Wages, Materials, and the Markup

In a recent post focusing on inflation and distribution, I touched on the connection between the aggregate markup and income distribution. Here, I thought it might be worth demonstrating the connection explicitly, and then outlining a simple extension that brings out the impact on distribution not only of the markup but also fluctuations in the prices of raw materials. The extension is due to Kalecki, who outlines the argument in the second chapter of his Theory of Economic Dynamics: An Essay on Cyclical and Long-Run Changes in Capitalist Economy, first published in 1954.

In the earlier post, the markup, k, was defined as nominal income divided by the aggregate wage bill:

k = (W + U) / W = PY / W

where P is the price level, Y real income, PY nominal income, W the aggregate wage bill, and U gross profit. Clearly, the share of wages in nominal income, ω, is just the reciprocal of the markup:

ω = 1/k

In other words, an increase in the markup redistributes income from workers to capitalists.

Intuitively, it seems equally clear that workers’ share in nominal income will be negatively affected if the prices of raw materials rise, since this will push up prices of finished consumer goods relative to wages. In considering distribution, Kalecki takes this additional factor into account.

In his analysis, he assumes that the prices of final goods produced in the dominant manufacturing and services industries are determined, at the micro level, in a different manner than prices of raw materials. He argues that the former are cost based, whereas the latter reflect demand conditions.

In manufacturing and services industries, Kalecki reasons that marginal cost tends to be constant over a fairly wide range of output below full capacity. He assumes that firms set prices as a markup over marginal cost, with the level of output being demand determined. The size of the markup in a given industry is argued to depend on market power, or the ‘degree of monopoly’.

In contrast, the prices of raw materials are assumed to fluctuate positively with demand on the grounds that the supply of raw materials is relatively inelastic.

Although there are differences in the pricing theories of classical, Marxian, Post Keynesian, and Kaleckian economists, the various approaches are all broadly consistent with the notion of cost-based pricing in the dominant manufacturing and services sectors of the economy.

For example, in Marx, competitive conditions – defined as free mobility of money capital – would tend to equalize profit rates across sectors. This is because investment, in the absence of impediments, would be directed into those sectors offering the highest rates of return, the process continuing until prices had gravitated to levels consistent with normal profits. However, to the extent that some industries are monopolistic or oligopolistic, this tendency toward profit-rate equalization in Marx will be hindered in much the same way as a higher ‘degree of monopoly’ results in unequal profit rates in Kalecki’s analysis.

Kalecki considers a broader definition of the markup than was employed above, which at the macro level he defines as the ratio of ‘aggregate proceeds’ to ‘aggregate prime cost’. He can then relate both the markup and material costs to distribution.

Aggregate proceeds in Kalecki’s analysis amount to ‘value added’ plus the cost of materials, M. Here, value added is identical to nominal income or nominal GDP, so aggregate proceeds total U + W + M. Aggregate prime cost is defined as wages plus the cost of materials, or W + M. Since the markup for Kalecki is the ratio of these two sums, we have:

k = (U + W + M) / (W + M)

It is simple enough to arrive at a relationship between this version of the markup and income distribution. Start by equating gross profit with itself and adding and subtracting prime cost to the right-hand side:

U = (U + W + M) – (W + M)

Strictly speaking, Kalecki separates out overheads, which include salaries of management, from the wage bill, since he considers these salaries more akin to profit. I am glossing over this by implicitly including those salaries in gross profit, U, rather than separating the left-hand side of the above identity into profit and overheads.

In the above expression, divide and multiply the first bracketed expression by prime cost:

U = [ (U + W + M) / (W + M) ] (W + M) – (W + M)

The fraction in square brackets is the markup, so we can write:

U = k (W + M) – (W + M) = (k – 1) (W + M)

Recalling that PY = W + U, we can substitute the above expression for U into the wage share out of income:

ω = W / PY = W / [ W + (k – 1) (W + M) ]

Finally, dividing the numerator and denominator of the right-hand side by the wage bill gives:

ω = 1 / [ 1 + (k – 1) (j + 1) ]

where j equals M/W, the ratio of material costs to wages.

This expression shows, as expected, that the workers’ share in nominal income will be negatively related both to the markup and the ratio of material costs to wages. An increase in the prices of raw materials relative to the wage bill will cause the prices of final consumer goods to rise faster than wages.

