Marginal Cost in the New Economy: A Proposal for a Uniform Approach to Policy Evaluations

A Proposal for a Uniform Approach to Policy Evaluations

Roger L. Conkling

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317465225
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Industria de medios y comunicaciones

This volume presents an approach for resolving a variety of public policy debates. It proposes that a single standard - marginal cost methodology - be adopted to replace the haphazard arrays of methods and techniques currenly employed to measure the costs and benefits of disputed policy issues.

1. The Challenge to Orthodoxy

The Boisterous Sea of Liberty is never without a wave.

—Thomas Jefferson

Introduction

“The Challenge to Orthodoxy” was launched by Lawrence H. Summers as secretary of the treasury, prior to his presidency of Harvard University. The challenge was laid down in skeletal fashion in a speech of May 10, 2000, on “The New Wealth of Nations.”¹

Various theoretical and practical issues implied in the challenge were later amplified and more fully explained in a paper by Summers as president of Harvard, written jointly with J. Bradford DeLong, professor at the University of California, Berkeley, and National Bureau of Economic Research (NBER), on a related subject, “The ‘New Economy’: Background, Historical Perspective, Questions, and Speculations.”²

The joint paper does not directly repeat the challenge, and covers more ground than is included in Summers’s 2000 speech. But it richly compliments the speech, and fills in the economic gaps therein. Chapters 1 and 2 quote extensively from these sources.

Because competition is the cornerstone of the nation’s antitrust statutes, any change that would limit competition, whether statutory or interpretive, is likely to be the subject of heated debate. Chapters 1 and 2 provide some of the grist for that debate.

The New Economy

The New Economy is not yet defined in the economic literature,³ but one fact is undeniable. The New Economy is different. Then-treasury secretary Lawrence H. Summers, in a May 10, 2000, speech, described it as “the move from an economy based on the production of physical goods to an economy based on the production and application of knowledge.” The enhancement of knowledge will involve very large fixed costs and much smaller marginal (variable) costs.

The joint DeLong-Summers paper enlarges on that description, comparing the new economy to the old.

We used to live in an economy in which the canonical source of value was an ingot of iron, a barrel of oil or a bushel of wheat. Such economies were based on knowledge just as much as our economy is, but the knowledge was of how to create a useful, physically-embodied good. We are moving to an economy in which the canonical source of value is a gene sequence, a line of computer code, or a logo…. In such an economy, what you know matters more than how much you can lift.

The joint paper also addresses the implications and some of the uncertainties of the shift to the new economy.

The principal effects of the “new economy” are more likely to be “microeconomic” than “macroeconomic,” and they will lead to profound—if at present unclear—changes in how the government should act to provide the property rights, institutional frameworks, and “rules of the game” that underpin the market economy.

* * *

The balance of probabilities is that our modern data processing and data communications technologies are indeed creating a “new economy.” It is likely that they are producing profound change with continuing powerful impact. These are seismic innovations, ranking with electric power. Even if they are not likely to have profound impact in reducing cyclical volatility, they will have profound microeconomic effects that we do not yet fully understand. We already know that the competitive paradigm is unlikely to be fully appropriate, but we do not yet know what the right replacement paradigm will be. We know that property rights become a central question. We know that some market practices—such as price discrimination—that have traditionally been looked at with some skepticism should perhaps be reevaluated.

* * *

… the structural changes that we call the “new economy” are ongoing. Moreover, as the economy’s structure changes, desirable government policies change as well. If we step back a bit, we can see that the governmental foundations underpinning the market system necessary to make it function well are not fixed in stone. As technology and society have changed in the past, what the government needed to do in order to make the market function changed too.

* * *

… in the “new economy” more markets will be contestable. Competitive edges based on past reputations or brand loyalty or advertising footprints will fade away. As they do so, profit margins will fall: competition will become swifter, stronger, more pervasive, and more nearly perfect.

Consumers will gain and shareholders will lose. Those products that can be competitively supplied will be at very low margins. The future of the technology is bright; the future of the profit margins of businesses—save for those few that truly are able to use economies of scale to create mammoth cost advantages—is dim.

* * *

… our modern computer and communication technologies simply make it too cheap and too easy to distribute a competing product.

The Challenge to Orthodoxy

Taking up the large fixed-to-smaller variable cost relationships that he saw would accompany the enhancement of knowledge in the New Economy, Summers in his 2000 speech launched a direct challenge to orthodox microeconomics, on the one hand, and to orthodox antitrust precepts, on the other. Instead of deploring all monopoly and lauding marginal cost pricing, keynotes of widely accepted prevailing doctrines, he advocated a reverse. For the New Economy, he declared: “The only incentive to produce anything is the possession of temporary monopoly power—because without that power the price will be bid down to marginal cost and the high initial fixed costs cannot be recouped. So the constant pursuit of that monopoly power becomes the central driving thrust of the new economy. And the creative destruction that results from all that striving becomes the essential spur of economic growth. In that sense, if the agricultural economies were Smithian⁴ the new economy is Schumpeterian”⁵ (emphasis added).

