Tuesday, 13 November 2012

Thinking at the margin .... or not

One of the most basis rules of economics is to think at the margin. For example, to maximise profits firms set marginal revenue equal to marginal cost. But do consumers think at the margin in the way economists do?

A new NBER working paper looks at this question. Koichiro Ito asks "Do Consumers Respond to Marginal or Average Price? Evidence from Nonlinear Electricity Pricing".

The abstract reads,
Nonlinear pricing and taxation complicate economic decisions by creating multiple marginal prices for the same good. This paper provides a framework to uncover consumers' perceived price of nonlinear price schedules. I exploit price variation at spatial discontinuities in electricity service areas, where households in the same city experience substantially different nonlinear pricing. Using household-level panel data from administrative records, I find strong evidence that consumers respond to average price rather than marginal or expected marginal price. This sub-optimizing behavior makes nonlinear pricing unsuccessful in achieving its policy goal ofenergy conservation and critically changes the welfare implications of nonlinear pricing.
So consumer's thinking is suboptimal insofar as they think on average not at the margin.

Interestingly as far as the theory of the firm is concerned there has been debate about whether firms price on the basis of average or marginal costs since at least the late 1930s. The most famous of these debates were the “full cost controversy” and the related “marginalist controversy”. The full cost controversy was started by the publication in 1939 of a paper by R. L. Hall and C. J. Hitch which looked at pricing policies of firms. On the basis of questionnaire data Hall and Hitch argued that firms set prices in a “full-cost” way by estimating an average-cost amount at a reference level of output and adding to it a fixed percentage. Full-cost pricing came to be seen as a challenge to the usual marginalist (neoclassical) profit-maximising view of the firm. Long-run profit maximisation would only be achieved if the mark-up bore the correct relationship to the firm’s perceived elasticities of demand. In 1946 labour economist R. A. Lester which argued that the theoretical predicts regarding the relationship between wages and employment could not be found in the data. Lester argued that “[ ...] his empirical research raised “grave doubts as to the validity of conventional marginal theory and the assumptions on which it rests” in the following ways: (1) market demand was more important in determining a firm’s volume of employment than wage rates; (2) the firm’s cost structure was not that suggested by “conventional marginalism” and its capital-labor ratio was not tied to its wage rate structure; and (3) “the practical problems involved in applying marginal analysis to the multi-process operations of a modern plant seem insuperable, and business executives rightly consider marginalism impractical as an operating principle in such manufacturing establishments”. Lester’s conclusion was that businessman did not adjust their employment levels in relationship to changes in wages and productivity in a manner consistent with the marginal theory.

So the debate comes back in a different form.

1 comment:

Eric Crampton said...

I pay about half as much for nighttime power use as compared to daytime; consequently, we shift tons of our household power use to nighttime - dryer, laundry, dishwasher. I'd be very surprised if others on day/night rates didn't do similarly. Is it that people don't *know* the marginal cost they're facing?