Last update: 16th September 2018

Lecture 2
Overview
 Lecture 2 seeks to explain the FUNCTIONING OF PRODUCT MARKETS
according to Neoclassicals. It seeks to explain why commodities are worth what
they are worth and why we produce more or less of one than another. That is, it
seeks to explain the price and quantity produced of individual commodities.
 It is important to note that the price that is being explained in the first instance is
the relative and not money price of a good, since for Neoclassicals (as for some
Heterodox) it is the relative price that provides signals for the behaviour of
individuals and allocates resources.
 The Neoclassical analysis of product markets uses the concepts of DEMAND and
SUPPLY, with the focus being on the determinants of demand and supply.
o For text book Neoclassical economics supply refers to the supply of goods
by firms but for strict Neoclassicals supply refers to the offer of goods in the
process of exchange by individuals who are naturally endowed with goods.
 Neoclassicals explain how the interaction of demand and supply explains the price
and quantity of a product, and why and how this interaction between them tends
towards an equilibrium price and quantity – a price and quantity where there is
no longer any tendency for change.
 Having explained the notion of equilibrium price and output, Neoclassicals then
proceed to try and show why this equilibrium can be regarded as giving rise to
maximum consumer welfare and productive (min average cost) and allocative
efficiency1. It should be noted that the ultimate aim of neoclassical product market
price theory is to show that market determined prices give rise to an optimal
allocation of resources in the sense of maximum consumer welfare and
minimum cost.
 A secondary aim, at least of textbook Neoclassical economics, is to argue that
producers produce at cost and increases in prices are brought about by rising
costs (with profits being argued to be part of costs).

Criticisms
 Neoclassicals (and Neoclassical textbooks) are unclear as to what prices are
being explained, viz., money (i.e., the dollar price of a commodity) or relative
prices (the exchange ratio between two commodities or even one commodity and
many/all other commodities). This is because they recognise that in the real world
prices are in fact money prices but want to argue that it is relative prices that
govern the behaviour of individuals and results in the allocation of resources.
Hence, they need to conceive of the money prices of commodities being explained
in a way that actually translates into relative prices. To do this they conceive of
prices in several different ways, all of which are problematic theoretically.
 Neoclassicals fail to see that it is not prices that allocate resources but profits.
Specifically, it is not prices but profits that shifts resources from sector to sector.
The two are not the same thing. Prices can move in a different direction to profits.
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Allocative efficiency refers to the best possible use of the productive resources at the disposal of a
society.

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 In the final instance, the Neoclassical theory of price is essentially an attempt to
replace an objective theory of price (the labour theory of price) with a subjective
theory of price – price being explained in the final instance by the relative
preferences of (or expected satisfaction derived by) individuals for (from)
commodities. The reason for this is the need to deny that it is the expenditure of
labour time, or, more precisely, surplus labour time, that is the source of profit (a
key component of price). Neoclassicals need to conceive of the price to be
explained as relative and not money price because they are unable to explain
money in terms of subjective worth.

Contents of lecture
General
 Neoclassicals explain the price of the product by the interaction of market demand
and supply. This causes them to focus on the determinants of market demand and
supply.