The 2001 joint paper explains the Smithian-to-Schumpeterian analogy, concluding that the competitive Smithian paradigm fits the old economy but fails to be fully appropriate for the new. It states:

… if we call the economy of the past two centuries primarily “Smithian,” the economy of the future is likely to be primarily “Schumpeterian.” In a “Smithian” economy, the decentralized market economy does a magnificent job (if the intial distribution of wealth is satisfactory) at producing economic welfare. Because goods are “rival”—my sleeping in this hotel bed tonight keeps you from doing so—one person’s use or consumption imposes a social cost: Because good economic systems align the incentives facing individuals with the effects of their actions on social welfare, it makes sense to distribute goods by charging prices equal to marginal social cost….

The competitive paradigm is appropriate as a framework to think about issues of microeconomic policy and regulation.

In a “Schumpeterian” economy, the decentralized economy does a much less good job. Goods are produced under conditions of substantial increasing returns to scale. This means that competitive equilibrium is not a likely outcome: the canonical situation is more likely to be one of natural monopoly. But natural monopoly does not meet the most basic condition for economic efficiency: that price equal marginal cost. However, forcing prices to be equal to marginal cost cannot be sustained because then the fixed set-up costs are not covered. Relying on government subsidies to cover fixed set-up costs raises problems of its own: it destroys the entrepreneurial energy of the market and replaces it with the group-think and red-tape defects of administrative bureaucracy. Moreover, in a Schumpeterian economy, it is innovation that is the principal source of wealth—and temporary monopoly power and profits are the reward needed to spur private enterprise to engage in such innovation. The right way to think about this complex set of issues is not clear, but it is clear that the competitive paradigm cannot be fully appropriate.

The Challenge Dissected

Both the antitrust statutes and prevailing economic thought treat monopoly as an evil, as a condition either to be eliminated or, if it is a “natural” monopoly, to be allowed to exist only under stringent price regulation.

The antitrust laws emphasize the advantages of untrammeled competition. Economics explains the reason, contending that prices will be higher and output lower under monopoly conditions than under competition, both of which are anathema to economic efficiency.

The first element of Summers’s challenge is his refusal to accept the prevailing view that monopoly, simply by reason of its existence, should not be tolerated under any circumstances.⁶

Second, he goes further. He states flatly that a temporary monopoly⁷ is necessary and essential to provide prices high enough to serve as an incentive for investment in a situation where initial costs are high but costs of production of the final product are low.

This situation of high initial and low production costs seem to be increasingly typical in an information economy. Certainly it is already widespread. High profile cases, such as Microsoft now pending in the courts, and the enormous public attention being given to the high prices of prescription drugs, are two illustrations of this cost phenomenon. For both software and new drugs, heavy expenditures for research and development (R&D) are required to engineer a final product. But when the final product is ready for market, production costs in total and per unit are miniscule. Thus a price that would recoup all costs would consist primarily of R&D recovery, with only a small portion for actual production.

The joint DeLong-Summers paper adds the following observations:

High initial fixed costs and low, even zero marginal costs pose difficult questions but also open up enormous opportunities for economic policy. In a “new economy,” the canonical industrial structure will be more like what we have seen in pharmaceuticals, publishing, or the recording industry than in the corn-production or textile or steel industry. The opportunity is that growth should have a greater potential to snowball. Success may have greater potential to become self-perpetuating, as growth leads to rapid declines in prices, and so to further expansion in the market and further growth. We see aspects of this today: orphan drugs cost much more than drugs with a larger market, and best selling books cost much less than academic monographs that very few people may read.

This reality points up the importance of making sure that we function with as large markets as possible. When a market is driven by a positive feedback, its efficiency will be directly related to its size. Larger networks and larger production lines over which to amortize high initial fixed costs will generate cascading benefits. Thus government policies that expand the size of markets in any way—through reducing trade barriers, through improved infrastructure, through the removal of other barriers to market access—become that much more important and that much more worthwhile.

As pointed out in the above quotation, Summers’s second challenge to orthodoxy has widespread implications. The actual impact is unknown, of course, as of this writing, but the fact that a high government official sees some virtue in monopoly, even though the virtue is limited to specific circumstances, may set in motion an ever-widening ripple effect.

The third element of the challenge invokes economic theory as justification for the position that monopoly, in some circumstances at least, is in the public interest.

The linchpin of the argument is that absent monopoly power, that is, under effective competition, prices will sink to an aggressively competitive level. This level, according to generalized micro price theory, will reach equilibrium only when prices have been reduced to marginal costs. So Summers has general theory on his side when he asserts that “price will be bid down to marginal cost.”

Because there is considerable leeway in different versions of theory about how marginal costs are defined, one must look to Summers’s further statement to know how broadly or narrowly he defines the term. He adds “and the high initial fixed costs cannot be recouped”—meaning that these are not included in the marginal cost-based price. By so doing he adopts the narrow version of the definition that economists call “Short-Run Marginal Costs,” abbreviated as SRMC.⁸ Short-Run Marginal Costs covers only the additional or incremental costs—essentially the additional out-of-pocket costs—incurred to produce an additional unit (or g...