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Strategic Competition
Political Economy is the overarching paradigm that combines Keynes’s
macroeconomics with Strategic Competition’s microeconomics. It includes
Institutionalists, Post-Keynesians (modern advocates of Keynes), radical economists,
many business economists. This essay focuses on Strategic Competition, drawing links
to Keynes’s macroeconomics to illustrate how this microeconomic approach is really
implicit in the Keynesian-Cross model taught in introductory macroeconomics.
Strategic Competition shares five assumptions with Imperfect Competition. They
are:
1. Industries tend to be dominated by a few companies.
2. Even in industries with many suppliers, if the top 4 sellers serve 20-30% of the
market, they have significant market power. The same is true for the top 4
purchasers (e.g., of agricultural products, or hirers of labor).
3. There are major barriers to entry (brand, capital costs), and exit is costly when
equipment has little alternative use.
4. Product differentiation is a conscious strategic choice, and goods are
heterogeneous as companies seek to define their own market niche. Similarly,
labor is not homogeneous but varies, and companies use ascriptive worker
characteristics to facilitate wage discrimination (a la the price discrimination
model).
5. Uncertainty prevails about the present and the future. Information is costly and
not necessarily reliable once acquired, and sequential time means the future is
unknowable.
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Strategic Competition is also premised on 4 additional assumptions which
differentiate it from the Neoclassical Synthesis of Perfect and Imperfect Competition:
6. Management is separated from ownership. There is no single entrepreneur who
performs both functions, the stockholders who get profits are not the same people
as the managers who decide on real capital investment decisions, whose
remuneration is often tied to profit performance by bonuses, but whose lived life
on the job also matters to them and whose career choices may benefit from
engaging in practices that hurt company profitability in the long run (private jets,
etc.).
7. Constant returns: Given an optimal staffing ratio for your capital stock, and
optimal K/L ratio at any point in time, companies expand output by expanding the
hours each piece of equipment is used. Businesses do not operate a piece of
equipment unless there is demand for the output they will produce. They use
shifts and overtime to expand past 8 hours/day. This has two implications: 1) the
economy is reproducible and expandable, and 2) companies are demandconstrained, not cost-constrained.
8. Companies seek long-run profitability, and are willing to sacrifice short-run
profits for long-run gain. This drive to increase their rate of profit lies behind
both macroeconomic activity and industry dynamics.
9. Choices are made by households based on the internal structure of the household
itself. Choices are social, not individualistic. And since the social distribution of
wealth implies that many people rely on wage labor to provide for basic needs,
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those needs dominate over choices in labor-market settings. Human beings are
mortal, they are not floating brains. Income effects dominate substitution effects.
Price Determination under Strategic Competition
Productivity
Companies operate at their optimal staffing ratios (e.g., one computer, one person.
Having an extra computer does them no good. Having an extra person is superfluous).
They expand operations by using only the machines whose output they can sell, adding
shifts, or overtime work.
As output expands, productivity does not rise and fall, it stays constant at the
optimal level. Therefore
APL = MPL
Average and Marginal Products are straight lines drawn through the highest point on the
Neoclassical APL curve.
Figure 1
Average and Marginal Labor Productivity
q/L
MPL = APL
L
Economists call this constant returns (as vs. the Neoclassical paradigm’s
diminishing returns).
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Costs
Using the same logic as the Neoclassical model, MC is inversely related to MPL
because labor costs are 60-80% of company variable costs. Therefore MC is the mirror
image of MPL, and the marginal cost curve is a straight horizontal line drawn at what
would have been the minimum of the Neoclassical AVC.
Since AVC mirrors APL, average variable costs are represented by the same
straight horizontal line as marginal costs:
MC = AVC = straight horizontal line (see figure2).
Figure 2
Company Costs: Average Total Costs,
Average Variable Costs, and Marginal Costs
$/unit
ATC
MC = AVC
q
Constant returns can be shown to be inconsistent with the standard Neoclassical
assumption of short-run profit maximization, a reminder that any paradigm has an
internal logic that typically does not allow us to vary one assumption at a time without
threatening the whole intellectual apparatus.