Kalecki appealed to these relationships to argue that the wage share in nominal income will be broadly stable over the business cycle. His reasoning was that the ‘degree of monopoly’ would tend to increase in a downturn, raising the markup, k, and impacting negatively on the wage share. But, at the same time, prices of raw materials, being positively related to demand, would tend to fall in a downturn relative to wages, at least partially offsetting the effect of the larger markup on the wage share.

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11 thoughts on “Wages, Materials, and the Markup

  1. DEVIL’S ADVOCATE WARNING:

    I know this tends to confuse and sometimes upset those following these posts, but I’m acting here as the devil’s advocate **only**.

    In other words: I am not necessarily subscribing to the mainstream economists’ views; I’m just trying to elicit reasoned replies to them.

    ———–

    “He [i.e. Kalecki] assumes that firms set prices (i.e. they are not neoclassical perfectly-competitive ‘price takers’). Firms are assumed to set prices as a markup over average variable costs (or marginal costs), with the level of output being demand determined. The size of the markup in a given industry is argued to depend on market power, or the ‘degree of monopoly’.”

    I suppose mainstreamers would object that, in Kalecki’s own words, the “degree of monopoly” varies across industries.

    In some, it may be high (i.e. monopolies), in others it may be low (i.e. price-taking, competitive industries).

    If profits come down to markups [i.e. amount of money added on top of production costs], where do “low monopoly degree” (i.e. price-taking) industries’ profits come from?

    After all, individual firms in a “low monopoly degree” industry, being competitive, cannot set up markups arbitrarily; indeed, in the absence of opportunity costs, **accounting** profits should be zero.

    But, if profits are zero, what motivates capitalists to operate in this industry?

    ———–

    A way out of the paradox is to admit opportunity costs, **economic** profits in the “low monopoly degree” industry should also be zero; **accounting** profits would be equal to opportunity costs.

    But this would seem to lead to a paradox for Marxists: if one admits opportunity costs, this apparently means that capitalists’ have a legitimate claim on *accounting** profits, independent of the claims of workers.

    ———–

    And, I imagine mainstreamers would add, it would be reasonable to assume that most industries in an economy are more or less “low monopoly degree”. So, this could not be easily dismissed as a simple anomaly.

    ———–

    Can one answer both these objections **within** Kalecki’s framework?

    Note that I am leaving out of the picture the case of monopolies. And I am also leaving for later questions relating to this, which I am not sure I understand:

    “Aggregate proceeds in Kalecki’s analysis amount to ‘value added’ plus the cost of materials, M. Here, value added is identical to nominal income or nominal GDP, so aggregate proceeds total W + U + M”.

  2. On second thoughts, after going through it more carefully, I understood this:

    “Aggregate proceeds in Kalecki’s analysis amount to ‘value added’ plus the cost of materials, M. Here, value added is identical to nominal income or nominal GDP, so aggregate proceeds total W + U + M”.

    I suppose one could consider within the cost of materials, M, things like depreciation/capital consumption, in which case, the above is roughly similar to the Marxist V + S + C.

  3. As it appears the questions above didn’t elicit much interest, I’ll let a well-known right-wing Australian columnist answer them for us.

    Arguing for a reduction in the wages burdening small-business owners (presumably as close to being price-takers as it gets), Paul Sheehan (SMH, “Labor’s big job-killing machine”, January 16, 2012) writes:

    “My favourite local restaurant was packed on Saturday night, as usual. What was unusual was that its co-owners, who used to take weekends off, were hard at work.
    “One was in the kitchen, cooking and running the staff; the other was front of house, running the floor. They each work six shifts a week and told me it is the difference between the success of their business and mere subsistence.” [*]

    Let’s translate this: at the moment, the restaurant is merely subsisting. Its revenue is enough to cover its costs (let’s assume W, paying for N staff), but there is no profit left (i.e. the Kaleckian U for this firm is 0).

    (Incidentally, Kalecki’s k would not be zero: it would be 1, hence my reluctance to call k a markup)

    The 2 owners are currently working; that’s part of the reason they are unhappy: they work too much, poor things, 6 days a week.

    They could hire 2 workers to cover for them, so they could take one additional day off.

