I support the idea that mining companies should pay a tax that distributes some of the profits from mining to the wider Australian community, and that this tax should be based on prices, rather than merely on volumes sold. The miners have clearly made windfall profits in the last few years as prices for minerals have skyrocketed, and those profits should be shared with the wider community since it, and not the miners, is the ultimate owner of Australia’s mineral resources.
However I can’t go along with the Resource Super Profits Tax (RSPT) as it has been designed, and precisely for the reason given by Ross Gittins in the SMH:
The resource super-profits tax is a state-of-the-art tax, designed by our leading economists not to do all the bad things it’s being accused of. (“Let’s mine bright ideas and stop being shrinking violets”, SMH May 26 2010)
What “state of the art” means in economics, sadly, is applying a textbook model that is empirically and theoretically false to a real industry. Only by luck will it actually have the intended impact.
The Appendix to the announcement document (“The Resource Super Profits Tax: a fair return to the nation”) explains the logic behind the tax using drawings of the costs and prices that economists assume are typical for all firms, from miners to manufacturers.
Figure 1: Treasury’s drawing of the costs faced by a mining project
Neoclassical economists draw this “average cost curve” by combining two other hypothetical curves: one for fixed costs that don’t depend on the level of output (machines in a factory, or the cost of prospecting), and the other for variable costs that do depend on the output level ( labour, raw materials, energy, fuel).
Average fixed cost necessarily falls as output rises—a constant cost level is divided by an increasing output. For variable costs, economists make two assumptions:
- that the cost of inputs remains constant: inputs like labour and raw materials (of a set quality) are assumed to be readily available at a set price, regardless of how many units the firm purchases; and
- that the productivity of these inputs falls as output rises. Economists call this assumption “the Law of Diminishing Marginal Productivity”. Since each worker costs the same amount, but produces a lesser amount than the one before, the marginal cost of production rises.
Average cost per unit falls as the decline in “average fixed costs” (the red line in Figure 2) dominates, but then rises as “marginal costs” (the blue line) increase. The average cost of production is therefore U‑shaped (the brown line).
Figure 2: The neoclassical model of a firm’s costs per unit of output
It’s a simple, intuitively appealing model that is believed by all neoclassical economists. And it’s also empirically false. Over 150 academic studies of manufacturing firms have found that most firms have cost structures that look nothing like these drawings.
The most recent such research—Asking About Prices, by Alan Blinder, a past Vice-President of the American Economic Association—found that 89% of firms reported either constant or falling marginal costs (Blinder (1998)), while previous studies had put the figure as high as 95% (Eiteman and Guthrie (1952)).
It appears that the “Law” of Diminishing Marginal Productivity doesn’t apply in the real world. The reason is simple, and best illustrated with a farming example where the fixed input is land and the variable input is fertiliser.
Economists imagine that a farmer with a 100 hectare farm and 1 bag of fertilizer would spread the entire bag of fertilizer over the entire farm—using all of his both his fixed and variable inputs.
But what a farmer does instead is leave most of the land unfertilized, and spread the bag at the recommended ratio per hectare—since this gives him the highest productivity. As each new bag of fertilizer is added, more land is fertilized, and so on, so that productivity remains constant right out to the 100 hectare limit.
A similar story applies for factories: they are designed by engineers so that they reach maximum efficiency at very close to maximum capacity. When a factory is first commissioned, it will have oodles of spare capacity—since it is built with the expectation that demand will grow over time. Therefore unit costs will fall as output rises because the factory becomes more efficient—not less, as economists fantasise.
There are some reasons to expect costs to be somewhat different in mining to manufacturing, but the proposal as drafted assumes the usual “one size fits all” model of costs. Only by luck would it approximate the real world costs that miners actually face.
Economists cling to the counter-factual fantasy they teach in their textbooks because without that fantasy, their model of a perfectly competitive market falls apart. As Blinder noted:
“The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost.” (Alan Blinder, Asking About Prices, p. 102)
This isn’t bad news for the real economy—it’s just how things are. But it can be really bad news for the real economy when economists design taxes that assume their theoretical model fits reality.
Blinder’s “discovery” of this phenomenon casts an interesting light on the nature of scholarship in neoclassical economics. He undertook the research to provide a “microfoundation” for his position as a “New Keynesian” macroeconomist, where that particular Neoclassical sub-school explains unemployment (and other real world macro-phenomena) by the proposition that prices are “sticky”, and therefore don’t instantly adjust to eliminate involuntary unemployment as unreconstructed Neoclassical theory argues should happen (the rival “New Classical” school argues instead that prices do in fact adjust rapidly, and that all unemployment is voluntary—including that which occurred during the Great Depression).
