Joseph Stiglitz Is Wrong About Marginal Pricing

By: Mateusz Machaj

In a recent piece called “Monopoly’s New Era,” professor Joseph Stiglitz has divided the long history of economic thought into two camps explaining the distribution of income: those who believe in competitive markets and those who believe in “market power.” The former tradition evolved into explaining incomes in terms of marginal prices, whereas the latter is focused on explaining two real world problems: rising inequality and higher concentration in various industries (which Stiglitz sees as rise in “monopoly” power). Those two things — we are told — prove the second camp right: market power decides, not marginal pricing.

Considering Government’s Role

One problem with Stiglitz’s analysis is that it attempts to reduce an outcome of complex factors to one simple variable, namely, market “power.” But, while debating and describing income inequality, numerous factors have to be considered. For example, one should not underestimate the essential nature of the current central banking system, which certainly adds to existing income inequalities. Stiglitz does not consider this. On the other hand, however, he gives the examples of banks, which are getting bigger and bigger (market concentration argument). Yet again without mentioning central banking.

To explain income inequality and market concentration in the regulated market economy without referencing government regulations is like telling the story of Romeo and Juliet without mentioning Juliet.

Entrepreneurs and Pricing

Even when we take disregard government’s role in increasing inequality and market concentration, it is worthwhile to explain that bigger gap between rich and poor is not a sign that something has gone wrong with the marginal theory of market pricing. Also, just because some companies are be getting bigger and more powerful in market relations, does not constitute a falsification of marginal pricing theory.

Why is that the case? The essence of marginal pricing theory is that all factors of production contribute to the creation of final value of a product sold to the consumer. Stiglitz actually muddles this theory for he says that factors receive their money according to their “social contributions.” But this is not quite how marginal pricing works. Pricing is not about “contributing” to “society.” It’s about contributing to creating a product sold in the market.

Any entrepreneur attempting to start a business project believes there is something “wrong” or “incomeplete” in the price system, and he wants to fix it. In other words,the job of entrepreneurs is to find gaps, mistakes, and a lack of choice in the price system and “correct” those problems with a more complete array of choices based on solid forecasts (only time tells how solid they are…).

Whenever any product is introduced by an entrepreneur into the market, he only introduces the new product because he believes that it will be valued “sufficiently” high by the consumers. In order to produce this new thing, he needs to hire the necessary factors of production. In a functioning market economy this necessarily leads to withholding factors of production from other lines of production.

Moreover, several conclusions contrary to Stiglitz’s line of reasoning follow from such reallocations of resources:

1. Entrepreneurs are bidding for factors, including labor. In the process they have to at least cover the value of marginal employments which are taken away into new projects (including interest payment). Therefore wages paid out in new business have to at least cover a loss of discounted marginal value from the alternative employment. This also explains why, for example, foreign capital companies when entering the emerging markets pay significantly more than local businesses — because they are bidding away the factors to create something more valuable in the market.
2. The higher income inequality associated with the bidding process does not undermine marginal pricing. It merely means that some of the factors are simply more valuable in production. If a young gifted computer scientist in India starts to work at a distance for the Sillicon Valley company, she will surely receive a higher payments for her work, which would lead to higher income inequality in India. Marginal pricing theory is not overthrown by this, and economic growth of India is not either (India actually gains because of such an increase in inequality!).
3. Successful and increased market concentration is a sign of efficient reallocation of resources and creation of additional market value. We often hear about those successes in the media. What we do not hear are cases of many companies that fail in concentrating, because their attempt is to increase market share without creating additional value to consumers. Concentration just for concentration’s sake is a sure recipe for a failure.
4. The important factor in entrepreneurial process is that market values are not known in advance, and they also are not valid forever. Many companies pay out lots of money to divert factors from alternative employments and miserably fail. Many companies successful in the past keep on doing what they were doing, after a while reach a “Kodak moment” and also miserably fail. No producer can know for sure its future fate in the market.

To sum up, contrary to professor Stiglitz’s thought on this, marginal pricing is doing quite a decent job in explaining the entrepreneurial process. This is especially true of marginal pricing theory with an Austrian flavor to it. We need a little less focus on exploitation, and a little more on human action, please.

This article was initially published on Mises.org.

Photo by Raimond Spekking via Wikipedia.