Markup Pricing Versus Marginalism PDF

Markup Pricing versus Marginalism: A Controversy Revisited
Author(s): Catherine Langlois

Source: Journal of Post Keynesian Economics, Vol. 12, No. 1 (Autumn, 1989), pp. 127-151
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CATHERINE LANGLOIS
Markup pricing versus marginalism:

a controversy revisited
Introduction
As economistsgatheredevidenceon firm price-makingpractices,a

controversydevelopedover the compatibilityof these ruleswith the
andindeed,the relevance
marginalist
principleof profitmaximization,
Inthispaper,themarginalist
of theneoclassicalapproach
and
altogether.
cost controversiesare re-examinedin the light of availablecost and
demandelasticityestimatesfortheautomobile
industry.Thisconfrontationsuggestsanalternative
to theneoclassicalvisionof thefirmthatcan
accountfor markup-over-average-cost-of-goods-sold
pricingandinteon
evidence
cost
and
the
priceelasticityof demand.The
grate empirical
firm describedin this paperviews inventoryholdingas the strategic
quantityvariableandmaximizesaverageprofitper unittimeover the
time it takes to sell outputinventory.In the standardapproach,by
contrast,therelevantstrategicquantityvariableis production,andprofit
time interval.Thusproduction
is maximizedwithina predetermined
costs anddemandmusthavethe sametemporaldimension(costsassociatedto weeklyproductionarematchedto weeklydemand).But this
canbe bypassedif thefirmis thoughtof as maximizingprofit
constraint
madeon the sale of a level of inventory,since the choice of a price
changessales time, andthus the temporaldimensionof the demand
The authoris at the GraduateSchool of Business Administrationat the University of
California,Berkeley. She thanksDennis Quinnand an anonymousreferee for extensive
feedback.
Journal of Post Keynesian Economics / Fall 1989, Vol. 12, No. 1

127
128
JOURNAL OF POST KEYNESIANECONOMICS
thefirmchoosesto consider.It turnsoutthatper-unit-time

relationship
maximization
yieldsa formulaforoptimalmarkupoveraverage
profit
costs (whereaveragecosts areheredefinedas the productioncost of
goodsin inventorydividedby inventory),whichhasbeenshownto be
compatiblewiththeinventoryandpricingbehaviorof GeneralMotors,
of the
Ford,andChrysler(Langlois,1989).Inthispaper,compatibility
modelwithautomobileindustryestimatesof priceelasticityof demand
is established.
Theseestimatesareshownto be compatiblewithaverage
per-unit-time
profitmaximizingbehaviorif averagecostsaredownward
slopingoverthe relevantrangeof outputs.The automobileindustryis
one wherescaleeconomiesandlargeproduction
runsarecharacteristic
of the productionprocess.This providesstrongevidencefor a cost
structure
wheremarginalcostlies belowaveragecostoverthefullrange
of outputs.
In section I, we drawupon Lee's (1984) extensivesurveyof the
tosummarize
thedebateandintroduce
thenature
marginalist
controversy
of this contribution.SectionII introducesthe cost controversyand
of costsanddemand.Interpretadiscussestemporalcommensurability
tionof theeconometric
estimatesof priceelasticityof demandinthelight
of the cost controversyleads to the modifiedspecificationof firm
behaviorpresentedin section III. SectionIV provideseconometric
evidenceto substantiate
thebehavioral
hypothesisof sectionIII.
I. The marginalistcontroversyrevisited
In the decadethatfollowedWorldWarII, the economicsprofession
overtherelevanceto realworldpractice
engagedinaspiritedcontroversy
of marginalist
pricingprinciples.Marginalist
theoryprescribeschoiceof
a priceto ensureprofitmaximization.The facts as presentedby the
authors,suchas Hall andHitch(1939)or Andrews(1949),pointedto
pricingrulesthatemphasizedaverage costs andthe conventionalnature
of theallowancemadeforprofit.Thus,firmsweredescribedas applying
some"standard"markupoveraveragetotalcosts,a factthatraisedthe
issue of compatibility
betweenbusinesspracticeandthe predictionsof
marginalist
pricetheory.
In defenseof marginalist
principleswas the argumentthatrealworld
practicedid not implyrejectionof the profitmaximizingmodelif the
ThusRobinson(1950) arguesthat,in
facts werecorrectlyinterpreted.
orderto decideon the bestuse of its resources,a producercan makea

MARKUPPRICING VERSUSMARGINALISM 129
"roughandreadytest," which"is to calculatethe directcosts,to add

thecostingmarginatwhichthefirm'sresourceswillbe reasonably
fully
employed,andrejectthoseusesinwhichthe'costs'so calculatedexceed
theprobablesellingprice"(Robinson,1950,p. 776).Thefacts,accordusedby firmsto choosethemost
ing to Robinson,reflecttheprocedure
profitablestrategythrougheliminationof theless profitablealternative.
Machlup(1946),amongothers,goesonestepfurtherandarguesthatthe
facts can be interpreted
directlyin marginalistterms:if marginaland
for
averagecostscoincide,andmarkup(chosenwithsomeconsideration
as a proxyfortheinverseof theprice
demandconditions)is interpreted
pricingproceduresare
elasticityof demand,thenaveragecost-oriented
principles.
fullycompatiblewithmarginalist
While authorssuch as Machlup(1946) offeredstrongmarginalist
rationalization
of averagecost-orientedpricingrules,others,such as
of marginalistprinciplesto
Gordon(1948), suggestedgeneralization
accountforuncertainty,
andalternative
information,
imperfect
objective
functionsto integratetheobservedpricingrules.Interestingly,
thebasic
firmassimultaneously
visionof themanufacturing
producingandselling
a continuousflow of outputwas not challengedby eitherpartyin the
debate.Yet,firmsholdinventory,a factthatto thisdayis recognizedby
the marginalistschool as difficultto rationalize(see, for example,
Blinder,1986).
Themodeldevelopedbelowtransforms
theneoclassicalvisionof the
firmto integratethe holdingof inventoryas a strategicresponseof the
firm.Thisapproach
reliesontheassumption
thatconsummanufacturing
ersrespondto theavailability
of commodities,andfirmsholdinventory
to endow their outputwith this characteristic.
Thus productionand
pricingdecisionswill takeexplicitaccountof a firm'sdesiredor target
level of inventory.Themodeldevelopedin thispaperis descriptiveof
the particularlevel that a firm could choose for targetinventory,but it
doesnotmakeexplicitthedynamicprocessof adjustment
of production
andpricethatmusttakeplaceto maintaininventoryat its targetlevel.
Thehypothesispresentedandempiricallytestedin whatfollowsis that
thelevel of targetinventoryis chosentogetherwithits sellingpriceso
thatprofitis maximizedoverthetimeit will taketo sell the inventory.
The firm achievesthis goal by maximizingprofitper unit of time,
optimizationwhichgeneratesa formulafor optimalmarkupover the
averagecost of goodsin inventory,whereaveragecost is the average
the
productioncost of the goods themselves.Thus,by transforming

