The first thing everyone learns about economics is that the demand curve slopes down and the supply curve slopes upwards. This is described as obvious 2+2=4 and a fact that needs little proof. But recently I read Debunking Economics by Steve Keen which has turned my view of economics on its head. What if down is really up? What if everything taught in basic economics is wrong? What if the supply curve really slopes down?
The orthodox or neo-classical view of the supply curve is simple. In order to increase production it is necessary to pay a higher price (according to the law of diminishing marginal returns) therefore the supply curve slopes upwards. There are various hypothetical examples given, such as farmers will naturally work the most fertile land. Therefore if they wish to increase production they must cultivate less fertile land. Or if you are picking apples, you will naturally pick the easiest to reach ones first. If you wish to increase your collection it becomes more and more difficult so that the number of apples you pick per hour decreases.
There are two things you note about these examples. Firstly, they are hypothetical not empirical. I have yet to see a textbook use a real world example of diminishing marginal returns. Secondly the examples refer to agriculture. This is a crucial point. While it is clear that the law does apply to agriculture (which was the dominant occupation in the 19th century when Ricardo theorised the law), it certainly does not apply to manufacturing. To apply the law of diminishing marginal returns to manufacturing is to completely miss the point of the Industrial Revolution. The essential reason for the jump in output and living standards that took us out of the Middle Ages is that industry harnessed the power of economies of scale. The Industrial Revolution occurred because the law of diminishing marginal returns did not apply.
Economics should be a study of why some countries are rich and why others are poor. The essential reason is due to specialisation and economies of scale. The fact that this is ignored by economics textbooks is absurd. If the law of diminishing marginal returns really was a law then we would not have much of an economy to study. If it was true firms would be tiny cottage industries and we would not have any of the massive global multinational behemoths.
These theory falls down (like most neo-classical theories) once we enter the real world. First it fails to take into account that all factories are built with excess capacity. That is they have some idle space just in case they need to expand production quickly. It would be daft not to. After all if a factory is always running at full capacity, it would need to move build a bigger factory every time its output grew by as little as 2%. All factories are deliberatively designed in such a way as to keep marginal costs down if production unexpectedly increases. In order words all factories are designed to make sure the law of diminishing marginal returns doesn’t apply and that their supply curve doesn’t slope upwards.
The neo-classical assumption is based on the presumption that capital is kept fixed. However in the real world it rarely is. Rather labour and capital usually rise hand in hand. For example if there are 10 workers equipped with 10 shovels, no firm is going to hire an extra worker without acquiring another shovel. While you can squeeze two workers at a table instead of one, this would only be a temporary situation lasting only a couple of days. If it went on for months or years it would be the sign of a deeply inefficient firm.
The commonest explanation for why the supply curve must slope up is that if it didn’t a firm could produce an unlimited number of goods. This misses the point. It is true that a firm could produce an enormous amount of goods at a profit, but it wouldn’t be able to sell it. It is competition and the size of the market that hold the firm back not the supply curve. The constraint lies in sales not production.
The law of diminishing marginal returns only applies when a firm is working past its maximum efficiency point. It is only here that the supply curve slopes up. But how many firms are at maximum efficiency? At the present moment stuck in a recession, I would say next to none. But even during a boom, the economy can only be past maximum efficiency with a full employment of labour and capital. The supply curve only slopes up in a world of zero unemployment and zero savings.
Steve Keen concludes that an upwards sloping supply curve is “wrong in fact as well as theory.” He mentions that 150 empirical studies of the firm have concluded that the vast majority of firms have high fixed costs and falling or constant marginal costs. In one study managers were shown graphs describing various possible supply curves. Almost none of them choose an upwards sloping supply curve in accordance with the law of diminishing marginal returns. Instead 95% of them choose a graph with a supply curve that initially slopes downward before flattening out. Another study in 1998 by the former Vice-President of the American Economic Association and vice-chairman of the Federal Reserve, Alan Blinder declared “The overwhelming bad news here (for economic theory) is that, apparently only 11 percent of GDP is produced under conditions of rising marginal cost.”
This discussion of the supply curve might have seemed to be a dry and obscure discussion of abstract principles. However if the supply curve does not slope up then (when the fact the demand curve does not slope down is also taken into account) the entire neo-classical theory collapses. All conservative free market arguments are flawed. All arguments against high wages or government intervention are based on false premises. Everything we think we know about economics must be rethought. We are truly through the looking glass and into the topsy-turvy world where up is down and down is and nothing they teach you is right. The problem is it resembles the real world better than any economics textbook.