Monday, January 27, 2014

Impact Of Piero Sraffa On Industrial Organization

1.0 Introduction

Piero Sraffa, with his 1926 Economic Journal article on the laws of returns, had a great impact on the emerging field of Industrial Organization (I/O). For the purposes of this post, Sraffa's paper can be said to have made two major contributions:

  1. An internal critique of Marshall's theory of partial equilibrium, showing it holds only under the most specious conditions.
  2. Suggestions for how to analyze the wide range of markets between perfect competition and monopoly.

The first contribution is still relevant today, given how the theory of the perfectly competitive firm is still presented in introductory textbooks. One might also argue that how the theories of imperfect and monopolistic competition were developed, they still are vulnerable to Sraffa's critique. In this post, however, I concentrate on a broad historical overview focused on the second contribution above. But Cameron Murray shows that some still find Sraffa's 1920s work of importance for contemporary theorizing about the theory of the firm.

I apologize for lacking references to recent secondary literature. I do not think that the thesis of this post is not well known among historians of economics or the authors of secondary literature.

2.0 Selected Quotes

Sraffa articulated the need for and possibility of theories of market forms between monopoly and perfect competition:

"...when we are supplied with theories in respect to the two extreme cases of monopoly and competition as part of the equipment required in order to undertake the study of the actual conditions in the different industries, we are warned that these generally do not fit exactly one or other of the categories, but will be found scattered along the intermediate zone, and that the nature of an industry will approximate more closely to the monopolist or the competitive system according to its particular circumstances, such as whether the number of autonomous undertakings in it is larger or smaller, or whether or not they are bound together by partial agreements, etc. We are thus led to believe that when production is in the hands of a large number of concerns entirely independent of one another as regards control, the conclusions proper to competition may be applied even if the market in which the goods are exchanged is not absolutely perfect, for its imperfections are in general constituted by frictions which may simply retard or slightly modify the effects of the active forces of competition, but which the latter ultimately succeed in substantially overcoming. This view appears to be fundamentally inadmissible. Many of the obstacles which break up that unity of the market which is the essential condition of competition are not of the nature of 'frictions,' but are themselves active forces which produce permanent and even cumulative effects. They are frequently, moreover, endowed with sufficient stability to enable them to be made the subject of analysis based on statical assumptions." -- p. 542

He stated some basic ideas developed in the theory of monopolistic competition:

"The causes of the preference shown by any group of buyers for a particular firm are of the most diverse nature, and may range from long custom, personal acquaintance, confidence in the quality of the product, proximity, knowledge of particular requirements and the possibility of obtaining credit, to the reputation of a trade-mark, or sign, or a name with high traditions, or to such special features of modelling or design in the product as-without constituting it a distinct commodity intended for the satisfaction of particular needs-have for their principal purpose that of distinguishing it from the products of other firms.

What these and the many other possible reasons for preference have in common is that they are expressed in a willingness (which may frequently be dictated by necessity) on the part of the group of buyers who constitute a firm's clientele to pay, if necessary, something extra in order to obtain the goods from a particular firm rather than from any other." -- p. 544

He described what could be seen as a forerunner of the theroy of kinked demand curves:

"...the forces which impel producers to raise prices are much more effective than those which impel them to reduce them; and this not merely owing to the fear which every seller has of spoiling his market, but mainly because an increase of profit secured by means of a cut in price is obtained at the cost of the competing firms, and consequently it impels them to take such defensive action as may jeopardise the greater profits secured; whereas an increase of profit obtained by means of a rise in prices not only does not injure competitors but brings them a positive gain, and it may therefore be regarded as having been more durably acquired. An undertaking, therefore, when confronted with the dual possibility of increasing its profits by raising its selling prices, or by reducing them, will generally adopt the first alternative unless the additional profits expected from the second are considerably greater." -- p. 548

Sraffa is also a forerunner of the theory of contestable markets, in which one analyzes the effects on existing firms of potential entrants into their markets.

"It should be noted that in the foregoing the disturbing influence exercised by the competition of new firms attracted to an industry the conditions of which permit of high monopolist profits has been neglected. This appeared justified, in the first place because the entrance of new-comers is frequently hindered by the heavy expenses necessary for setting up a connection in a trade in which the existing firms have an established goodwill - expenses which may often exceed the capital value of the profits obtainable; in the second place, this element can acquire importance only when the monopoly profits in a trade are considerably above the normal level of profits in the trade in general, which, however, does not prevent the prices from being determined up to that point in the manner which has been indicated."-- p. 549

I suppose I could also quote Sraffa's suggestion that developments along some of these lines would lead to models with determinate solutions. To summarize, you can see in this paper an outline of a program for the I/O field.

3.0 Impact on Economists Developing I/O

Sraffa was not a voice crying in the wilderness, ignored by economists of his day and thereafter. His paper was one contribution, among many in the 1920s, attempting to articulate the logical requirements for a theory of perfect competition. Sraffa was not even alone in expressing skepticism that one could confidently connect Marshall's theory to the empirical facts. I think of, for example, what has come to be known as the "empty economic boxes" debate.

Edward Chamberlin and Joan Robinson, with their 1933 books on, respectively, monopolistic and imperfect competition, is an example of simultaneous discovery in I/O. Richard Kahn provided Robinson quite a bit of help with her book and was also working on the theory of imperfect competition, if I recall correctly, in his thesis. Kahn and Robinson were directly inspired by Sraffa and interacted with him in Cambridge.

Joe S. Bain and Paolo Sylos Labini provide a later example of simultaneous discovery in I/O. They develop what has become known as "old" I/O, as opposed to more game-theoretic approaches. Sylos Labini, at least, thought of himself as following a Sraffian tradition inasmuch as he was attempting to develop I/O in keeping with a revival of classical political economy. But this observation takes me into Sraffa's later work and beyond the scope of this post.

  • Franco Modigliani (1958). New Developments on the Oligopoly Front, Journal of Political Economy, V. 66, no. 3 (Jun.): pp. 215-232.
  • Piero Sraffa (1926). The Laws of Returns under Competitive Conditions, Economic Journal, V. 36, no. 144 (Dec.): pp. 535-550.
  • Paolo Sylos Labini (1995). Why the interpretation of the Cobb-Douglas production function must be radically changed, Structural Change and Economic Dynamics, V. 6, no. 4 (Dec.): pp. 485-504.

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