130
neoclassicalvisionof thefirmto integrateinventory,directcostpricing

is predictedusingmarginalist
terms.
of
wellexplainedin non-neoclassical
terms
is,
course,
Markuppricing
authors
as
Eichner
such
or
who
(1973) Sylos-Labini(1962),
by
emphasizethedynamicaspectsof competition
toexplainfirmpricingbehavior.
is theideathatpricingstrategies
Crucialto thepostKeynesianapproach
areembeddedinhistoricaltime,sincetheyaredesignedto accommodate
capitalaccumulation
by drawingout sufficientfundsto coverthe costs
of growth.Insuchaframework,
costsarethecrucialdeterminant
of price,
and
anddemandconstrains
hence
instead
of
deterprofitability,
growth,
excess demandas
miningpricein responseto a non-zeroper-unit-time
the neoclassicalmodelrequires.Insofaras the modelpresentedin this
papermakesuse of neoclassicalideas (profitmaximization,demand
theoriesof
function),it canbe viewedas opposingthenon-neoclassical
intwo
this
work
deviates
from
the
neoclassical
vision
However,
markup.
treatment
of
time
its
as
a
decision
and
its
variable,
respects:
emphasison
thatfollow
compatibilityof the modelwiththe data.The paragraphs
elaborateon thesedifferences.
Neoclassicaltheoryconfinestherepresentative
firm'sdecision-making
It
chosen,a priori,by thetheoretician.
problemto a temporalframework
is daily,weekly,or monthlyprofitthatis maximized,dependingon the
In
madeaboutthefrequency
of observable
demandvariations.
assumption
thisapproach,
by contrast,thetemporaldimensiongivento demandand
is
determined:
thisfirmchoosesprice,inventory,
and
profit endogenously
thetimeit willtaketo sellit,notjusta priceandalevelof outputtobe sold
withina given intervalof time.By addinga degreeof freedomto the
firm,thismodelallowsforflexibletimingof decisionsover
representative
historicaltimein responseto observedratesof depletionor accumulation
of inventory
is a conceptdefined
holdings.Inotherwords,targetinventory
in continuous
or priceto
time,decisionsto adjustcontinuous
production
accommodate
a changingtargetinventoryandinventory-to-sales
ratio,
made
at
intervals
determined
demand
and
cost
conditions.
being
by
By
theneoclassicalframework
contrast,
impliesthatdecisionsaremadewith
a periodicitythatis commensurate
withthe time intervalwithinwhich
is
and
thepastessentiallyleavesno trace,
maximized,
profit supposedly
in
an
ideal
anddemandhavebeenmatchedand
situation,
since,
production
willhaveno bearingon futuresupplyordemandconditions.
of theproposedmodelwiththe datais also of primary
Compatibility
this
concernto this author,andpromptstwo remarksthatdifferentiate

empiricalapproachfromthe one generallypracticedby neoclassical

of neoclassicaltheoryinvolves
theorists.First,testingof theimplications
of
of the equilibrium
the
unresolved
observability
question
addressing
Because
the
defined.
equilibrium
conceptdevelopedhererelates
concept
it
can
be
level
of
to a target
arguedthat adjustmentto
inventory,
situationsoccursfastenoughto ensurethattheseinvendisequilibrium
toryequilibriaareindeedobservable(FeldsteinandAuerbach,1976,and
this claim).Secondly,it has
MacciniandRossana,1981, substantiate
been arguedby the marginalistschool that the "neoclassical theory of
the firm deserves to survive because of its ability to produceverifiable
predictionsof the qualitativekind" (Blaug, 1980, p. 176). By contrast,
the relevanceof this approachis linkedto its abilityto produceverifiable
kind.If firmbehaviorcanbe describedin

predictionsof thequantitative
the terms outlinedhere, then markupover the cost of goods sold should
coincide with the inverse of the price elasticity of the sales time of
inventory. This elasticity has been measured for General Motors,
Chrysler,and Ford, and its inverse does indeed coincide with markup
over the cost of goods sold as recorded by company accounts (see
Langlois, 1989). It is one of the objectives of this paperto provide yet
furtherevidence of the compatibilityof this approachwith the data.
The marginalist debate illustrates the marginalist school's lack of
emphasis on verifiable quantitativeprediction.Empiricalmeasures of
price elasticity of demand were available in the early 1960s, yet the
proponentsof themarginalistcontroversydidnot appealto themto refute
or confirmthe neoclassical approach.Yet, as will now be arguedusing
automobileindustrydata,the analysis of these elasticity measuresprovides interesting insights. The demand for automobiles has been the
subjectof numerouspost-warstudies,andvariousauthorshaveestimated
price elasticities for the shortandlong runs(Chow, 1960, is the standard
referencefor long-runestimates).As shown in Table 1, short-runprice
elasticity of demandfor automobilesin the U.S. has been estimatedto
lie in the range (-3.1, -1.32). In Machlup's (1946) interpretationof the
facts, the inverseof thepriceelasticityof demand1/IqlIshouldyield profit
maximizingmarkupover marginalcost.
FromTable 1, markupis then estimatedto lie between 32 percentand
76 percent,a promisingoutcome for marginalisttheory,given estimates
of marginalcost in the automobileindustry.White states that marginal
costs formanufacturinglie betweenone-halfandtwo-thirdsof wholesale
prices(White, 1971, p. 120).This estimateis corroboratedby Evans,who