Market demand
 The market demand for a product is seen as the aggregation of the demand for
these goods by all individuals in a society (and also all other societies when
international trade is taken into account).
 This means that the starting point for Neoclassical analyses of the market demand
for a product is the demand by an individual for the product.
 The individual demand for a product is typically explained by its PRICE,
INCOME LEVEL (nb., normal, inferior and luxury goods), TASTES,
EXPECTED PRICE and PRICES OF RELATED GOODS (nb. complements and
substitutes).
 The starting point for analysis of the product by an individual is usually taken to
be the impact of price on this demand. The relationship between the price and
the demand for the product is argued to be given by the individual DEMAND
CURVE.
 The individual demand curve is assumed to slope down from left to right because
of diminishing marginal utility.
 Diminishing marginal utility is the tendency for the extra satisfaction derived
from the consumption of the last unit of a good to fall as increasing quantities of it
are consumed.
 Diminishing marginal utility is used by Neoclassicals to explain why prices fall as
more of any good is demanded – the downward sloping individual demand curve.
o Utility and marginal utility has been replaced by preferences and the
marginal rate of substitution between commodities by the individual (as
depicted by indifference curves) in most modern economics texts. The reason
for this is to avoid the connotation that satisfaction is something that is
objective and measureable (as in the next slide). By definition it is subjective
and, therefore, not measureable objectively. The present lecture series will
continue with the use of marginal utility analysis since it is typically more
intuitive.
 Market demand curves link different quantities of a product demanded by all
individuals in a society to the prices they are willing to pay for the different
quantities of it demanded. Market demand curves are derived by aggregating

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 (adding together) individual demand curves linking various quantities of a product
demanded by an individual to the prices individuals are prepared to pay for the
different quantities.
 Individual demand curves, and therefore market demand curves, linking prices to
quantities demanded, are derived assuming that all other factors (apart from price)
which impact on the demand for a product are held constant. The most important
of these other factors are argued to be INCOME LEVEL (nb., normal, inferior and
luxury goods), TASTES, EXPECTED PRICE and PRICES OF RELATED
GOODS (nb. complements and substitutes).
 Of particular note in respect of the non-price factors is taste. For Neoclassicals
tastes of individuals are naturally given.
 The impact of changes in any of these non-price factors on the quantity of a good
demanded is shown in a two-dimensional graph by a movement inwards or
outwards from the verticle axis of the individual (and therefore market) demand
curve.

Criticisms
 Neoclassicals, especially Neoclassical textbooks, do not make clear that when
explaining relative prices it should be relative demand (the demand for one
commodity as opposed to another) that matters and not absolute demand (the
money demand for a product). Yet in most Neoclassical textbooks the notion of
relative demand (like relative price) is missing.
o The problem is that if it is the money demand for a commodity that is
being explained (with a view to explaining its money price), changes in this
demand would typically be dominated by a change the money incomes of
individuals alongside the value of money and such that the demand for all
commodities would tend to rise at the same time along with their money
prices. This means that changes in demand for commodities could not be
argued to give rise to changes in their relative prices and, therefore, provide
signals guiding the behaviour of individuals.
o Also, if what is being explained is the money price of the commodity then
money must be recognised as the measure of exchangeable worth, and its
worth determined in the context of individuals setting money prices – which is
destructive for Neoclassical thinking.
 Neoclassicals tend to ignore in the first instance the fact that the demand for a
product can be by firms and this would not be motivated by utility maximisation
as it is for the individual – even assuming utility maximisation is the motivation of
individuals. The usual Neoclassical response to this is that producers are
individuals undertaking production with a view to exchanging the produced goods
for other goods with a view to maximising their consumption satisfaction. That is,
producers are assumed to be surrogate consumers motivated by, say, consumption
satisfaction, and not wealthy individuals seeking to expand their wealth.
 Tastes are not natural but can be influenced by habit, custom, tradition and
advertising. For Neoclassicals advertising is only to INFORM not PERSUADE.
If it is accepted that it persuades, then it does considerable damage to the
Neoclassical model.
 Some critics argue Neoclassical analyses of demand assume changes in relative
market prices of goods do not affect income distribution and therefore preferences

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 of individuals for particular goods. Allowing for changes in relative prices to
affect income distribution (and therefore the structure of preferences) could mean
a highly unstable market demand curve.
 Critics from even within the Neoclassical school point out that adding individual
demand curves to get a market demand curve means of necessity assuming that it
is possible and meaningful to add individual preferences to get aggregate
preferences. In fact, it has been shown that the only way of doing so is to assume
all individuals behave alike or that there is only one consumer in the market.

