An overwhelming majority of the entrepreneurs thought that a price based on full average cost (including a conventional allowance for profit) was the ‘right’ price, the one which ‘ought’ to be charged.’ In some cases this meant computing the full cost of a ‘given’ commodity,and charging a price equal to cost. In others it meant working from some traditional or convenient price, which had been proved acceptable to consumers,and adjusting the quality of the article until its full cost equalled the ‘given’ price. A large majority of the entrepreneurs explained that they did actually charge the ‘full cost’ price, a few admitting that they might charge more in periods of exceptionally high demand, and a greater number that they might charge less in periods of exceptionally depressed demand. (Hall and Hitch 1939: 19)

This result, among others, caused a heated discussion in American Economic Review, which was started by Richard A. Lester and Fritz Machlup. Lester conducted an empirical analysis similar to the one that Hall and Hitch did, i.e. interviewing companies about their pricing policies. His findings included:

Market demand is more important than wages rates in determining the employment levels for a firm. The firm’s actual cost structure was different that the one suggested by conventional marginal analysis When wage rates change, firms generally do not adjust their use of labor and capital. There are huge difficulties in applying marginal analysis to a real world problems. As a result, many business owners consider it impractical.

These results again put marginalism into serious question.

In his response to Lester, Machlup emphasized two points. First, he claimed that Lester misunderstood the nature of marginalism. Marginalism wasn’t designed to predict and explain the behavior of real firms. Rather, it was designed to explain changes:

Instead of giving a complete explanation of the “determination” of output, prices, and employment by the firm, marginal analysis really intends to explain the effects which certain changes in conditions may have upon the actions of the firm. What kind of changes may cause the firm to raise prices? to increase output? to reduce employment? What conditions may influence the firm to continue with the same prices, output, employment, in the face of actual or anticipated changes? Economic theory, static as well as dynamic, is essentially a theory of adjustment to change. The concept of equilibrium is a tool in this theory of change; the marginal calculus is its dominating principle. (Machlup 1946: 521)

Second, Machlup rejected Lester’s claim that marginalism had no practical use because it was difficult for firms to implement. He used the analogy of an automobile driver changing lanes:

The driver of the automobile will not “measure” the variables; he will not “calculate” the time needed for the vehicles to cover the estimated distances at the estimated rates of speed; and, of course, none of the “estimates” will be expressed in numerical values. Even so, without measurements, numerical estimates or calculations, he will in a routine way do the indicated “sizing-up” of the total situation. He will not break it down into its elements. Yet a “theory of overtaking” would have to include all these elements (and perhaps others besides) and would have to state how changes in any of the factors were likely to affect the decisions or actions of the driver. The “extreme difficulty of calculating,” the fact that “it would be utterly impractical” to attempt to work out and ascertain the exact magnitudes of the variables which the theorist alleges to be significant, show merely that the explanation of an action must often include steps of reasoning which the acting individual himself does not consciously perform (because the action has become routine) and which perhaps he would never be able to perform in scientific exactness (because such exactness is not necessary in everyday life). To call, on these grounds, the theory “invalid,” “unrealistic” or “inapplicable” is to reveal failure to understand the basic methodological constitution of most social sciences. (Machlup 1946: 534-535)

Business owners don’t need to understand the concepts of elasticity of demand, marginal cost, and marginal revenue to implement marginalism. Rather, just like the automobile driver changing lanes, they are implicitly using these concepts in their rule-of-thumb pricing policies. So contrary to the claims of Hall, Hitch, Lester, and others, procedures that appear contrary to marginalism are actually grounded in marginalism (3).

For those familiar with the debates in economic methodology, Malchup’s arguments might look familiar. While he’s certainly not the first economist to support instrumentalism (and Machlup doesn’t explicitly embrace it in his paper), his statements started a noticeable trend in economics. From this point on, neoclassical economists would defend the unrealistic assumptions in their economic theory on the basis of instrumentalism. This would eventually culminate in Milton Friedman’s famous statement (in the context of the marginalist debates) that:

Under a wide range of circumstances individual firm behave as if they were seeking rationally to maximize their expected returns (generally if misleadingly called “profits”) and had full knowledge of the data needed to succeed in this attempt; as if, that is, they knew the relevant cost and demand functions, calculated marginal cost and marginal revenue from all actions open to them, and pushed each line of action to the point at which the relevant marginal cost and marginal revenue were equal. Now, of course, businessmen do not actually and literally solve the system of simultaneous equations in terms of which the mathematical economist finds it convenient to express this hypothesis, any more than leaves or billiard players explicitly go through complicated mathematical calculations or falling bodies decide to create a vacuum.