132
JOURNALOF POSTKEYNESIAN
ECONOMICS
Table 1
Short-runprice elasticity of new automobilepurchases:

summaryof studiesof the U.S. market
Study
Period
Estimate
Evans
1948-1964
-3.1
Westin
1. Stock AdjustmentModel
2. DiscretionaryReplacementModel
Weiserbs
1. DynamicLinearModel
2. DynamicQuadraticModel
1953-1972
-1.32
-1.65
1929-1970
-2.13*
-2.32*
* Uncompensateddemand elasticities.
Compensateddemand elasticitiesare also reportedin Phlips.
Sources: Evans, M., MacroeconomicActivity.Theory,Forecastingand Control.An EconometricApproach.Harperand Row, 1969.
Westin,R., "Empirical
Implicationsof InfrequentPurchase Behaviorin a
Stock AdjustmentModel,"AmericanEconomicReview,June 1975, p. 393.
Weiserbs, estimates reproducedin Phlips,L.,AppliedConsumptionAnalysis,
pp. 201 and 207.
statesmarginalcosts to be "abouttwo-thirdsof the manufacturer's

price" (Evans,1969,p. 172).The econometricestimatesof 1 / Irllare
generatedusingretaildata,however,andarethusnotdirectlycomparableto manufacturer
overmarginalcosts.Butmarginalcostdata
markups
attheretaillevelis elusive.Nevertheless,
valuesobtainedfor1/lr\cannot
be heldagainstthemarginalist
if marginalcost
hypothesis,particularly
in the automobileindustrylies belowaveragecost.
Dataon automobilemanufacturing
costssuggeststhatmarginalcosts
areindeedbelowaveragecosts.Theimportance
of scaleeconomiesfor
themanufacturing
andretailof automobiles
is welldocumented
(White,
1971; Pashigian,1961; Davissonand Taggart,1974), and data for
markupover directcost of goodssold is available.Forthe 1950s and
1960s,costof goodssoldwasontheorderof 80percentof thewholesale
price(weightedaverageof Big Threedirectcost of goods sold for the
Manualsis 78.6
period1953to 1972as recordedby Moody'sIndustrial

MARKUP PRICING VERSUSMARGINALISM 133
onlyone-thirdof wholesaleprice,
percent).Marginalcost,representing
fallsshortof averagecost.Thesecostdatarelateto costsincurredgiven
industryoutput.Thefactthatmarginalcost is less thanaveragecost at
that outputlevel suggeststhat,over the whole rangeof outputs,the
downwardslopingaverage
marginalcostcurvelies belowapresumably
Studiesof automobileretailing
cost curve,at least for manufacturing.
suggesta similarpatternfor costs (see Pashigian,1961;Davissonand
Taggart,1974).Thus,thelow valuesfoundfor ITllarenotincompatible
with the industry'scost structure.However,in a worldof declining
averagecosts over the whole rangeof outputs,marginalrevenueand
marginalcost mayneverintersectto yield an optimalmarkupequalto
1 / ITl.The cost controversythatdevelopedalongsidethe marginalist
debatewas concernedwithpreciselythispoint,andit is to a summary
of this controversyand an analysis of its contributionthatwe now turn.
II. The cost controversy and the commensurability
of costs and demand
The debateoverthe shapeof the short-runcosts facedby firmsbeganwith
Eiteman's(1947) discussionof costs.Thecentralquestionwas thepractical
relevanceof the conceptof marginalcost. As Lee (1984) reports,Eiteman
"had never heard any price settereven mentionmarginalcosts." And,
accordingto Eiteman,this was attributableto the difficultiesinvolved in
measuringmarginalcost as soon as a firm used multipleprocesses. But
even if marginalcosts weremeasurable,the shapeof the cost curvesfaced
by a typicalfirmmay denymarginalcosts anypracticalrelevancein terms
of pricingstrategy.Marginalistprinciples,accordingto Eiteman,can only
be implementedif minimumaveragecost obtainsat outputswell below
capacityto guaranteean intersectionbetween marginalrevenueand the
upwardslopingportionof marginalcost.
Eiteman and Guthrie(1952) questioned 366 firms and found 316 to
believe averagecosts to decline with increasedoutput,reachinga minimum at or close to full capacity,with averageandmarginalcost curves
simply stopping at full capacity. The implicationis that marginalcost
lies below averagecost at all levels of operationand "cannot intersect
the marginalrevenuecurve(1) if the averagerevenuecurveis horizontal
or (2) if the average revenue curve is high and relatively elastic"
(EitemanandGuthrie,1952, p. 832). Ritter(1953) pointedout atthe time
thatthis did not invalidatemarginalismas a doctrineprescribingrational

134
doesnotrequireequalityof marginal
behavior,sinceprofitmaximization
revenueandmarginalcostif adiscontinuity
preventsit.Moretothepoint,
EitemanandGuthrie'sfindinglimitsthesetof quantitylevelsoverwhich
costsaredefinedandin mostinstancesimposesa comersolutionto the
neoclassicalprofitmaximization
problem.But,if profitmaximizingdoes
notoccurattheintersection
of marginalrevenueandmarginalcost,the
optimalmarkupovermarginalcost is no longerequalto the inverseof
thepriceelasticityof demand.Andthis sameconclusionholdsif firms
areassumedto makeintertemporal
tradeoffsto, for example,preserve
marketshare,since profitmaximization,thus constrained,no longer
impliesequalityof marginalcostandmarginalrevenue.
Thus,the failureof realworldfirmbehaviorto conformto the marruledoesnotnecessarilymeanthat
ginal-cost-equals-marginal-revenue
profitis notmaximized.Theimplicationis ratherthattheinverseof the
priceelasticityof demandneednotbeaproxyformarkupovermarginal
cost.Theissueis animportant
one,sincenumerousauthorsbaseempirical workon theassumption
that1 /1,9I
doesindeedcapturemarkupover
marginalcost (see,forexample,Sumner,1981,orRosse, 1970).
Withreferenceto automobile
industrydata,thefactthatmarginalcosts
lie belowaveragecostscouldexplainthelow valuesfoundfor Irl.But
forthesevaluesto confirmthehypothesisthatfirmssetmarginalrevenue
equalto marginalcost,it mustbe arguedthatthe schedulesintersect.In
whatfollows,it is shownthat,as longas demandforthefirm'soutputis
not horizontal,an intersectionbetweenmarginalcost and marginal
revenuealwaysexists if the temporalcommensurability
of costs and
demandis bypassed.Moreover-andmoreimportantly-itturnsoutthat
thisdissociationsuggestsamodelof firmbehaviorthat,whenconfronted
withthe data,canbe reconciledwiththe empiricalevidenceon 11 for
the automobile
industry.
Costs definedin the standardmanneras productioncosts have a
temporaldimension.Itis thecostof daily,weekly,ormonthlyproduction
thatis described.The demandandmarginalrevenuecurvesassociated
to suchcostsmust,of course,havethesametemporaldimension.To the
cost of dailyproduction
is associateddailydemandforoutput.It is this
of costs and demandthatprenecessarytemporalcommensurability
cludesanyguarantee
of existenceof a pointof contactbetweenmarginal
costandmarginalrevenuein thecostconfiguration
revealedby Eiteman
andGuthrie(1952).
betweencostsanddemandis a constraint
Temporalcommensurability

