Against Marginalist Pricing Theory: US Consumer Prices and Capacity Utilisation

Fixing the Economists Article of the Week

by Philip Pilkington

Marginalist economic theory tells us that when there is unemployment of capital resources prices should fall. Some marginalists like the New Keynesians and the neo-Keynesians will supplement this by saying that prices can tend to be ‘sticky’. Let us ignore these for a moment and come back to them in a moment. Let us first take the idea that prices should fall when there is unemployed plant and equipment.

First of all, some theory. The argument is extremely simple: if plant and equipment are unemployed then there is inadequate demand for the goods and services being produced. In marginalist theory firms should respond to this shortfall of demand by cutting prices. This will generate more demand at the lower price and the market should clear; i.e. the plant and equipment will be brought online once more.

If this argument is true then we should see prices fall when capacity utilisation falls. We should clear here: we are not saying that we should see inflation slow down when capacity utilisation falls. Rather we should see prices fall — i.e. we should not see inflation slow but rather we should see deflation.

During the extreme events of 2009-2010 we actually saw this relationship for a very brief moment in time. You can see how this relationship looks on the two graphs below. On the left is a scatter-plot diagram that maps the relationship between CPI inflation and capacity utilisation while on the right is a simple line graph depicting the same relationship. (The blue line is CPI and the red line is capacity utilisation).

Without getting into the debate as to how far prices should theoretically fall for a given fall in capacity utilisation we can at least visualise how such a relationship should look. (In actual fact we should see far larger amount of price deflation to clear markets where capacity utilisation has fallen below 68% as we see above, but regardless…).

Now, when we turn the the larger aggregates of data we see something rather different altogether. Here is the data for the inflationary period between 1967-1981.

Not much a positive correlation here at all. In fact we appear to have something of a negative correlation (indicated by the downward-sloping trend-line). We could probably do some arbitrary ‘lagging’ here to get a better fit but as we shall see we would then have to alter the lags significantly in the next time period to get a similar fit. Besides, at no point in this period do prices actually fall.

But maybe given that the inflation in this period was rather high this was just a freak accident. So, let’s turn to the era of the ‘Great Moderation’.

Here we have a slight positive correlation. But it is not very strong. Again, some lagging might do the trick. But a glance will confirm that the lags imposed on this time period would have to be very different from those applied in the last time period to make it fit. Frankly, I think any move in this direction would be the sort of statistical cheating that goes on so much in economics and should be dismissed well before it gets underway. Anyway, none of this should concern us too much lest we lose sight of the key argument.

What is most important, as we have said, is that we actually only see one period in which prices actually fall (2009-2010). Even when we do see the positive correlation that we are looking for in other periods — however slight that might be — it is only a manifestation of a slowing of inflation and not deflation.We can see this particularly clearly if we zoom in on the period of the 1981-1982 recession which, apart from the recession of the late-00s, is the largest on record after World War II.

As we can see, we have a very tight positive correlation between inflation and capacity utilisation. But all we see is a fall in the rate of inflation. We never see actually see a fall in prices (i.e. deflation) and as we have said: for the marginalist argument to work prices have to actually fall when demand dries up and capacity utilisation falls.

Okay, but no one really believes that prices adjust in the short-run, right? As I said, the New Keynesians argue that prices are indeed ‘sticky’ and so we should not expect them to fall when demand for goods and services dries up. But my question then becomes: where is this ‘long-run’ period in which prices do fall in response to a shortfall in demand? If the long-run is merely a series of short-runs — and, indeed, what else can it be? — then when or where does it come about?

I suspect that it is not actually an entity that we can track in time-series data because it is not actually an entity that exists outside the minds of marginalist economists. When they say that prices adjust in the long-run they are saying nothing at all, or at least nothing that corresponds to anything that happens in the real economy. The New Keynesians hint that markets will clear up low capacity utilisations in the ‘long-run’ but this long-run never turns up in reality because it is a mystical and spectral entity. Indeed when we consult Wikipedia we see that the ‘long-run’ is actually a tautological entity.

In macroeconomics, the long run is the period when the general price level, contractual wage rates, and expectations adjust fully to the state of the economy, in contrast to the short run when these variables may not fully adjust.

The long-run is thus defined as being when the price level falls to soak up excess capacity. Now, when we examine the data this never appears to happen. Does this not then mean that, by the above definition, the long-run does not exist in the real-world? I would argue that this is indeed the case: the long-run as so defined does not exist in the real-world. It is either a tautological thought experiment or it is nothing at all.

So, why do the marginalists hold to such a tautological thought experiment? I believe that this is ideology plain and simple. It is simply a belief — not subject to empirical validation or invalidation (i.e. in Popperian terms: non-falsifiable and thus non-scientific) — that the marginalists believe because they want to believe in it. When you start to dig this deep you start to see what this particular wing of the profession actually are and what purpose they serve in society. But let us not address such issues here.