still rule: they set their salaries and they defraud small shareholders. • But profitability is now more likely to be obtained by pressuring down costs (wage costs) instead of raising prices.

7. What is managerial capitalism? Main authors • Berle and Means 1933 • Galbraith 1967 The Industrial State • Marris 1972 • Chandler 1977 • (Veblen 1899, 1904) Absentee Ownership

8. What is managerial capitalism? • There has arisen a new class, the managers, who are neither owners nor ordinary workers • They are the white collars : managers, but also engineers, • They constitute the Technostructure, a going concern (collective will) • They have strong ties with the firm: tradition, working rules, dividend policy, etc. • Long-run survival, permanence, long-term objectives • Large institutional shareholders are passive, and rarely attempt to modify the behaviour of management

9. What is financial capitalism ? • More hostile take-overs • Target rates of return on equity (ROE), often set at 15% • Share value maximization • Pay schemes to encourage managers to achieve the goals of high stock market prices and high ROE • Managers have no loyalty to fellow workers or their clients: their only loyalty ought to be to the owners – the shareholders • Short-terminism: short-term goals take precedence over long-term goals since many of today’s owners will not be owners in the future.

10. The constraints on growth Profit rate R  Finance Frontier G r  Expansion Frontier 1/(1+) i g Growth rate

11. The expansion frontier • The expansion frontier relates the maximum profit rate firms can hope to reach for each growth rate. These frontiers must be thought of as constraints operating on firms and their long-term prospects. It has a bell shape. • The growth of an institution can carry both positive and negative effects. When rates of growth are weak, positive effects outweigh the negative effects. When firms invest a lot, they are better able to integrate the latest technologies and therefore reduce their costs of production and increase their profit rate. • However, with ever faster growth, it becomes more difficult to familiarize employees with the philosophy and the management techniques of the firm. This is the Penrose effect (1959). • Moreover, rapid growth often implies diversifying towards less familiar lines of products, engaging into important marketing expenses, or reducing profit margins. All of these are bound to reduce the maximum attainable profit rate, thus explaining the downward-sloping part of the expansion frontier.

12. The finance frontier • The finance frontier (Marris, 1971; Sylos Labini, 1971) defines the minimum profit rate, r, that a firm must get in order to grow at g, when the average interest and dividend rate are equal to i. • The finance frontier explains the internal and external financing opportunities of the firm. Investment can be financed internally (self-financed) or externally, through debt, by either borrowing from banks or turning to financial markets by issuing shares. We assume borrowed funds are a multiple, ρ, of retained earnings.

13. The constraints on growth I = (P – iK)+ (P – iK) retained earnings + new loans Profit rate r = i + g/(1+) R  Finance Frontier G r  Expansion Frontier 1/(1+) i gg Growth rate gr

14. Managerial vs finance capitalism • “Among the manifestations of this lack of control over management were the pursuit of market share and growth at the expense of profitability” (OCDE 1998, in Stockhammer 2003).

15. The constraints on growth: Impact of higher interest rates or dividend rate Profit rate r = i + g/(1+) R  Finance Frontier G r  i’ Expansion Frontier 1/(1+) i g Growth rate

16. The constraints on growth: Impact of weaker labour unions R’ Profit rate r = i + g/(1+)  R  Finance Frontier  r  G i’ Expansion Frontier 1/(1+) i g g’ Growth rate

17. What has happened to the new capitalism? Financialization • With their excess profits, firms purchase financial assets, i.e., they purchase the shares of other firms and they lend to households • Excess profits are taken over by managers, whose income skyrockets

18. Managerial income has gone up

19. Consequences of financialization • Financialization has not given more control to small shareholders. • Managers earn more: payment schemes yield huge bonuses and separation pays. • New payment schemes have induced managers to defraud their own companies or to report fake profits • In some way, managerial control at the top is greater than ever.

20. Financialization and growth • According to Stockhammer (2003), financialization has led to a situation of slower growth, which was only temporarily hidden by the stock market boom of the late 1990s that drove fast consumption.

21. The constraints on growth Utility function of managers with financialization Profit rate R U  Finance Frontier  r  G Expansion Frontier 1/(1+) i g Growth rate

22. Why is there ‘excess capacity’? • 1. Excess capacity is a deterrent to entry by new or outside firms (Sylos Labini). • 2. A reserve of capacity is necessary to take care of possible shifts in the pattern of demand (Steindl 1952). • 3. Fear of losing share of market when demand suddenly rises. • 4. Indivisibility of plants. • 5. A range of acceptable rates of capacity utilization (Dutt (1990)

23. Stylized facts of costing • Marginal costs are constant up to practical capacity (fixed technical coefficients) • Total unit costs are decreasing up to practical capacity • Full capacity is defined as the sum of practical capacity of all plants • It is possible to produce beyond total capacity, up to theoretical capacity • Firms usually operate at 70 to 90% of total capacity

24. The shape of cost curves mc TUC AVC AVC = UC = mc q qpc qth

25. The Alan Blinder (1998) survey of U.S. firms • 10% of respondents say marginal costs are rising • 40% say they are falling • 50% say they are constant • Although the question mentioned « variable costs of producing more units », there may have been some confusion between unit direct costs and total unit costs.

26. p TUC mc p .NUC NUC .UC UC q qs qpc qth 80% 100%

27. Variants of cost-plus pricing • 1. Simple mark-up pricing (Kalecki) p = (1+)(UC) , UC=W/pr • 2. Historic full cost pricing (Godley) p = (1+)(EHUC) • 3. Normal cost pricing (Andrews) p = (1+)(NUC) • 4. Target-return pricing (Lanzillotti, GM)  = rsv/ (us – rsv)

28. Historic full cost pricingp = (1+)(EHUC) • Historic full cost pricing takes into consideration the fact that goods sold this period are in part taken out of stocks of inventories, i.e., goods that were produced in the previous period at the unit cost UC(-1), the rest of what is being sold having been produced this period, at the current cost UC. • To set prices firms must make estimates of sales (se); they don’t know the proportion of sales that will arise out of inventories. Call this proportion: • σse = in(-1)/se • EHUDC, the expected historic direct costs will thus be: • EHUDC = σse.UC-1 + (1 - σse).UC

29. Historic full cost pricing (2) • To the direct costs, Godley adds the interest costs on inventories, to get EHUC: • EHUC = (1 - σse).UC + σse (1 + r).UC-1 • Ultimately, putting together equations (9.A.19) and (9.A.21), the price equation, assuming full-cost historic pricing, is given by: p = (1+)(EHUC) • p = (1 + ){(1 - σse).UC + σse (1 + r).UC-1} • With cost inflation, the formula becomes: • p = (1 + ){(1 + σse.rr).UC} • where rr is the real rate of interest

30. Normal cost pricing • With normal cost pricing, normal unit costs are computed. These are costs computed as if normal ratios were achieved. • The normal inventories to sales ratio is the target rate set by firms, σT = inT/s • It follows that normal direct costs are: • NDC = (1 - σT).UC + σT.(1 + r).UC-1 And hence: p = (1+)(NUC) • p = (1 + ){(1 - σT).UC + σT.(1 + r).UC-1} • With cost inflation, the formula becomes: • p = (1 + ){(1 + σT.rr).UC}

31. Target-return pricing (Lanzillotti, GM)p = (1+)(NUC) = rsv/ (us – rsv) • Target-return pricing is the industrial- organization equivalent of Sraffian pricing. • The only major difference is that the target rates of return rsare assumed to be uniform (identical) in Sraffian pricing.

32. Prices of production and target return pricing • The Sraffian prices of production (see Pasinetti, 1977), excluding intermediate goods, • p = wn + rMp • pis a column-vector of prices, w is the wage rate, nand M are a vector and a matrix of technical coefficients representing respectively labour per unit of output and the amounts of each kind of machines per unit of output). Finally, r is the uniform profit rate. • We can re-write the above equation: • p = wn [I – rM] -1 • This equation is very similar to target-return pricing in the case of the simple firm. By integrating the value of Θ in the normal-cost pricing equation, and assuming that direct costs are wages per unit of production, we get: • p = unw.n (un – rn.v) -1

33. Target return pricing or the determinants of the costing margin  or normal profit rate rs • Check: • p = (1+)(NUC) •  = rsv/ (us – rsv) • Use: r = i + g/(1+) • Higher target rates are induced by: • Faster growth rates • Higher real interest rates • Tougher borrowing requirements (low )

34. Implications • Cost-plus pricing shows clearly that the purpose of pricing is income distribution • Income distribution is at the heart of inflation phenomena • Higher demand does not necessarily induce higher prices or higher inflation rates • Cost inflation may be induced by energy and material world price increases

35. Further implications, for the incidence of the corporate tax • In the competitive model, the tax on corporate profits has no incidence on prices, since it has no effect on marginal costs and hence on the supply curve. • Similarly, in the monopoly model, once again the tax on corporate profits has no incidence on prices. Hence in these two cases, the corporate tax falls entirely on owners. • In the cost-plus model, in particular the target-return pricing model, corporations will shift the tax onto consumers, by pushing up the profit margin and prices.