that can be bypassed. Instead of interpretingquantity as an amount
as a level of inventory.
producedperunitof time,it canbe interpreted
An inventorylevel is just datedandcanthereforebe associatedto demand
relationshipswith varying temporaldimensions. A stock of outputcan
be sold within a week or a month,dependingon the price chargedfor it.
In other words, an arbitraryprice-quantitypair can always be fitted on
a demandschedule if the temporaldimension of demandis allowed to
vary. If marginalproductioncosts lie below average costs, the pattern
can be reproducedin the cost of goods in inventory.Thus marginalcost
associatedto variouslevels of inventorymay lie below averagecost. But
the possibilityof choosingthe temporaldimensionof demandguarantees
existenceof anintersectionbetweenmarginalcost andmarginalrevenue.
The possibility of choice raises the questionof the significance of the
particulartime frame chosen. In the model developed below, the firm
chooses thattime frameforthe sale of its inventorythatmaximizesprofit
made over the period.Thus the temporaldimensionchosen for demand
is generatedendogenously and is non-arbitrary.To clarify the above
ideas and introducethe model (which will be developed in section III
below), a formalpresentationof demandis necessary.
Inthe standardmonopolymodel,demandis approachedas a one-to-one
relationshiplinking selling price to quantitydemanded.According to
Debreu(1959), who providesa precisedefinition,thetime intervalwithin
which demand will actually be realized is a "compact elementary
interval" whose length "is chosen small enough for all the instantsof
an elementaryintervalto be indistinguishablefromthe point of view of
the analysis" (Debreu, 1959, p. 29). Thus, in defining the concept of
demand,for example, a subdivisionof the elementaryintervalwill not
revealvariationsin quantitydemandedthataremeaningfulfromthepoint
of view of the decisionmaker'sstrategy;day-to-dayvariationsin demand
for a productmightbe meaningful,while the fluctuationsobservedfrom
one minuteto the next aresurelynot.The elementaryintervalis therefore
chosen, in what follows, as the unit within which flow demand is
measured.Following Debreu'sterminology,the elementaryintervalwill
be referredto as a date. Demandat date t is referredto as flow demand
q. At pricep, flow demandof date t can be written
q= q (p, )
Within any date T, flow demandis a one-to-one relationshiplinking
price to quantity.

136
ECONOMICS
The firmdescribedbelowchoosesan inventorylevel andthe time it

will taketo sell it by choiceof a sellingprice.Thusquantitydemanded
is explicitlyassociatedto a lengthof time spanningmanysequential
timeintervals,as wellasto aprice.Forexample,thedemand
elementary
scheduleassociatedto thetimespanrunningfromdate0 to datet, (0, t),
is derivedfromflow demandas follows:
q0(p,t)=
q(p@,)dx
To simplifynotation,the dateat whichdemandoversometime span

asthequantity
is definedwillbeomitted.Thusq (p,t)is tobeunderstood
demandedat pricep if t elementaryintervalsof time elapsefromthe
datefor whichthe conceptis defined.Formally,then,demandat any
date is approachedas a relationshipamongthreevariables:pricep,
quantityq, andtimet. Givenvaluesfor anytwo of thesevariables,the
R (p, q, t) yieldthe valueof the third:to a
dateddemandrelationships
pricepandaquantityq is associatedatimespant anda demandschedule
q(p, t) such that q = q(, t).1 Moreover,providedsome technical
aresatisfied,2theimplicitfunctiontheoremguarantees
that
assumptions
q = q (p, t) or, for that matter,p = p (q, t) or t = t(p, q) can always be
1Givena pricep and a quantityq, sales time t is not uniquelydeterminedif, as flow
demandvaries throughtime, the rangeof prices over which the sales rate is positive
varies. This is a purelytechnicalpoint thatthe following example illustrates.Suppose
expected flow demandfor dateT is given by
q(T)=(-2
+
s-
) p+18 +sin
The flow fluctuatesbetween a peak flow of q = -1.75p + 19 and a troughflow of q =

-2.25p + 17 with periodicity2n. The rangeof prices over which demandis positive
varies between (0, 10.86) for peak flow and (0, 7.55) for troughflow. The demand
schedule thatwould prevailover a periodof t time intervalsis
q(t)=f
q(T)d= -
-2t - c- s+
p+18t-cost+1
It tums out that the demandschedules for t = 5 (q = -9.8209p + 90.7163) and t = 7

(q = -13.9385p + 126.2461) intersectatp = 8.6288, q = 5.9741. Thus this one pricequantitypair is associatedto two values of t.
2If R(p, q, t) has continuouspartialderivativesanda-
( Q, , 7) 0, then thereexists a
neighborhood
U, q,, i) such thatp
p(q, t)
Similarlyfor the othervariables.
t) in U. Similarly
neighborhood
U(p,
thatp = p(q,

locallydefined.Itis to thisconceptof demandthatthefirmwe nowturn

to will refer.
m. A modelof targetinventoryand markup

The modeloutlinedin the paragraphs
thatfollow is descriptiveof an
but
does
not
equilibriumsituation,
attemptto describethe processby
whichthatsituationis reached.Inparticular,
thequestionof existenceof
suchanequilibrium
astheoutcomeof dynamicinteraction
betweenfirms
in an imperfectlycompetitivesettingis not addressedat all. Thus,the
empiricaltestingof the hypothesisdevelopedhereusingdatafroman
oligopolisticindustryrelies on the assumptionthat the equilibrium
describeddoes indeedexist. The model is formallypresentedfor a
monopolist,sincethissimplifiesexposition.Extensionoftheequilibrium
conceptto animperfectlycompetitivefirmis brieflydiscussedin a final
paragraph.
Insteadof maximizingprofitfromthesaleof elementary
timeinterval
demand
at
that
same
firm
this
views
as idealthe
date,
production,
given
situation.
Given
a
the
level
of
held
date,
following
inventory atthatdate
andits sellingprice(whichis assumedunique),aresuchthatprofitmade
over the time it will take to sell the inventory is maximum. Thus, the
choice (p*,q*,t) is optimalfor datet if:
*
*
Atp*it takestimet to sell q*.