Market supply
 The market supply of a product is seen as the aggregation of the supply of these
products by all firms producing the product in a given society (and also all other
societies when international trade is taken into account).
 This means that the starting point for Neoclassical analyses of the market supply
of a product is the supply of it by an individual firm.
 The supply of a product by an individual firm is determined by a number of
factors including PRICE, TECHNOLOGY, WORK EFFORT, TAXES and
SUBSIDIES and INPUT PRICES.
 The starting point for analysis of the product supply by an individual firm is
usually taken to be the impact of price on this supply. The relationship between
the price and its supply is argued to be given by the individual firm’s SUPPLY
CURVE.
 The individual supply curve is argued to be upward sloping because of the
assumption of increasing costs. Costs are assumed to increase over the short-
run because of diminishing marginal productivity and over the long-run
because of (internal) diseconomies of scale.
 Neoclassicals define the short-run as a period of time when at least one factor
input is fixed (usually capital and land), and the long-run as a period of time
when all factor inputs are variable. The assumption that at least one factor input is
fixed over the short-run usually translates into the assumption of full capacity
utilisation (although not for all Neoclassicals).
o In many textbooks reference is made to inputs and/or resources and not
factor inputs although what is meant is actually factor inputs with capital
seen as produced material inputs having a lifespan in excess of one
production period – capital and fixed capital being synonymous.
 When some factors are assumed fixed over the short run an increase in output is
argued to be brought about by an increase in the quantities of the variable factor
inputs (usually labour). Neoclassicals argue that the increase in output
accompanying the increase in the variable factor input diminishes with time after
initially increasing. Hence, the notion of diminishing marginal productivity
(following increasing marginal productivity) of the variable factor. Diminishing
marginal productivity translates into rising unit costs (costs per unit of output) of
the product. If less is being produced by more and more workers, the unit cost of
what is being produced must rise (assuming that the price of the factor input,
labour, stays the same).
 When explaining short-run costs Neoclassicals distinguish between fixed and
variable costs, with fixed costs pertaining to the fixed factors of production and
variable to the (one) variable factor. Unit fixed costs are assumed to fall
continuously as output expands (due to the increase variable factor input added),

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 while unit variable costs are assumed to fall as output expands, due to diminishing
marginal productivity of the variable factor input.
 When all factor inputs are variable, over the long run, the diminishing marginal
productivity of individual factors can no longer be invoked to explain increasing
costs. Hence the need for an alternative explanation of rising unit costs. This
alternative is provided by the notion of decreasing economies of scale. What
decreasing economies of scale means is that as the individual firm produces on an
ever larger scale it incurs increasing costs related to the large scale. The most
frequently cited of these problems is managerial and logistical problems. The
increasing costs translates into increasing unit costs.
 The costs which are seen as rising and impacting on prices as a result of
diminishing marginal productivity and diseconomies of scale are marginal costs.
Marginal costs are the additional (total) costs arising from the production of an
extra unit of output. To avoid losses from increased production, firms need to
increase prices to cover the increase in the marginal costs.
o It is of note that strictly speaking the costs which matter for businesses in
Neoclassical economics are what are referred to as opportunity costs.
Opportunity costs are the returns from the (second best) alternative use of the
productive asset in question.
o It is also of note that for Neoclassicals costs include profits. The logic for
this is that since wages and rent are treated as costs because firms need to pay
wages and rent to obtain labour and land inputs profit (or interest) should also
be treated as a cost since it is required to obtain the capital input. To include
profit as part of costs Neoclassicals invoke the notion of an economic profit.
A positive economic profit is the profit over and above costs which include a
normal profit (based on a normal profit rate – the return to the material inputs
in relation to the value of these inputs). Normal profits are the opportunity cost
of using capital in an alternative (second best) activity. If firms are earning
only a normal profit, their economic profit would be zero. If they are earning
an abnormal profit, the economic profit would be positive.
o Since profits are seen as profits on fixed capital outlays, unit profits are
seen as falling along with unit fixed costs over the short-run, even though the
firm will be earning a normal profit rate.
 Adding all the individual supply curves of individual firms producing a given
product gives the market supply curve. In the derivation of the market supply
curve it is assumed TECHNOLOGY, WORK EFFORT, TAXES and SUBSIDIES
and INPUT PRICES are given.
 The impact of these other factors on the output of all firms is typically shown in a
two-dimensional graph by the movement of the supply curve either inwards or
outwards from the verticle axis.

