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?)