This post is part of a series on the Methods of Political Economy.
Neoclassical economists see-saw between the twin poles of perfect markets and “market failure” in either advocating laissez faire or state intervention. And yet this dichotomy rests on a fundamental mischaracterization of the business enterprise, its role in society, and markets more generally. This essay draws out a heterodox theory of the firm and argues that real-world business behavior can only be understood in light of insights from the Law and Political Economy (LPE) tradition. I draw on the classical economists as well as the Oxford Economists’ Research Group (OERG), especially P.W.S. Andrews. The constitutional theory of the business enterprise (“small-c constitutional” as used by Sabeel Rahman and Christine Desan) discussed here fuses this economics literature with the Legal Realist framework, thereby creating a bridge between microeconomics, macroeconomics, and law. Development of this theory and its implications ought to be central to LPE approaches to understanding how firms do and might operate.
What the neoclassical school calls profit-maximizing behavior involves equating the marginal cost (MC) of production with the marginal revenue (MR) from the output produced. The key features of this theory that I wish to highlight are (1) that the supply and demand curves that undergird it are assumed to be independent from one another, and (2) that under “highly competitive conditions” firms are assumed to remain passive price-takers over time even as they invest and grow. This fantastical model of the perfectly competitive firm is the foundation to general equilibrium theory and free trade and yet, despite criticisms by major authors such as Friedrich Hayek and Joseph Schumpeter, it persists without debate in neoclassical discourse.
In fact independent demand and supply curves are theoretically impossible, following the arguments made by major economists such as Piero Sraffa and P.W.S. Andrews. All firms set prices through continuous, iterative, and strategic behavior as they attempt to differentiate their products and lower their unit costs, especially by exploiting increasing returns to scale. Such behavior is inconsistent with perfect competition, the highest state of competition in neoclassical economics. Of course, neoclassical theory recognizes the existence of large-sized firms and strategic interactions, with the latter obliterating the standard neoclassical pricing theory involving MR and MC since demand curves cease to be stable. However it relegates such a situation to a subset of firms, called oligopolies, which constitute “market failure.” But in fact all firms engage in strategic behavior. It is therefore not surprising that neoclassical models are not used to describe the pricing policies of real-world firms in business management textbooks. And they are not deployed by practical business people as Andrews emphasized.
Real-world firms are price-setters, not price-takers. They try to achieve target rates of return by setting prices on unit costs to sell the output, given their price elasticities of demand and pressures from rivals. Andrews emphasized that price-setting behavior was not a putative index of “monopoly power” since all firms attempt to set prices on the basis of actual and potential new competitors entering the industry. Industry studies confirm that price-setting behavior is prevalent even in highly competitive industries. In other words, competitiveness and price taking are antonymous in the real world. Of course, given their unit costs and competitive pressures, some firms will be more capable than others in setting the price that they want. Consider for example Chinese solar manufacturers who are currently the lowest cost producers, setting the industry’s benchmark price.
Management sets prices on the basis of investment plans which, as Keynes and institutionalist economists like John Commons and Thorstein Veblen argued, are made on the basis of expected profits. The goal, to use Commons’ expression, is to be a going concern over the long haul, i.e. to be financially viable. Pricing policy is central to the going concern: setting an appropriate price over unit costs in an attempt to obtain a target rate of return has to generate adequate cash flow for the firm to grow. Crucially, the time gap between current debt obligations and future revenues always compels the firm to have an adequate stock of liquidity, or cash on hand to pay debts. This money-centered view of the firm is not consistent with the barter-based framework undergirding neoclassical economics which separates money from the real (production-based) economy. And if money fundamentally has a political and legal foundation then so does the firm.
While the business literature conceptualizes a firm’s expected future stream of revenues in terms of risk, Keynes (and Frank Knight before him) demonstrated the importance of the distinction between risk and uncertainty, the latter of which is (a) unmeasurable and (b) sensitive to legal and political context. Contrary to neoclassical models, this implies that firms may not necessarily plough back savings into long-term fixed investments including in R&D activities with hazy or unknown long-term rates of return. Given the legal context, profits could be invested in share buybacks and any number of other high-return financial operations, including derivatives, real estate, junk bonds, etc. In short, a key aspect of supply-side policies is inconsistent with real-world business behavior.
Pricing policy also plays a role in struggles between firms involving what Joseph Schumpeter called the “perennial gale of creative destruction” as opposed to general equilibrium. It is therefore not surprising that since early capitalism, jurists have recognized the principle of damnum absque injuria in order to promote capital accumulation and market growth. Thus, the social costs of business investment (or negative externalities such as pollution) are the inevitable consequences of profit-oriented behavior. It is therefore quite strange to refer to something which is ubiquitous as a “market failure”.
As Legal Realists have long emphasized, law’s constitutive role in determining property and contracts shapes distributional struggles between capital and labor, e.g. over the level of wages and the intensity of labor. Laws also determine business tax rates, the value of land (via zoning law), subsidies, the extent of environmental damage, export-promotion policies and so on. All these background laws influence business costs, market development, and thus pricing and investment decisions. Given systemic uncertainty and their profit motive, firms have always attempted to tailor the political and legal foundations of markets by externalizing costs on to society and undoing laws that restrain their profitability. A key benefit of scale is that, as firms’ weight in the economy increases, so does their structural and instrumental power, making “too big to fail” government bailouts or generous tax cuts and environmental deregulation possible.
In short, corporate lobbying and strategic litigation to fight regulation are not distinct from investment or pricing strategy. The crisis of American manufacturing in the 1980s, for example, which engendered declining stock market valuations not only spurred managers to invest in new cost-saving techniques in an attempt to be competitive but also increased their political lobbying efforts. Clearly, both types of investment had the goal of trying to maintain their firms as going concerns. Business enterprises are fundamentally political creatures.
It is not enough to claim, as do neoclassical critics of neoliberalism such as those who have formed the Economists for Inclusive Prosperity that perfect competition should not be taken seriously given the pervasiveness of “market failures”. I have suggested that both poles of this dichotomy are chimeras. We would do well to jettison the neoclassical theory of the firm. Investment driven by profitability, price-setting, cost containment, and market expansion are at the center of a firm’s identity as a going concern. Thus the business enterprise’s investment activities can only be understood in terms of its embeddedness in a country’s governance structure, i.e. its location in a legal and regulatory framework and political context. This theory of the firm provides another example of the Legal Realist argument that the public and private spheres are enmeshed, and developing its implications is a worthy task for the inheritors of this tradition.