(p*,q*)maximizesprofitgiven the demandrelationshipof
dateT; q, = q, (p, t*). Thus, given t, marginalrevenueequals

marginalcost.
(p*,q*, t) maximizes,by choice of any two of the three

variables,p, q, t, averageper-unit-timeprofitx; where
P q- c(q)
t(p, q)
The cost of a level of outputinventoryq to be held at futuredate T is

3 The maximizationof in guaranteesthatgiven optimalt, marginalrevenue equals
marginalcost. However, what is criticalto our argumentis the fact thatunconstrained
maximizationof per-unit-timeprofityields pricingrules thatcan be confrontedwith
the data and shown to be comparablewith it. It is this compatibilitywhich allows us
to conclude thatfirms can be describedas choosing a price to equatemarginalrevenue to marginalcost, not the existence of this intersectionin and of itself. Indeed, if an
upperlimit qxto inventoryof datax is introduced,the firm then solves

138
ECONOMICS
representedby c,(q). Thus, time availableto adjustinventoryto its

desiredlevel (theintervalspanningthe currentdateto datet), as well
costswithineachelementaryintervalof thattimeperiod,
as production
will enterthespecificationof c,(q).It is in thissensethatcostshavethe
threedimensionsprescribedby Alchian(1959). But the time interval
from
relevantto the definitionof productioncosts is hereindependent
the temporaldimensionthe firmwill choosefor demand:optimalt,(p,
to temporalcomq). Thusproductionanddemandarenot constrained
mensurability.
problem,subscript
Turningtotheresolutionof thisfirm'soptimization
Tis omittedto simplifynotation.Thefirm'sobjectiveis to determine
the
time
t.
values
of
three
variables:
and
horizon
pricep, quantityq,
optimal
three
the
value
of
the
Oncevaluesareassignedto two of the
variables,
thirdfollowsfromthedemandrelationship
R(p,q, t).As a result,average
profitperunitof timeXcanbe expressedas a functionof anytwo of the
interest:
variables.Twoformulations
areof particular
above-mentioned
(i)
(ii)
I (p' ,Pq
t) - c (q(p, t))
X (p, q) = p q- c (q)
t (p, q)
Inthefirstcase,thefirmchoosesp andt to solve

Max Xc(p, t)
p, t
while the optimizationproblemassociatedto the secondformulation

reads
Max X (p, q)
P, q
Expressingfirstorderconditionsin eachcasewill yield,amongother

things,a formulafortheoptimalprice.
Max tp, q
P,
p, q - Ct (q)
rt,(p,C)
Sto q< q-c

and, if the constraintis binding,per-unit-timeprofitis not necessarilymaximized
where marginalrevenueequals marginalcost.

MARKUPPRICING VERSUSMARGINALSM
139
Inthefirstcase,theoptimalpriceis obtainedby solvingthefirstorder

conditiona n / a p = 0. As t is held constantto solve forp usingthis
condition,the optimizationyields the optimalprice on the demand
scheduledefinedfortimeintervalt, andtheusualformulafortheprofit
maximizingpriceobtains:
MC
(1)
1+ 1/n (p, t)
whereMCis marginalcost andt1thepriceelasticityof demand.

Inthe secondcase,a formulaforoptimalpriceis obtainedby solving
thefirstorderconditiona / a p = O.Inthiscase,it is inventorylevel q
thatis heldconstantandtheoptimalpriceobtainedcanbe expressed:
AC
(2)
P
l-l/(p,
q)
whereAC is the averageunitcost of goodsin inventory,ande(p, q) =

(at / ap) x (p/t)is thepriceelasticityof thesalestimeof a givenlevel of
inventoryq.
The standardformulaformarkupovermarginalcost is derivedfrom
overaveragecost
Equation(1).Equation(2) yieldsa formulaformarkup
of goodssold:
1
p-AC
P
e(p, q)
Econometricestimates of 1 / e (p, q) for General Motors, Ford, and
Chryslerhave been generated(see Langlois, 1989). They are not statistically different from markups over average cost of goods sold as
recordedin Moody'sIndustrial
Manuals.
In sectionIV, furtherempiricalevidenceof the compatibilityof the
abovemodelwiththedatais presented.Theliteratureprovideseconometricestimatesof r forthe automobileindustry.Dataon markupover
Manuals.
averagecost of goodssoldis recordedin Moody'sIndustrial
The theoreticallink betweenelasticitiesrl ande providesthe tool for
empiricaltestingof themodel.
LinkingT1ande involvesdefinitionof a thirdconceptof elasticity:r =
(3 q / t) x (t/q). {, defined holding price constant,measures the percentage change in quantitydemandedand sold for a 1 percentchange in
the time span allowed for demandto be realized.As shown in Appendix

140
1, elasticitiesr1,e, and C evaluatedat any point (p, q, t) satisfythe

relationship
1 -1
nr=-Ce
or
=-
At the optimalpoint,therefore,C equalsthe ratioof markupover

averagecostto markupovermarginalcost.Givenestimatesof 1/lI and
dataonmarkupoveraveragecost,generatedeconometricestimatesof C
canprovideevidenceto reconcilethedatawiththemarginalist
principle
of equatingmarginalrevenueto marginalcost.
Beforeturningto the empiricalfindingsof sectionIV, thelimitations
of the modelpresentedheremustbe acknowledged.
The abovemodel
describesa monopolist.A formalextensionof the aboveequilibrium
conceptto animperfectlycompetitivefirmcanbe achievedby making
the demandrelationship
R dependon all otherfirms'pricingstrategy.
Thus,in a Nashequilibrium
situation,eachfirmwill choosea markup
overaveragecost of goodssoldequalto 1/e, bute will be a functionof
the prices chosenby all firmsin the industry.Therefore,if a Nash
describesrealworldsituations,the forequilibrium
conceptadequately
mulae derivedfrom the above model are appropriate
tools for the
of
the
model.
Our
model
does
not
address
the fundaempiricaltesting
mentalissueof dynamicsandstabilityof competitivesituations,butthis
is clearlybeyondthescopeof thispaper.
IV. Empiricalfindings:a reconciliationof directcost oriented
pricingwith the empiricalevidenceon priceelasticityof demand
The model presentedin this paperpredictsthatthe ratioof optimal
markupoveraveragecostof goodssoldtooptimalmarkupovermarginal
cost is equalto the percentagechangein quantitysold for a 1 percent
changein salestimegivena price:
1
(3)
C
Iril
Estimatesof 1 /IrlIareprovidedby a numberof authorswhilemarkup

over averagecost of goods sold is recordedin Moody's Industrial
Manuals.Oureconometrictest of the hypothesisthat firms behave
accordingto the abovemodelinvolvesestimatingCforthe automobile
industryfor post-warsamplesthat cover those used by the authors

