Fallacy of Equilibrium Part 2: The Supply Curve of Monopoly

In our previous post, we exposed the biggest fallacy in Economics as the concept of Market Equilibrium which is taught in basic economics or ‘Econ101’ everywhere, as the supply and demand curve forming an ‘X’ and meeting in a state called exact equilibrium. This was exposed by Smith as mercantile sophistry in Book 4 of the Wealth of Nations because in effect, it establishes a perpetual fight between businesses (suppliers or merchants) and society (demanders or consumers) .

 

We also saw that the mercantilist (Mun), the economist (Samuelson), and the moralist* (Smith), all agree on a downward sloping demand curve. Next, we shall see what they say about the supply curve.

David Hume explained that economic justice is part of general justice since no man can survive or get resources alone. Justice in turn, is an agreement based on a sense of common interest, in the same way that languages and money are created through agreement. This sense of common interest is then derived, not from reason, but from feeling, which is then derived from sympathy with others. Smith then explained that this sympathy arises from a fellow-feeling naturally originating from the conscience of all humans.

Samuelson’s Manufacturer Version

the supply..curve is..the relation between market prices and the amounts of the good that producers are willing to supply. At a higher price of wheat, farmers will take acres out of corn cultivation and put them into wheat. In addition, each farmer can now afford the cost of more fertilizer, labor, machinery, and can now even afford to grow extra wheat on poorer land. All this tends to increase output at the higher prices offered. If society wants more wine, then more labor will have to be added to the same limited hill sites for producing grapes.. according to the law of diminishing returns.. the necessary cost to coax out additional product will have to rise.

Basically, Samuelson says that suppliers react to society’s high demand for a product (which manifests as higher prices), which then motivates them to produce more of that product. Because of natural limitations, the costs of producing each additional product eventually increase and this leads to higher prices at higher quantities.

In this version, the main cause for the rise in prices with rising quantity is the rising cost of production. Thus, we will call this the manufacturer’s version of the supply curve.

Screenshot from 2015-08-24 15:21:05

To Samuelson, the supply curve slopes upward because of rising costs

The Mercantile Version

In England’s Treasure by Foreign Trade, Mun describes the mercantile supply curve:

In our sales overseas, we must think of our neighbours’ necessities, so that we can produce as much of the goods they want that are unavailable anywhere else (besides raw materials), and also sell them dear as long as the high price does not reduce our sales. (Simple England’s Treasure, Chapter 3)

Unlike the manufacturer’s supply curve which rises because of rising production costs (or caused by the supplier), the mercantile supply curve rises because of high demand (or caused by the demander).

When the Merchant is able to sell his goods overseas, he returns to buy more local goods. This raises the price of our local commodities, and consequently improves the landlords’ rents as the leases expire daily. This money, gained by the nation, enables many men to buy lands and make them the dearer. (Chapter 5)

Like Samuelson, Mun also says that higher sales causes prices to rise. However, the cause in this case is not the rising cost of production, but the rising demand, since the merchant also becomes a demander in the process. The main obstacle then is the competition from other merchants who also buy and sell, since they will be fighting for the same suppliers and markets. In this early stage, the mercantilist properly sees that prices are justly determined by the buyers.

Screenshot from 2015-08-24 15:33:02

The upward sloping supply curve is properly stopped by the downward sloping demand curve. A merchant that prices his goods too high, will have no buyers and cannot stay in business unless he has a monopoly, which was the goal of mercantilism

This mercantile supply curve is also seen in modern economics textbooks as the ultra-short run supply curve which is based on profits instead of costs. It explains why Samuelson’s farmer switches from corn to wheat in the first place. Samuelson seems to downplay the profit motive in order to emphasize the law of diminishing returns, whereas modern textbooks seem to go straight for profits.

 

Smith’s version

Smith’s supply curve can be seen in Book 1 of The Wealth of Nations, and like Samuelson, is based on cost and not profits.

When the price of any commodity is neither more nor less than what is sufficient to pay the rent,  wages, and profits employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is sold its natural price…The natural price is the lowest price that a dealer can sell his goods for any considerable time in the state of perfect liberty, or where he may change his trade as he pleases. (WN I. 7. 4)

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Unlike the producer’s or mercantile supply curves which slope upwards, Smith’s ‘social’ supply curve slopes downward to represent less toil and trouble and less energy expense while increasing production, in a phenomenon called economies of scale or division of labour. Why does Samuelson’s costs go up with more production, while Smith’s costs go down, properly leading to lower prices? This is simply because Smith and Samuelson’s costs are seen from different positions:

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From welkerswikinomics.com

Smith’s supply curve is in the left side sloping downwards, representing efficient production, while Samuelson’s is the one on the right, representing diseconomies of scale or when the production is being forced beyond its natural rate or limits. All economics books that discuss the upward sloping supply curve have no choice but to admit that it is caused by inefficiency:

Often an individual firm’s ability to respond to an increase in price is constrained by its existing scale of operations, or capacity, in the short run. For example, Brown’s ability to produce more soybeans depends on the size of his farm, the fertility of his soil, and the types of equipment he has. The fact that output stays constant at 45,000 bushels per year suggests that he is running up against the limits imposed by the size of his farm, the quality of his soil, and his existing technology. (Case & Fair, p. 62)

This admission means that the upward sloping supply curve is unnatural. If a company is unable to supply the needs of its customers, then other companies can enter and address those needs, relieving the original company of the need to produce unnaturally and inefficiently. Therefore, the upward sloping curve can only be true if the company had a monopoly and could charge high prices at higher quantities. This means that both the mercantilist and manufacturer’s supply curves exist only in a non-free society or world which Smith explains simply:

The price of monopoly is.. the highest.. The natural price, or the price of free competition.. is the lowest.. (WN I.7)

Thus we see that the supply curve of modern economics unnoticeably establishes the idea of monopoly as a natural state. This is consistent with the current trend of mergers and acquisitions leading to too-big-to-fail companies which stifle competition for the sake of higher profits for private investors at the expense of the demanders or society.

In part three, we will put these two curves together to see how the merchant and manufacturer’s supply curves, espoused by Economics, actually competes with society, in order to force people to pay higher real prices or endure more toil and trouble (manifesting most usually today as stress and in people working more hours), when in fact, technological and human progress dictate that real prices and toil and trouble must be naturally be lower through time.

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