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Suppose a company under Strategic Competition assumptions followed the profitmaximization rule of the Neoclassical model, just for the sake of argument. Profit
maximization implies
P = MC
But
MC = AVC,
so all companies are at a shutdown point. [Under PC, when MC crosses AVC, if P =
AVC at that minimum, you learn that the company will be unable to cover its overhead
costs at all, and will shut down, even in the short run.] The whole economy would be out
of business.
Administered Pricing
If marginal-cost pricing cannot be the rule for pricing and output supplied, what is?
Gardiner Means, in the 1930s and 1940s, studied what he called administered pricing,
whereby the company’s administration sets prices consistent with its short-run and longrun goals.
What the company does is to gather data from its regional offices and subsidiaries
about current output and sales, and projected sales for the following year. What they
think they will be able to sell next year, combined with the central office’s projections of
aggregate economic activity, determines q*, their targeted output. Their marginal cost
equals the average variable costs as shown above, and their average total costs (ATC)
will be steadily declining towards AVC as companies spread their overhead over more
units of output.
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Figure 3
Administered Pricing Under Constant Costs
$/unit
P*
ATC
MC = AVC
q
q*
Under PC, ATC includes normal profits as the opportunity cost of capital. Under
Strategic Competition, ATC includes the targeted profit rate. So at q*, find ATC, set that
equal to P*, the administered Price chosen by the business. Note companies’ bias
towards expanding beyond q*. This will not only generate profits from additional sales,
but also additional profits from spreading the overhead over more units of output.
We can interpret this price (P*) as a mark-up over average (variable) unit cost.
P* = (1+ *)AVC
Suppose AVC = $5, and P* = $10, what is the mark-up (*)? Express it as a percent.
$10 = (1+ *) $5 =>  = 1 = 100/100 = 100%.
Company Supply
What will the company actually supply? It has its target q*, its actual sales will
depend on what people are willing to buy. Then the company supply curve would be:
qs = qd , since companies will supply whatever they can sell. Demand drives company
production, demand creates its own supply.
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Figure 4
Individual Company Supply Schedule
P*
S
Q
This is called passive supply or responsive supply. It is a perfectly elastic supply
curve. However, companies are not passive in the marketplace, they are active in pricesetting, and responsive in supplying output.
Effective Aggregate Supply, Keynesian-Cross Model
This passive supply line is the same as the original theory of supply offered by
Keynes in the General Theory of Employment, Interest and Money. It is the same as you
learned in intro macro when you did the Keynesian-Cross model. The 45o line is a
passive supply line, along which Ys responds to effective demand, or AE:
Ys = AE.
Combining Keynes’s theory that consumer spending depends son income, so
AE = A + mpcYD,
Where A is the autonomous component of spending,
mpc is the marginal propensity to consume out of each additional dollar of
income,
YD is disposable income (take-home pay, after-tax income).
In Keynes’s model, which we teach as the Keynesian-Cross model, AE determines the
level of output supplied by business. The microfoundations of that model is the Strategic
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Figure 5
Keynesian-Cross Macro Model of GDP-Determination
Ys = AE
AE = C+I+G+NX
= A+mpcY
AE
A
45o
Ye
Y
Competition model based on different underlying assumptions from the Neoclassical
Synthesis. This is Keynes’s theory of Effective Aggregate Supply: companies do not
supply what they wish they could sell so as to “maximize profit,” they supply what they
can actually sell.
Labor Supply and Goods Demand
To analyze both labor supply and the demand for goods, it is necessary to look at
households rather than individuals and to recognize the social character of choice.
Choices are made by households based on the internal dynamics of the household itself.
Economic actors are not ‘Robinson Crusoe’ individuals but household members. Their
choices are social, not individualistic.
Decision-making inside the household depends on power structure there. Patriarchy
or rule by the father (over the mother and over the children, male and female) has been
the traditional decision-making mode. Modern capitalism has broken down some of the
basis of patriarchal rule. More egalitarian household structures are emerging. To the
extent that women can earn a living wage, wives are no longer as economically
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dependent on their husbands. And husbands can make a living without dependence on
their fathers for farmland, or for the tools of their craft, and are no longer burdened with
total responsibility for providing the family with income. To discern whether patriarchy
(in its many different cultural forms, including Purdah for instance) or egalitarianism
reigns requires looking inside the household, not treating all households as identical.
In addition, people do have a sense of justice, morality, and their rights as human
beings that affects their choices, they are not just motivated by individual well-being.