MARKUPPRICINGVERSUSMARGINALISM141
Table 2
Per-unit-timesales patterns:threenumericalexamples
A:declining
per-unit-timesales
B: constant
sales
per-unit-time
C: increasing
per-unit-timesales
1
2
3
10
9
8
10
19
27
1
2
3
10
10
10
10
20
30
1
2
3
10
11
12
10
21
33
referredto in Table1.Theseestimatesarethenusedin conjunction

with
dataon markupandpriceelasticityof demandto checkwhether(3) is
satisfied.Thedataused,as well as thecopiesof theregressionsrun,can
be obtainedfromtheauthoruponrequest.
The first subsection below discusses the method used to estimate 5,
whilethesecondpresentstheresults,andthethirdconfrontsthemwith
the availableevidenceon markupoverdirectcostsandrl.
Methodology
C is an elasticity concept associatedto the integral of flow demand. In
t), where
otherterms, = q
q (p, t) = o q(p, ) d. Thus, Cwill
at
q
be descriptiveof the progressionof cumulativesales over time, not of
the change over time of per-unit-timesales. To fix the ideas, consider
the numericalexamples in Table 2.
To each date t is associatedsales at that date, q, and cumulativesales
since date 1, q. The elasticities are computedbetween dates 2 and 3. If
per-unit-timesales areconstant(exampleB), the elasticityof the change,
over time, in per-unit-time sales (A q /A t) x t/ q = 0, since this elasticity
is, in fact, a measureof the per periodgrowthrateof sales. By contrast
Aq t
10
5/2
At
50/2
If per-unitsalesdecline,-.2941growthfromdate2 to 3 in exampleA,
r dropsbelow 1 to 0.8696, while for sales growingat + .2174 as in
exampleC, r risesabove1to 1.1111.Thusbarringdramaticfluctuations

142
Table 3
Estimatesof C:Methodology
Sample: 1953.3-1973.5
MultiplicativeModel: DependentVariableLNSALE
IndependentVariables
1
C
LNTRND
LNPRIX
LNGPY
Coefficient
12.730330
0.0183887 -2.0451384 0.6263535
(T)
(6.9467845) (0.3694518) (-4.6618805) (6.3647833)
Adjusted R2= 0.598306
D.W. = 1.600705
MultiplicativeModel: DependentVariableLNQNT
2
C
LNTRND
LNAPRC
Coefficient
(T)
LNCGPY
15.422906 .= 0.5185682 -2.3902806 0.5353927

(7.5093672) (2.9432297) (-5.2871581) (4.4286640)
AdjustedR2 = 0.999878
D.W.= 1.850189
= 0.5185682
Sample 1953.3-1972.4
3
C
LNTRND
LNAPRC
A
= 0.4899031 -2.3714331
Coefficient
15.272142
(T)
(6.82194796) (2.3536793) (-49388468)
LNCGPY
0.5562831
(3.8418860)
AdjustedR2 = 0.999868
D.W.= 1853300
5 = 0.4899031
in sales,Cwill oscillatearound1 whiletheelasticityof thechange,over

saleswill oscillatearoundzero.Typically,inlarge
time,in per-unit-time
in
markets(and the automobileindustryin particular),
percentagefluctuationsin sales are modest.Moreover,if shortenoughperiodsare
consideredso thatpositiveas well as negativechangesin sales occur
fromperiodtoperiod,forexampleseasonally,theelasticityof thechange
sales will indeedfluctuatearoundzero,but
overtime in per-unit-time
with a trendthatmay not departsignificantlyfrom zero. Consequently,
if per-unit-timesales are regressedagainsta time trendto generatethis

to mayturnoutto be
elasticity,theregressioncoefficientit corresponds
modestly positive, but the confidence intervalsurroundingit is likely to
contain zero. In regression 1 of Table 3, the logarithm of quarterly
automobile sales (LNSALE) is regressed against the logarithm of the
time trend (LNTRND), the logarithm of the implicit new auto price
deflator(LNPRIX),andthelogarithmof personalincome (LNGPY).The
coefficienton LNTRNDis indeedcloseto zeroandit is notstatistically

significant.
Therearetwo methodological
to theestimationof r:
approaches
1.Estimate5directlyusingcumulative
seriestoperformtheregression.
2. EstimateCindirectlyusingestimatesof the sensitivityof per-unittimesalesto thetimetrend.
Thesecondmethodassumesthatthefunctional
formchosentodescribe
sales at a price permitsderivationof C, and if so, that the relevant
coefficientis statistically
significant.ButCis linkedto thesensitivityof
salesto thetimetrend,which,as we havearguedabove,is
per-unit-time
not likelyto be statisticallysignificant.Forthesereasons,it is the first
methodthatwe havechosento implement.
The firstmethodis not withoutdrawbacks,
however.Workingwith
cumulativeseriesintroduces
serialcorrelation
thatmustbecorrectedfor.
Moreover,a singlepricemustbeassociatedwitheachlevelof cumulative
sales. If Q, is cumulativesales madeover t quartersstartingfromthe
beginningof the sampleperiod,p, ideallycapturesthe priceat which
cumulativesalesQ,wouldhavebeenmadehadpricesremainedconstant
overtheperiod.A simpleaverageof thepriceschargedoverthetrelevant
is usedto approximate
quarters
p. However,as illustrated
by regression
2 of Table3, this approachprovidesa direct,statisticallysignificant
estimate of C. In regression2, the logarithmof cumulativesales
(LNQNT)is regressedagainstthelogarithmof thetimetrendLNTRND,
averagepriceLNAPRC,andcumulative
personalincomeLNCGPY.By
1
contrastwithregression of thesametable,all coefficientsaresignificantandwithreferencetotheadjustedR2,99.98percentof thevariations
in LNQNTarecapturedby the regression.By comparison,only 59.83
percentof thevariationsin LNSALEarecapturedby theregression.
A finalmethodological
issueis thatof the sampleusedto estimate5.
The estimatesof Careto be confrontedwithestimatesof short-runrl
computedby variousauthors.Butthe samplesuseddo not necessarily
spanfull businesscycles. BecauseCcapturesa trendin the growthof
salesovertime,it is sensitiveto theparticular
endpointchosenforthe