But though he expected to find a reason for prices not to behave as the textbook said they should—to rapidly bring all markets into equilibrium—he was obviously surprised by what he found. His summary of findings included statements like the following (in addition to the “overwhelmingly bad news” comment above; I’ve added the emphases below):
“in a fair number of cases—and this was the big surprise—we found that the ‘fixed’ versus ‘variable’ distinction was just not a natural one for the firm to make.” (p. 101)
“Firms report having very high fixed costs-roughly 40 percent of total costs on average. And many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks.” (p. 105)
“First, about 85 percent of all the goods and services in the U.S. nonfarm business sector are sold to “regular customers” with whom sellers have an ongoing relationship … And about 70 percent of sales are business to business rather than from businesses to consumers…
Second, and related, contractual rigidities … are extremely common … about one-quarter of output is sold under contracts that fix nominal prices for a nontrivial period of time. And it appears that discounts from contract prices are rare. Roughly another 60 percent of output is covered by Okun-style implicit contracts which slow down price adjustments.
Third, firms typically report fixed costs that are quite high relative to variable costs. And they rarely report the upward-sloping marginal cost curves that are ubiquitous in economic theory. Indeed, downward-sloping marginal cost curves are more common… If these answers are to be believed … then [a good deal of microeconomic theory] is called into question… For example, price cannot approximate marginal cost in a competitive market if fixed costs are very high.” (p. 302)
However, if Blinder had bothered to consult the literature beforehand, he wouldn’t have been the least bit surprised. There have been about 150 empirical surveys of what firms’ costs look like, and how firms actually set prices (See Lee (1998), Downward (1994) and Downward (2001) for surveys). Every single one of them has contradicted the neoclassical textbook. Yet none of them have actually influenced how textbook writers describe firms or their costs.
This is because economics is far more religion than science, and the belief that firms face rising marginal costs—and that prices are set by equating marginal cost to marginal revenue—are akin to the belief in the Resurrection of Christ by Christians: if that belief could be rejected by empirical evidence, then the religion would crumble. So despite the fact that there are a host of academic studies confirming that marginal costs fall for the vast majority of firms, textbooks continue to teach a model based on rising marginal cost.
In a true science, this gaping gap between theory and reality would lead to the revision of theory—after all, that is what ultimately gave us science in the first place, as the failure of the Heavenly Bodies to follow the Celestial Spheres of the Earth-centric Ptolmaic model gave way to the correct Sun-centric view of the solar system developed, against huge opposition, by Tycho Brahe, Copernicus and Galileo.
In economics, this same gap had led to economists ignoring the empirical evidence, even when it is brought to their attention.
As usual, Milton Friedman played a significant role here in suppressing empirical research. Most people with more than a passing acquaintance of economics know that Friedman was the father of the “assumptions don’t matter” methodology that dominates neoclassical economics—the argument that a theory isn’t tested by how close its assumptions accord with reality, but with how well the theory’s predictions fit reality (Friedman (1953b)).
Few realise that Friedman’s actual objective in writing that nonsensical paper was to encourage economists not to read the empirical research by predecessors to Blinder who also discovered that the textbook model of the firm was wildly at variance with reality.
These predecessors—in papers like Means (1935), Hall and Hitch (1939), Eiteman (1947), Gordon (1948), Eiteman (1948), Eiteman and Guthrie (1952), Eiteman (1953), Gordon (1961), Means (1972), and many others—had surveyed businessmen, and like Blinder had found that the vast majority reported that their marginal costs fell with output (the opposite of the textbook model). They therefore challenged the empirical validity of the theory of perfect competition—since if marginal costs were falling, then competitive firms couldn’t set price equal to marginal cost (as the theory asserted) since price would be less than average cost.
Friedman’s advice to economists was to ignore this research, because of his proposition that the realism of assumptions doesn’t matter:
The lengthy discussion on marginal analysis in the American Economic Review some years ago is an even clearer, though much less important, example. The articles on both sides of the controversy largely neglect what seems to me clearly the main issue—the conformity to experience of the implications of the marginal analysis—and concentrate on the largely irrelevant question whether businessmen do or do not in fact reach their decisions by consulting schedules, or curves, or multivariable functions showing marginal cost and marginal revenue.” Friedman (1953a, p. 16; emphasis added)
In fact, whether marginal costs rise or fall with output was far from “irrelevant”, because if that’s how the real world was, then firms couldn’t behave as the theory assumed—since any firm that set its price equal to marginal cost would go bankrupt, as Figure 1 illustrates. It was therefore not a “negligibility” assumption that ignored unimportant details of the real world, but a “domain” assumption that meant that the theory was inapplicable to the real world (Musgrave, Wood and Woods (1990)).
Figure 3: Marginal cost pricing means losses if marginal cost is constant or falling
Nonetheless, economic pedagogy followed Friedman’s advice—rather than empirical research—and economists like those in the Treasury graduated from University without even realizing that the textbook model of the firm was wildly at variance with reality. Then they craft economic policies like the RSPT, as if this unrealistic economic model actually fits the real world.