Economists have frequently concluded that strike activity is irrational because they can
show that the wage earnings lost to the strike are always larger than the wage increases
gained for the years of the new contract. But labor-relations experts recognize the
importance of workers’ sense of being treated unfairly, of the unreasonableness of
company demands for givebacks, or of their outrage when company profits are improving
and employees are asked to cut back. Neoclassical economists consider it irrational for
someone to act on the basis of emotions rather than short-term self-interest. Political
Economists recognize the importance of incorporating the full human condition,
including feelings, into economic analysis of we are to understand economic events, their
meaning, and their likely consequences. Keynes for instance incorporated fear as an
economic motive, suggesting that in the face of uncertainty this produced the herdmentality and wide swings in speculative reactivity given a sudden unexpected trigger.
Households are not “free to choose” whether or not to supply labor to the labor
market, for instance. They are constrained by the mortality of household members:
people have physical needs, and households have needs. People are not floating brains,
we need to stay alive. Because wealth is unequally distributed, 1% own about half all
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corporate wealth, most cannot “choose” whether or not to work. Their property-less
status forces them to seek wage work, and to depend on it for their livelihood and the
well-being of their family.
Probably 80% of the labor force needs their current job just to pay their weekly
bills. The remaining 20% of the labor force can forego several paychecks before they too
need a job just to stay alive. But savings disappear rapidly when professionals and lowerlevel managers are “downsized out” and unemployed for months on end. Only the
independently wealthy can afford not to work, and have a realistic choice between labor
and leisure.
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This means households exhibit lexicographic preferences (“first things first”), and
labor supply for household heads and anyone whose income is indispensable to
household wellbeing will tend to be vertical. Income effects dominate substitution
effects. As a result it may be that the supply of labor is even backward-bending at high
wage rates, because a wage increase may permit someone to choose fewer hours at work
and still provide higher income to their family. Empirically this is supported by the
evidence for prime-age male labor-force participants. Their labor-supply schedules are
steep or slightly negatively sloped, with a more elastic negatively sloped segment at very
high wages.
From the Strategic Competition perspective, Need rather than Choice prevails in
labor-supply decisions. Or, to echo the sentiment expressed in a graffiti painted on the
side of a gas station that went bankrupt in the 1991 recession, “With so much to choose
from you’d think you’d have a choice.” Household choices are constrained by their
priority to maintain income and their standard of living.
Figure 6
Macroeconomic Supply of Labor
SL
W/P
L
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The household itself requires work to run, and the emotional dimension of life
means that children’s bonds with their parents take time. The standard Neoclassical
labor-leisure trade-off abstracts from the work women have traditionally done to make
the home run, and the time they’ve dedicated to the upbringing of children. This work
can in part be substituted by labor-saving appliances and by market substitutes for home
production (take-out food, preschool, nursing homes). Then the apparent trade-off
between labor and leisure is instead a cost-benefit calculus of the net benefits to the
household and the woman’s independence of wage work, relative to the costs of
substituting paid goods and services for her own contributions in kind and the foregone
time with children. To this extent, given traditional patriarchal values and identities,
historically women’s supply of labor should have been more wage-elastic than men’s.
The empirical evidence is that prime-age women’s supply of labor has been upward
sloping, which is more consistent with Neoclassical hypotheses than the male supply of
labor, but not for Neoclassical reasons. However, recent evidence suggests that in many
households women’s income contributions are no longer optional, and women’s supply
of labor curves have become steeper.
Goods Demand
The Neoclassical perspective that substitution effects dominate income effects
even when it comes to buying commodities reflects a view of personality that is too
random and insufficiently structured. Institutionalists have suggested that households
choose lifestyles, not individual products, since household members form identities that
imply a set of metapreferences (sports-oriented, health-oriented, workaholic, child-
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oriented, etc.) that then shape particular goods and services bought. Many items are
complements rather than substitutes.
Identities are not easily mutable, so once companies get a customer they cultivate
return sales by catering to that lifestyle pattern. Grocery stores provide dollars-off
discount cards in order to learn consumers’ buying habits, and to target marketing efforts
to the most likely potential customers.
Neoclassical general-equilibrium theorists have long known that unless
substitution effects prevail over complementarity and income effects, it is not possible to
assume that decentralized decisions by utility-maximizing individuals and profitmaximizing businesses will necessarily lead to economy-wide equilibrium, even within
the terms of their paradigm. Strategic Competition points out that this necessary hidden
assumption does not characterize many consumer choices
Strategic Competition also recognizes the local character of many kinds of sales,
and that many companies have market power as a result of the relative immobility of
their consumers. Companies also do not face a “given” demand curve, but make costbenefit calculations about how much advertising expenditure is profitable given its
expectant effect in shifting demand for their products outward. Finally, in light of their
market power, once they have chosen their advertising budget and anticipate the shape of
their demand curve, companies most profitably opt for price discrimination over uniform
pricing in order to price-discriminate.
If a company does face horizontal marginal costs and has chosen a price target
(P*), it may in the extreme case choose total price discrimination among customers (see
figure). In a world of uncertainty, the company may cease expanding at q*, or it may be
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willing to sell below target price to capture a few additional buyers. Either way, it is
clearly more profitable to charge consumers the highest price they are willing to pay than
to price all goods the same, whether this reflects consumer income, their search for
status, or the intensity of their demand because of their own identities.
Figure 7
Price Discrimination
P1
P2
P3
P4
P5
P*
P6?
Passive Supply
MC= AVC
Demand Curve
q1
q2 q3 q4 q5
q* q6?
Quantity of sales
Notice that the extra profits earned by price discrimination, shaded in blue, are
over and above the targeted rate based on q* expected sales.
However, because households do act on the basis of perceived justice as well as
simple self-interest, companies have to choose their differential prices strategically, so
that they are not perceived as unfair, extortionate, etc. So the identical shampoo you buy
at the “super” grocery store in the suburbs for $2.00-$4.00 may sell for $1.00 at a Dollar
Store in New Brunswick or Philadelphia.
Demand for Labor
The Neoclassical demand for labor was derived from the conditions for short-run
profit-maximization. If that rule is applied under conditions where the marginal and
average product of labor are equal and constant across a wide range of employment, then
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MC = MR =>
MR = MC = W/MPL = W/APL.
As was true for price determination, when short-run profit maximization is applied in a
constant-returns setting, the company has to shut down: it is paying its workers the entire
product of the business. Note, too, that even setting wage at the level does not imply any
determinate level of labor demand, since any number of labor-hours from zero to infinity
is equally likely.
Under Strategic Competition, since output is demand-constrained, so are hires. Labor
demand will be determined by output to be supplied, which in turn depends on projected
sales (q*). Given average labor productivity,
LD = q*/APL.
Implies that the demand for labor is a vertical line at some level of work-hours
demanded, LD.
In macroeconomic terms, this view is implicit in the Keynesian-Cross model. When
the Aggregate Expenditure (AE=C+I+G+NX=A+mpcY) curve shifts up and the economy
moves along the 45o line along which ys = AE, we reason that the unemployment rate is
falling proportionately. The rounds of spending story of the process behind the
expenditure multiplier describes job creation leading to increased expenditure, therefore
sales, therefore employment, therefore income, therefore expenditure. No one asks about
the wage rate or the shape of a supply of labor curve in order to determine whether or
how much unemployment declines. The Strategic Competition labor market provides the
analytical underpinning of this Keynesian-Cross or Post-Keynesian approach, since
expected sales becomes aggregate expenditure, so
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LD = AE/APL,
and changes in expenditure lead to proportionate changes in employment.
Figure 8
Macroeconomic Labor Market
DL
SL
LD
LS
W/Pmax
Range of
Indeterminacy
W/Pmin
Involuntary U
Labor-Market Nonequilibrium
As is visible in the graph above, there is no reason that the vertical DL and the
vertical SL should coincide. The labor market is typically not in equilibrium. As Keynes
said at the macro level, there is chronic involuntary U.
There is a legal minimum wage that sets a lower limit; a maximum viable wage for
the company sets an upper limit beyond which it will be forced to shut down. There are
also other lower reference wages which are too high for the company to earn its targeted
profit rate even if it succeeds in meeting its sales targets. So in practical terms, there is a
relatively wide range of indeterminacy for wages. This leaves Strategic Competition
open to both a bargaining model of wage determination and a theory of discrimination..
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