144
sample.A samplerunningfroma peakto a troughwill providea lower

estimateof r thanwoulda samplerunningfrompeakto peak.To avoid
introducinga biasassociatedwiththeendpointchosenforthe sample,
to
Chas beenestimatedoverthe samplesthatmostclosely correspond
those of the authorsestimatingTI,but span full businesscycles. For
example,Westin(1975) estimatesshort-runelasticitiesfor the period
1953to 1972.Cis estimatedfortheperiod1953.3to 1973.4,thesample
thatmostcloselycorresponds
to Westin'sbutspansfullbusinesscycles
(1953.3and1973.4arepeakquarters).
Regression3 of Table3 illustrates
thedownward
biasassociatedwiththechoiceof sample.
Statisticalestimatesof C
Forthereasonsdiscussedabove,Cis estimateddirectlyusingcumulative
series.Moreover,a rangeof valuesfor Cis generatedto accommodate
the multipleestimatesof Trprovidedby the authorsof Table 1. To
generatea rangeof valuesforCforeachsampleperiod,cumulativesales
areexplainedusingtwo differenteconometric
models.
The firstexplainscumulativesales Q, as a multiplicative
functionof
timeelapsedt, averagepricep,, andcumulativeincomey,:
Qt=B Pt ,ptly
Ps
'u,
whereu, is whitenoise. P,is a directestimateof C. P2 reflectsthe

salesto a changeinprice. P2doesnotmeasure
sensitivityof cumulative
a priceelasticityof demand,however,sincefunctionQ,(t,p,,yt)doesnot
capturea demandfunctionbutratheruses pointson demandfunctions
definedforvarioustiIe intervalstodescribecumulativesalesovertime.
ForthesamereasonI3doesnotcapturetheincomeelasticityof demand
buttheelasticityof cumulativesalesto cumulativeincome.
The secondeconometricmodelexplainscumulativesales as a linear
functionof price,timeelapsed,andtotalincomeaccumulated
duringthe
time
elapsed
period:
Q= A +acot+ 2p, + cy, + v,
wherevtis whitenoise.Usingthesecondmodel,Cis theratioof catothe
ratioof averageQtto averaget.
^
Turningto theeconometricestimatesof C,Table4 presentsestimates
to be confrontedto Westin's(1975),Evans'(1969),andWeiserbs'(in
cumulativesales,in numberof
Phlips,1983)estimatesof r. Quarterly

variable.A timetrend(TRND),theaverage
units,QNT,is thedependent
new auto implicitprice deflatorseries (APRC),and the cumulative
The
variables.4
currentdollarnationalincome(GPY)aretheindependent
coefficients
and
5.
All
modelis usedforregressions,1, 3,
multiplicative
aresignificantandhavethe expectedsign. An averagepriceincrease
decreasescumulativesales while an increasein incomeor in the time
allowedforsalesto be madeincreasessales.Theadditivemodelis used
for regressions,2, 4, and6. Again,all coefficientsaresignificantand
havethe expectedsign. All regressionshavebeen correctedfor serial
correlation
AdjustedR2 is of the
procedure.
usingthe Cochrane-Orcutt
orderof 99.9 percentfor all regressions.
Test of the behavioralhypothesis
If firmschoose inventorylevels andpriceso as to maximizeper-unit-time
profit,then at the optimalpoint the following relationshipholds:
or
1
m=m+
where m is markupover average direct costs. Thus, given a range of
values for , computationof the ratio-C/m will yield an intervalwithin
which Tris expected to lie.
For example,regressions1 and2 providea rangefor the estimated

valueof C:.369176to .8789.An estimateof markupoveraveragecost
attheretaillevelhasbeenconstructed
markupsas a
usingmanufacturer
on
dealer
Bresnahan
andReiss
and
information
costs
base,
providedby
(1985)andDavissonandTaggart(1974).Markupoveraveragecostsat
the retaillevel for the period1954to 1973has beenestimatedat 29.6
The
percent.Appendix2 providesa detailedaccountof thecomputation.
ratioof -C to markupthereforerangesfrom -2.97 to -1.25. This is
compatiblewith Westin'sestimatesof price elasticityof demandas
in Table5.
summarized
Regressions3 to 6 of Table4 presentestimatesof Cfor the sample
4The NationalIncome Accounts are the source for the new auto implicit price deflator and currentdollarnationalincome. WardsAutomotiveYearbooksare the source
for unit sales.

146
Table 4
Estimatesof 5
Sample 1953.3-1973.4
1
C
LNTRND
LNAPRC
LNCGY
Coefficient
(T)
14.029798
= 0.3691767 -2.1531173 0.6385347
(6.1594962) (2.0023913) (-4.3748699) (5.1321090)
A
Adjusted R2 = 0.999888
D.W. = 1.897562
5 = 0.3691767
Additive Model: DependentVariableQNT

Average QNT = 70398.839
2
Coefficient
(T)
Average TRND = 43.5
TRND
APRC
LNCGY
44532.420
1422.4177
-667.78975 3.8673892
(1.7941245) (4.0623119) (-4.4233425) (3.0547783)
A
D.W. = 2.066540
, = 0.8789
Sample: 1948.4-1969.4
3
LNTRND
C
LNAPRC
LNCGY
Coefficient
(T)
21.570651
(7.133456)
= 1.1056435 -3.9007135 0.3005679

(8.2087430) (-5.1475341) (2.9499693)
A
D.W. = 2.115463
r = 1.1056435

AverageQNT= 65172.02
AverageTRND= 46
4
Coefficient
(T)
TRND
APRC
CGY
90346.118
1053.7905
-1203.1536 6.466371
(5.3364858) (6.4495549) (-5.0331825) (6.2957888)
Adjusted R2R= 0.999964