Criticisms
 It is questionable whether it is meaningful to assume fixed factors of production
over the short run. Apart from the fact that technology does not really permit
adding labour without other material inputs, critics argue that most inputs into
manufacturing production are produced inputs. Hence, it makes no sense to
assume these are fixed (i.e., cannot be increased) while assuming output is
flexible.

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 o Sraffa notes that the more narrow the definition of an industry or a
product, the less plausible it is to assume fixed inputs into production. Inputs
into the industry can be drawn from other industries. Sraffa also notes that the
broader the definition of an industry, the less plausible it is to assume that
changes in the factor price into the industry in question does not affect the
factor price of other industries.
 It is questionable whether it is plausible to assume full capacity – empirical
studies show businesses typically operate with excess capacity.
 If the price being explained is relative price then the costs which explain this
must be conceived of as relative costs, which begs the question of how one is
expected to conceive of an upward sloping supply curve and rising costs for all
firms.
 Empirical evidence and common sense casts doubt on the Neoclassical contention
that unit costs rise as the scale of production (level of output) increases when all
factor inputs are variable.
o The plausibility of the assumptions of managerial and logistical problems
accompanying the growth in scale of firms is dubious.
 It is extremely doubtful that firms calculate their marginal costs of production
and use these as a basis for pricing. Among other things, to calculate marginal
costs would require firms to know the increase in total costs for a one unit
increase in output.
 The notion of opportunity cost as being a guide for business decision-making is
similarly questionable.
 The notion of an economic profit is seen as little more than an ideological
justification for profits – putting it on the same basis as wages for labour.
 Adding individual supply curves to derive a market supply curve requires one to
assume that all firms in an industry operate with similar techniques of production.
 Neoclassicals are even less clear than in the case of demand that when they are
explaining the supply of the product in the context of explaining its relative price,
they are explaining relative supply and, underlying this, the relative costs of
producing it. Indeed, in most textbooks the notion of relative supply, like relative
demand, is missing. The problem is that, if it is the money costs of producing a
product that are seen as underlying the upward sloping supply curve (relating the
supply of the product to its money price), the changes in these (money) costs
would have to be seen as accompanying changes in the value of money and,
therefore, the money costs of producing all commodities. This in turn means that a
change in the (money) price of the product cannot be seen as providing signals for
producers to expand their absolute or relative production of the commodity.

Equilibrium
 This concept shows that the unfettered interaction of demand and supply will
result in an EQUILIBRIUM price which will balance the desires of the buyers of
products (demand) with their availability (supply).
 It is argued that if price either exceeds or falls below its equilibrium level, with no
change in any of the factors determining demand and/or supply, the forces of
supply and demand will bring the price level back to its equilibrium level.
o If price rises above its equilibrium level then supply will exceed demand
and the price will fall back to its equilibrium level. The two forces which

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 ensure this return of price to its equilibrium level are a reduction in the level of
demand and competition among suppliers to sell their goods.
 Shifts in the equilibrium price level are caused by shifts in demand, as a result
of changes in income, tastes, etc., and supply, as a result of changes in technology,
management, worker effort, etc.

Criticisms
 When commodities are seen as being produced and reproduced, then the costs of
production have to be regarded as the primary determinant of the price level,
not demand and supply, especially over the long-run. That is to say, it is costs that
determine prices in the final instance and not demand. Changes in demand will
only have a bearing on prices through changes in the costs of production.
 The existence of an equilibrium price depends crucially on the existence of
(monotonically) downward sloping market demand curves (i.e., continuously
downward sloping demand curves) and, more importantly, upward sloping market
supply curves. For reasons given above neither need necessarily to be the case.
 Market participants may not have accurate information regarding available
products and prices. This could result, in among other things, multiple price
levels. This is a criticism from within the Neoclassical school.
 Prices may be “sticky” or “rigid” – the tendency for prices not to fall. This is also
a criticism from within the Neoclassical school.

Maximum welfare
 Neoclassicals invoke the assumption of CONSUMER OPTIMISATION to show
that the market equilibrium corresponds to a point of maximum welfare. The
assumption is that consumers equate the marginal utility of each good (e.g., MU
of mangoes) with the amount of money they spend on the last unit of that good
(i.e., the amount spent on mangoes) such that all marginal utilities in relation to
the amount spent on the last unit of each good are equal. If all individuals do this
then by definition,

MUx MUy MUz

= = , etc
Px Py Pz

Criticisms
 The implicit presumption is that one can meaningfully talk of aggregate utility or
marginal rates of substitution between commodities.
 Consumers lack the information and processing power to optimise in respect of
every consumption decision. In fact, market demand is better analysed in terms of
advertising, fashion, environment, culture, etc.

Productive efficiency
 Neoclassicals invoke the notion of PERFECT COMPETITION to show that the
market equilibrium corresponds to productive efficiency, i.e., minimum average
cost.

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 Neoclassicals compare perfect competition with monopoly to show that a perfect
competition environment will result in lower average costs and higher output.
 The key assumptions of perfect competition are that firms are; price takers,
earning a normal rate of profit, can produce as much as they wants for the given
market determined price, and there are no barriers to entry in any sector. This
means that no individual firm can influence price; all firms faces a FLAT
DEMAND CURVE.
 Since all perfectly competitive firms must take prices as given, they can only
decide on which level of output to produce. For Neoclassicals this decision is
guided by profit maximisation. Specifically, firms will choose an output level
which maximises profit. This output level for Neoclassicals is where MC=MR.
 At this output level it is assumed the perfectly competitive firm will also be
producing at minimum average cost. The minimum average cost result follows
from the assumptions that there are no barriers to entry. With no barriers to entry
firm cannot charge a price in excess of that consistent with minimum average
costs (which includes a normal rate of profit).
 MONOPOLY is where there is a single firm in an industry. In this case the firm
faces the same (average and marginal) cost curves as firms in perfect
competition but a different demand curve. The demand curve facing the
monopoly firm is the industry or market demand curve, which is downward
sloping.
 Although Neoclassicals are not clear on the matter, it appears that Monopolists too
will chose a profit maximising level of output, i.e., where MC=MR. This level of
output is seen as being lower than in perfect competition and resulting in a higher
level of average costs (and price).

Criticisms
 Although it is certainly true to say that the individual firm does not set the prices
for the products it produces, this does not mean that it is incorrect to conceive of a
certain average firm producing a standard product setting the price of the
product (to cover its profits and yield and acceptable profit).
 Profit maximising firms do not set output levels where marginal cost equals
marginal revenue but rather tend to expand output as much as possible. The
reason they do so is that in reality firms face declining average cost curves and not
U-shaped average cost curves.
 It is unclear that all firms in an industry face the same horizontal demand curve.
This would deny that firms compete with one another by differentiating their
products – by producing slightly different products and advertising.
 One of the premises of profit maximising perfectly competitive firms is they face
U-shaped cost curves. As noted above, this is empirically as well as logically
doubtful.
 Not all firms in the same industry have the same technology and, therefore, the
same cost curves and profit rates. One of the ways in which firms compete with
one another is precisely the lowering of their relative costs of production.
 Many Neoclassicals themselves admit that monopoly industries arise because of
economies of scale. If this is the case then the Neoclassical comparison of
monopoly with perfect competition falls apart. For one thing it cannot be argued

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 that perfectly competitive firms are necessarily lower cost producers than
monopolies.
 If the monopolist also maximises profit by choosing an output level which
corresponds to MC=MR it too needs to be seen as a price taker. Yet, it is known
that monopolists set prices in order to maximise their profits.

