Sunday, November 7, 2010

Understanding Excess Supply (The Non-Algebraic Version), Round Two

Nick Rowe, over at Worthwhile Canadian Initiative, has offered an alternative explanation for excess supply. For the full treatment, see his blog, but the basic idea is this:

Suppose a firm faces a downward-sloping demand curve, as it would under monopolistic competition. (What makes it competitive is that the lack of barriers to entry and exit brings long run economic profits to zero, but that isn’t important here.) The firm sets output where MR=MC, going up to the demand curve to peg the price. At this price, since the firm makes a margin above MC, it would willingly sell additional units if it turns out there are more buyers than it had initially forecasted. This eagerness to sell more “will look very much like excess supply”, according to Nick.

What say I?

1. First, much depends on what we mean by excess supply. I understand this in the ex post sense that, when forecasts are replaced by what actually transpires, most firms are producing at price-quantity points that are not validated by actual quantities demanded. To put it differently, the pricing decisions of such firms, which would have maximized immediate profits (margin times units sold) at a more rightward-situated demand curve, are less-than-maximizing at the demand curve that actually materializes. Excess supply is not just a matter of sellers wanting to sell more; it is oversupply, as demonstrated by the existence of price-quantity alternatives that would have been chosen if the firm had known with certainty what its demand curve was going to be and had priced/produced for that demand curve. To put it a third way, uncertainty about the position of its demand curve can cause a firm to err in either of two directions: it can base its decisions on a demand curve that proves to be to the left of the true curve, or to the right of it. Systematic excess supply says that firms predominately make the second sort of choice. That’s how I would frame the problem: how do we explain this bias, so clearly visible in the real world?

2. Nick’s downward-sloping D solution, off the bat, raises the issue of monopoly itself. The pure monopolist is in Nick’s position, setting a profit-maximizing price and then hoping that an unexpected bounty of consumers materializes. This in turn implies that pure monopoly is effectively a situation of excess supply, even though it is commonly viewed as generating supply restriction relative to perfect competition. I don’t want to use a definition of excess supply for which pure monopoly is the prime exemplar.

3. Another issue is that, to generate its appearance of excess supply, the model constrains a firm facing a downward-sloping demand curve to alter its supply at more frequent intervals than its price. This strikes me as, at best, arbitrary. If pricing and output choices are simultaneous, the appearance of excess supply vanishes from the model.

4. If we were to compare the downward-sloping demand curve hypothesis to my consumer-satisficing alternative, an interesting prediction would be that excess supply would be more prevalent in a more competitive economy in my model and in a more monopolized one in Nick’s. (If consumers face fewer alternative sellers, the force of satisficing in generating repeat sales would be weaker.)

5. In my original post, I did not actually address the pricing side of the firm’s decision, only the output. As it happens, I think pricing is a lot more complex than economics usually portrays it. My limited knowledge of the marketing literature tells me that there are many pricing models to choose from, depending on circumstances and market strategy. There are times when the best idea is to price as low as possible, subject to a cash flow constraint, in order to prioritize market share. There are times when you want to price fully to market, maximizing net revenues myopically, since you are in a late stage of your product’s life cycle. And there are the majority of situations that lie between these extremes. I don’t know what a general theory of pricing would look like, but I know I don’t want to be tied to a mechanistic formula based on MC, MR and D, the first two of which are not often calculated in practice. (How many firms do activity-based accounting?)

10 comments:

Nick Rowe said...

Peter:

This is good. I want to work on your point 1.

Imagine a baker, who bakes one batch of bread early in the morning, then sells it throughout the day. Sometimes demand is unexpectedly high and he runs out of bread ("excess demand"). Sometimes it is unexpectedly low, and he has stale loaves left over ("excess supply").

I am trying to put together some simple sort of analysis to show that under monopolistic competition "excess supply" will be more common. I'm not quite there yet, but intuitively, the bigger the markup of P over MC (i.e. the less elastic the demand curve) the greater the opportunity cost, at the margin, of running out of bread. And so the more bread he will bake, for a given expected number of loaves sold. And so the greater the probability of "excess supply".

Would that metaphor for "excess supply" capture what you mean?

Peter Dorman said...

But why, Nick, would the baker's pricing decision not match his or her output decision? If your point estimate (the certainty equivalent of the prob dist of demand) is x loaves, why not price at the demand curve that yields x loaves?

But now, if actual x is below the point estimate, you have a too-high price as well as a too-low quantity demanded -- an exaggeration of the monopoly outcome, and not what I think of as excess supply.

rosserjb@jmu.edu said...

Peter,

Is this not just the old Chamberlinian "excess capacity theorem"?

Peter Dorman said...

Not really, Barkley. Excess capacity is not the same as excess supply. Chamberlin said that firms would produce to the left of the minimum on their ATC curve, meaning that they had the ability to produce more at lower cost but were not doing so. There is nothing in Chamberlin that implies that the number of goods offered for sale at the prices set by producers will normally exceed the demand for them at that price.

media said...

this is a tangent (or intangible) but regarding bread, i heard on npr (which newt g---i think a character in some story---wants to sh-t down for censoring fox news) that stores throw away huge amounts of bread because they want the shelves full ('attractive') but can't sell all of it.
i bought some bread a couple of weeks (or months) ago. i hear it has gluten in it, whatever that is. whatevuh man, jyb.

john c. halasz said...

How is your question about the excess of supply over demand in an industrial capitalist economy different from the Marxian trope about a tendency toward over-accumulation of productive capital? Of course, the other side of the question of excess supply is the matter of how incomes from production are recycled to constitute demand.

Peter Dorman said...

JCH,

Off the top of my head, I can see these differences:

1. The mechanism is different. It is micro-founded, whereas Marx's is macro-founded (whether or not you think it holds).

2. At the micro level, I think this gives consumers more power than they would otherwise have. Marx doesn't consider how much or little power workers have in their role as consumers. (This is a big gap in his theory. I've written in the past about the significance of this issue in the analysis of alienation.)

3. It's not clear to me that excess supply is a "problem" (much less a "contradiction") at the macro level, although it does say something about how macrodynamics should be understood. For instance, there is no apparent cyclical implication of excess supply as I've described it, nor is there any reason to predict a rate of capital accumulation insufficient to absorb labor supply. It does imply somewhat lower rates of return and higher rates of business failure than would otherwise occur, but I don't see why they can't persist as "equilibrium" features.

SIR said...

Getting down to the company level.

Draw an error band around your expected demand curve. What types of firms might be more inclined to err on the right side of the band?

- those with high margins and lower inventory costs - ie high opportunity costs. Consumer electronics for example

On the left side of the band?

- those with low margins, high inventory costs , low turndown , or short shelf time. Maybe a commodity like coal (storage problems, or not easy to ramp up/ramp down production).

Just a thought.

Martin Langeland said...

"the model constrains a firm facing a downward-sloping demand curve to alter its supply at more frequent intervals than its price. This strikes me as, at best, arbitrary."
Reality being far less rational than the worst of models, I wonder if individual producers vary supply more often than price because it is easier to do. To vary production only requires an order to the shop floor. Complex if GM is the shop, a lot simpler if it is a storefront operation that converts mill rolls of fabric to retail bolts. OTOH to change prices requires informing distributors, marketers, and the general public. Any of these may push back, hence 'sticky' prices.
--ml

Nick Rowe said...

Peter: Here's my second post, in response to this one:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/11/excess-supply-and-monopolistic-competition-again-with-inventories.html