=
0.999964
Adjusted
D..
D.W. == 2.081139
2.081139
0.7438
= = 0.7438

Table 4 (continued)
Sample: 1948.4-1973.4
5
C
LNTRND
LNAPRC
Coefficient
(T)
9.4495282
(5.1430586
LNCGY
= 0.7657066 -0.9499821 0.3499533

(4.7955937) (-2.1064163) (3.0954979)
A
D.W. = 2.057361
{ = 0.7657064

AverageQNT= 79724.366 AverageTRND= 54
6
Coefficient
(T)
TRND
APRC
CGY
1055.7221
-351.69931 5.3452385
24667.608
(1.9598794) 10.434661) (-2.2546144) (8.5465201)
A
D.W. = 2.178076
{ = 0.7151
period 1948.4 to 1969.4, which spansEvans' (1969) sample, andsample

period 1948.4 to 1973.4, which spans the post-war sample used by
Weiserbs (in Phlips, 1983). A comparisonof regressions 1, 2, 3, and 4
reveals that the use of an additiveratherthan a multiplicativemodel to
explaincumulativesalesdoesnotbiastheestimateof Cin anysystematic

way. Indeed,for the sample 1948 to 1969, the linearmodel yields lower
estimatesof Cthanthemultiplicative
model,whilethereverseoccursfor
the sample1953 to 1974. As shownin Table5, the rangeof values
generatedfor11includesEvans'(1969)estimateforthesample1948to
1969.The 1948to 1973sampleprovidesa narrowrangefor l, whichis
close to the values foundby Weiserbs(in Phlips, 1983). Weiserbs,
however,usespre-waras well as post-wardatato generatehis demand
elasticities.Oursample,therefore,doesnotoverlaphis.
in Table5, of estimatedpriceelasticitiesof
The fit, as summarized
demandto the rangeof values for iT generatedindependentlyusing
estimatesof C and values for m, providesevidencethat the model
withthedata.
presentedin thispaperis notincompatible

148
ECONOMICS
Table 5
Summaryof results
Regression Results
RelevantComparisonStudy
Sample 1953.3-1973.4
Range for {: [.369, .879]
Markupm: .296
Range foriT:[-2.97, -1.25]
Author:Westin(1975)
Sample: 1953-1972
Price elasticityestimates: -1.65, -1.32
Sample 1948.4-1969.4
Range for r: [.744, 1.106]
Markupm; .302
Range foril: [-3.66, -2.46]
Author:Evans (1969)
Sample: 1948-1964
Price elasticityestimate:-3.1
Sample 1948.4-1973.4
Range for {: [.715, .766]
Markupm: .296
Range forrT:[-2.59, -2.42]
Author:Weiserbs (in Phlips, 1983)

Sample:1920-1970
Priceelasticityestimates: -2.32, -2.13
Conclusion
This paperreviewedthe marginalistandcost controversiesin light of the
post-warstatisticalestimatesof short-run
priceelasticityof demandfor
automobiles.
Theserangefrom-1.32to -3.1.Dataonautomobile
industry
costssuggestthatmarginalcostslie belowaveragecosts.Sincemarkup
over averagecost at the retaillevel is on the orderof 30 percent,this
explainsthelow valuesfoundforir. Buttheissueis thevalidityof the
of 1 / Irllas markupovermarginalcost.Thiswouldimply
interpretation
that firms indeedchoose price so as to equatemarginalrevenueto
marginalcost,butin thecostconfiguration
typicalof the autoindustry,
theseschedulesmaynot evenintersect.Thus,in the absenceof precise
dataon marginalcostsattheretaillevel, confrontation
of themarginalrule
to
the
data
on
would
haveto remain
11
cost-equals-marginal-revenue
inconclusive.This papersuggestsa modificationof the standardfirm
model,whichprovidesadditionaltools to analyze
profitmaximization
thedata.If firmschooseinventoryandpriceso as to maximizeperunit
time profit, formulaefor optimalmarkupsover averageas well as
marginalcostsaregenerated,andtheirratiois predictedto match(, the
percentagechangein cumulativesales thatresultsfrom a 1 percent

changein thetimeallowedforthosesalesto be realized.Inanempirical

finalsection,estimatesof ( aregeneratedandareusedto showthatthe
valuesfoundforrl arecompatiblewithper-unit-time
profitmaximizing
behaviorandtheirinverseare,consequently,proxiesfor markupover
marginalcost.
Appendix 1: Relationship between elasticities rl, e, and 5
Proposition:Elasticitiesil, e, andCevaluatedatanypoint(p,q, t (p, q))

satisfy the relationshiprl = - ( x e.
Proof:
Let
q+
d=d.P=[.E=
dp
a3p at
. dt 1. P
dp
and
A
dt .
dp
at d+at
t=
ap aq dp_
By definitionof l, , and e
A
(1)
+A
=rA
and
A
Replacing e by its value in (1) we obtainthe relationshipbetween rl, e,

and C:
n =- -
Appendix 2: Computationof automobileindustry markup over

directcost at the retaillevel
Thefollowinginformation
anddataare usedto computemarkup:
1. Dealerdirectcostsrepresent
on average35 percentof grossmargin
overmanufacturer
Bresnahan
andReiss, 1985,andDavisson
(see
price
andTaggart,1974).

150
2. Theratioof dealerto manufacturer

marginis constantandestimated
andReiss, 1985).
at .71 (see Bresnahan
3. WeightedaverageBig Threemarkupoverdirectcosts as recorded
inMoody'sIndustrial
Manualsis usedas a proxyformarkupoverdirect
cost.Weightsusedarefirmsharesof totalproduction.
Computationforsampleperiod 1954-1973
Let 100= manufacturer

directcost
over
Manufacturer
markup directcostfor 1954-1973is 21.4 percent.
Manufacturer
price= 127.2
= (.71)x (27.2)= 19.3= 65 percentof grossdealermargin
Dealermargin
Dealer costs = 10.4 = 35 percentof gross dealermargin
Gross dealermargin= 10.4 + 19.3 = 29.7
Retail price = 127.2 + 29.7 = 156.9
Average costs = 100 + 10.4 = 110.4
Marginover averagecosts = 46.5
Markupoverdirectcosts= 29.6 percent

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Markup Pricing versus Marginalism: A Controversy Revisited

Author(s): Catherine Langlois

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