If economics behaved more like a science than a religion, students might instead have learnt that real companies face cost structures more like the 6th and 7th drawings below than the one drawn by the Treasury above (see Figure 1). Eiteman and Guthrie sent these drawings out to a random sample of firms, and asked their managers to indicate which drawing most closely approximated their average costs as a function of the level of output (Eiteman and Guthrie (1952, pp. 835–836.)). Of the 8, only the 3rd to the 5th are like the drawing used in economic textbooks—and that drawn by the Treasury.
Figure 4: Eiteman’s drawings in his survey of businessmen’s estimates of their cost structures
Just 18 of the 334 survey respondents chose the textbook model; almost 95% of them instead chose Figures 6 and 7. The majority choice of the 7th drawing is completely incompatible with the “price equals marginal cost” neoclassical model, since costs decline right out to capacity, while the second-placegetter 6th is incompatible except right at capacity.
Figure 5: Answers by firms to Eiteman’s survey
|Curve chosen||No. of companies|
Almost 95 percent of firms rejected the neoclassical model—and yet over half a century later, that is still the model that rules economics textbooks. Worse, it is the model on which economists in positions of power over industry—like those in the Treasury and the ACCC—base their interventions in the marketplace.
Figure 6: Summary of Eiteman and Guthrie’s findings
|Result||By Firms||By Products|
|Supports marginal cost model||18||62|
|Contradicts marginal cost model||316||1020|
|Percent supporting theory||5.4||5.7|
The real-world impact of imposing this fantasy model on reality is probably worse for regulated privatized utilities—energy companies and the like—than it is for miners, since there the economic bureaucrats have the power to impose prices that only cover their marginal costs. But the impact of this tax on miners is likely to be far different than what the Treasury predicts on the basis of its “state of the art” model.
This is only one of several problems that come from the RSPT being designed by neoclassical economists. I’ll cover two other problems in later posts.
References—and recommended readings for all economists!
Blinder, A. S. 1998, Asking about prices : a new approach to understanding price stickiness, Russell Sage Foundation, New York.
Downward, P. 1994, ‘A Reappraisal of Case Study Evidence on Business Pricing: A Comparison of Neoclassical and Post Keynesian Perspectives’, British Review of Economic Issues, vol. 16, no. 39, pp 23–43.
Downward, P. 2001, ‘Revisiting a Historical Debate on Pricing Dynamics in the United Kingdom: Further Confirmation of Post Keynesian Pricing Theory’, Journal of Post Keynesian Economics, vol. 24, no. 2, pp 329–344.
Eiteman, W. J. 1947, ‘Factors Determining the Location of the Least Cost Point’, The American Economic Review, vol. 37, no. 5, pp 910–918.
Eiteman, W. J. 1948, ‘The Least Cost Point, Capacity, and Marginal Analysis: A Rejoinder’, The American Economic Review, vol. 38, no. 5, pp 899–904.
Eiteman, W. J. 1953, ‘The Shape of the Average Cost Curve: Rejoinder’, The American Economic Review, vol. 43, no. 4, pp 628–630.
Eiteman, W. J. and Guthrie, G. E. 1952, ‘The Shape of the Average Cost Curve’, The American Economic Review, vol. 42, no. 5, pp 832–838.
Friedman, M. 1953a, Essays in positive economics, University of Chicago Press, Chicago.
Friedman, M. 1953b, ‘The Methodology of Positive Economics’, in Essays in positive economics, University of Chicago Press, Chicago.
Gordon, R. A. 1948, ‘Short-Period Price Determination in Theory and Practice’, The American Economic Review, vol. 38, no. 3, pp 265–288.
Gordon, R. A. 1961, ‘Differential Changes in the Prices of Consumers’ and Capital Goods’, The American Economic Review, vol. 51, no. 5, pp 937–957.
Hall, R. L. and Hitch, C. J. 1939, ‘Price Theory and Business Behaviour’, Oxford Economic Papers, no. 2, pp 12–45.
Lee, F. S. 1998, Post Keynesian price theory, Cambridge; New York and Melbourne: Cambridge University Press.
Means, G. C. 1935, ‘Price Inflexibility and the Requirements of a Stabilizing Monetary Policy’, Journal of the American Statistical Association, vol. 30, no. 190, pp 401–413.
Means, G. C. 1972, ‘The Administered-Price Thesis Reconfirmed’, The American Economic Review, vol. 62, no. 3, pp 292–306.
Musgrave, A., Wood, J. C. and Woods, R. N. 1990, ”Unreal Assumptions’ in Economic Theory: The F‑Twist Untwisted’, in Milton Friedman: Critical assessments. Volume 3, Critical Assessments of Contemporary Economists series, London and New York: Routledge.