Money prices
 As noted above, the Neoclassical product market analysis is in principle
concerned with the explanation of relative prices. However, since it is recognised
that prices are in fact money prices, what Neoclassicals do is explain the relative
prices of products as relative money prices assuming the value of money is either
constant or given, and then explain the value of money subsequently to derive the
money worth of each commodity.
 For Neoclassicals the value of money will depend on the quantity of money in
relation to the quantity of commodities. When there is an increase in the quantity
of money in relation to the quantity of commodities, the value of money will fall
and the average money prices of all commodities will rise. The relative prices of
commodities will, however, remain unchanged unless relative preferences for the
commodities change.

Criticisms
 Neoclassicals are unable to translate relative prices into relative money prices
without making some questionable assumptions – e.g., that money reflects a
certain quantity of general utility for the individual. The notion of general utility is
of course contrary to the very foundations of Neoclassical thought.
 The Neoclassical explanation of the value of money requires Neoclassicals to
aggregate commodities in some way other than in terms of their money value.

Underlying logic
 Neoclassicals seek to emphasise the importance of the price mechanism in the
OPTIMAL ALLOCATION OF RESOURCES (i.e., max welfare and lowest
cost). It is the price mechanism which serves to coordinate the division of labour.
It is the price mechanism which serves to coordinate demand and supply since it is
the sole factor that both of them have in common. Heterodox economists, and
common sense, suggests that far more important in the coordination of economic
activities is profits. It is of note, however, that some Heterodox economists,
following Nicholas Kaldor, see quantity signals as more important than prices in
coordinating activities.
 Neoclassicals want to show that if the market is allowed to work such that there
are no constraints to demand and supply, it (the interaction of demand and supply)
will result in a unique equilibrium sets of prices which will reflect;
a) (natural) PREFERENCES OF INDIVIDUALS, and
b) MINIMUM COSTS OF PRODUCTION where the costs comprise factor
rewards which are determined by preferences of individuals (e.g., between
work and leisure, present and future consumption, etc) and productivities of
factors.

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 Neoclassicals want to show that all economic phenomena can be explained in
terms of the natural (selfish) behaviour of individuals.
 It is of note that Neoclassicals are not alone in explaining the workings of the
system in terms of market demand and supply. Heterodox economists also use
demand and supply. However, the differences between the two concerns the prices
being explained, their perceived role in the functioning of the economic system,
and how they are determined.

Key elements for an alternative theory of product market

behaviour
 Prices being explained should be money price.
 Money prices should be seen as those facilitating the expanded reproduction of
the commodity.
 Demand for commodities should be seen as both consumer and business demand.
o Businesses should also be seen as demanding commodities, and this
demand is motivated by their desire to make profits and not for owners of
the firm to consume products, or consume other products with the revenue
from the sale of the products.
o The consumer demand for the commodity should be seen as being
influenced by advertising and marketing strategies of companies.
 Firms do not set prices on the basis of marginal unit costs, but rather (expected)
average unit costs.
 Firms do not operate at or near full capacity levels.
 Firms see average unit costs falling with expansions in scale and the introduction
of new technologies.
 The magnitude of prices need to be seen as determined by costs in the final
instance (even if the scale of output is seen as determined by demand).
 Although one can accept that markets (prices and output level) move in a way so
as to result in a balance in demand and supply, the norm is imbalance – firms
constantly trying to expand production and take market share from rivals.
 A competitive environment is not one where firms produce at an output that
equates marginal cost with marginal revenue, but one where producers use
marketing and technology change to expand production and take as much market
share as possible.

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