Alchian’s Uncertainty, Evolution, and Economic Theory

So where does Alchian fall into this? To understand this and why his paper, Uncertainty, Evolution, and Economic Theory, is important, we need to understand how the assumption of profit maximization fits into the marginalist debates. Neoclassical theory assumes that firms want to maximize profits, (which is how they make their price and output decisions) where MC = MR is the profit maximizing condition for the firm (4). Hall, Hitch, and others found was that firms and entrepreneurs don’t really think this way (5). Hall and Hitch suggested several reasons for this, e.g. tradition and fairness, but one of the main things they pointed out was lack of information:

Producers cannot know their demand or marginal revenue curves, and this for two reasons: (a) they do not know consumers’ preferences; (b) most producers are oligopolists, and do not know what the reactions of their competitors would be to a change in price. (Hall and Hitch 1939: 22)

In a world of continuous dynamic change, getting the information needed for marginal analysis is incredibly difficult, if not impossible. In this complicated, uncertain world, profit maximization as a goal doesn’t even make sense, so these firms use rule of thumb policies, e.g. “full cost” pricing, because they provide a helpful benchmark. There needn’t be any assumptions about profit maximization. So we already know how Machlup and others responded to this, i.e. by relying on implicit marginalism (6), but Alchian took a different approach.

For many years, Alchian worked at the RAND Corporation doing systems analysis and the early studies he worked on convinced him that uncertainty (7) was a central challenge to marginal analysis (8). This is immediately clear when he admits that in a world of uncertainty, profit maximization cannot be a guide to action:

In the presence of uncertainty – a necessary condition for the existence of profits – there is no meaningful criterion for selecting the decision that will “maximize profits.” The maximum profit criterion is not meaningful as a basis for selecting the action which will, in fact, result in an outcome with higher profits than any other action would, unless one assumes non-overlapping potential outcome distributions. (Alchian 1950: 212)

But Alchian had a clever way to get around this problem. Instead of focusing on the individual workings of the firm or relying on “implicit marginalism”, Alchian thought that economists should look at the “decisions and criteria dictated by the economic system” (Alchian 1950: 213). To put it differently, an economic system will have a set of “optimal conditions”. We would expect surviving firms, the ones with “positive profits”, to have characteristics closer to these “optimal conditions” (as opposed to the firms that failed). As exogenous and endogenous variables change, the economic system will change over time and the set of “optimal conditions” will be different. New firms will thrive while old firms either adjust or die out and would expect these firms to have characteristics closer to the new set of “optimal conditions”. So via some “evolutionary” process of selection, the system determines which firms will survive and which ones will not.

How specific firms survive doesn’t really matter. Surviving firms could innovate, imitate other successful firms (which would explain why the surviving firms would share many of the same characteristics), use a trial and error process, or just be lucky (9). What matters is that when the economic system changes, the economist can use his analytical tools (i.e. marginalism) to predict where the “optimal conditions” will tend to go. Therefore, the economist can make predictions that are similar to ones in the conventional model with profit maximization. Despite uncertainty, the assumption of profit maximization is still valid:

Empirical investigations via questionnaire methods, so far used, are incapable of evaluating the validity of marginal productivity analysis. This is true because productivity and demand analyses are essential in evaluating relative viability, even though uncertainty eliminates “profit maximization” and even if price and technological changes were to have no consciously redirecting effect on the firms… …The essential point is that individual motivation and foresight, while sufficient, are not necessary. Of course, it is not argued here that therefore it is absent. All that is needed by economists is their own awareness of the survival conditions and criteria of the economic system and a group of participants who submit various combinations and organizations for the system’s selection and adoption. Both these conditions are satisfied. (Alchian 1950: 217)

This is an ingenious way to get around the problem of uncertainty. Instead of making an unconvincing appeal to instrumentalism, Alchian took a macro-based, realist approach to try and save the generality of marginalism. However, despite Alchian’s creativity, his approach wasn’t without it’s problems. His use of biological analogies, e.g. evolution and selection, has some major flaws and whether his model actually succeeds in its aims is another story all together (10). But I’ll save that for another post.

Footnotes: