The Circular and Cumulative Structure of Administered Pricing

How are prices determined? This is a very basic economic question that many economists have sought to answer. The short explanation from neoclassical economics is that firms, seeking to maximize profits, produce until their marginal revenue equals their marginal cost, thereby generating a supply of goods and services. Consumer demand for these products arises from income-constrained utility maximization. Together, the interaction of firms and consumers, supply and demand, determines price in the market. Many, if not most, economists will also tell you that this is not literally how things work. However, neoclassical economists will usually invoke the “Friedman defense” (1953), claiming that a more literal explanation is unnecessary because the neoclassical model predicts well. It is as if the firm’s only goal is profit maximization, achieved as if it equated marginal revenue and cost. A model’s usefulness is judged by its ability to predict firm-level data well, not by its realism. Indeed, extremely simple models, devoid of institutional detail, are to be preferred because their results are not specific to any particular time or place. Yet even the ability of the neoclassical model to predict well can be questioned. The economy in general, and prices in particular, are not as frictionless as the theory predicts. Studies by Gardiner Means (1935, 1936, 1972), Alan Blinder (1998), Frederic Lee (1994, 1995), and others (see Lee 1999), have demonstrated the inflexibility of prices over long periods of time. Moreover, heterodox economists have long emphasized the