    Problem is, with things as they are, they merely subsist, adding to their payroll would leave them losing money.

    So, Sheehan’s solution is to lower wages: labour becomes cheaper, presumably just so as to allow the owners to hire 2 more staff; labour costs do not change: the owners still pay W, but now employ N+2 staff.

    In other words: the idea is to transfer, externalize, the burden, the cost, of working on Saturdays to 2 workers, without paying anything extra.

    Now, let’s just imagine for one moment that wages fall more than required to hire exactly 2 more workers.

    In that case, the restaurant’s payroll may fall to W’ < W, without a change in revenue (W'+U'=W): labour becomes cheaper and costs go down, a positive profit margin (U') appears out of nowhere, without adding any markup on top of production costs.

    The profit margin is "carved out" from labour costs: labour costs are "shaved" and this is where profits come from in this price-taking industry. This profit margin does not come into being as a reward for lost opportunities (at the moment, according to Sheehan, the restaurateurs are operating regardless of opportunity costs).

    Now, we all are familiar with the precepts of Keynesianism: a generalized income loss may end up in a generalized fall in aggregate demand.

    So, perhaps the whole thing could still backfire: the restaurateurs could end up with less patrons and lower revenue. I will not argue otherwise, except to say that for individual capitalists this is not clear: somehow I doubt these restaurants' staff eat out much, anyway.

    Ultimately, and this is the main thing, neither Sheehan nor the restaurateurs believe this.

    [*] http://www.smh.com.au/opinion/politics/labors-big-jobkilling-machine-20120115-1q15f.html

    ———-

    Now, with your permission, I'm going to work (I work overnight on Saturdays). Unlike Sheehan's poor restaurateurs, I enjoy enormously working on weekends. :-)

  4. I suppose one could consider within the cost of materials, M, things like depreciation/capital consumption, in which case, the above is roughly similar to the Marxist V + S + C.

    I am not that familiar with the intricacies of Kalecki’s pricing approach (I know the details changed somewhat over time), but that was my impression, too. It seems to be a price-term analog of Marx’s C + V + S, except excluding fixed capital. Capital goods would be produced in the manufacturing sector where Kalecki assumes price making. So he seems to be taking a ratio that is akin to (C+V+S)/(C+V) if there were no fixed capital. (?)

    Any reference to marginal cost (which occurs in 1954) makes me queasy, but here is a defense of his pricing approach:

    Kalecki’s pricing theory

  5. Peter

    As I see things, Kaleckians should think long and hard about Marx’s exploitation theory: it not only explains profits in competitive industries without appealing to markup, it also gives the middle-finger to the opportunity cost thing.

    Unless there is a different alternative which I can’t see, a Kaleckian unconvinced about Marx’s exploitation theory (or otherwise unwilling to accept it) appears to be faced with a dilemma: (1) either to accept opportunity costs, or (2) to accept that competitive industries are not really within Kalecki’s purview.

    Can you think of another possibility that I might have overlooked?

    At the other hand, for a Marxist (apart from the reservation about Kalecki’s k already expressed and which could be only a matter of interpretation), I think that to accept Kalecki’s views does not appear particularly problematic.

    What say you?

    —————–

    Thanks for the link!

    I’m back among the living, and in better mood! :-)

  6. I’m with you on the source of surplus value. As I’ve mentioned previously, Marx’s explanation is one of the three moments I consider light-bulb ones for me.

    Kalecki interests me very much, though, because of the apparent connections with the macro analyses of Marx in volume 2 of Capital. Also, Kalecki seems to be a very good match with MMT, even though there are obviously some institutional differences that result in somewhat different details in their discussion of money and interest.

    I don’t like anything that verges on marginalist analysis, which occasionally seems to creep in to Kalecki’s work, though earlier in his output than later, I think. I guess the Sraffians have influenced me in my wariness of marginalist ideas.

    I’m more interested in finding points of convergence in the various heterodox approaches than criticizing one or the other. Definitely MMT, Marx, and Kalecki interest me the most. (I’m not really sure what I make of Keynes, to be honest. I prefer the rest of his small Cambridge circle and the other Post Keynesians, Kaleckians and Sraffians who followed.)

  7. Not so fast, Magpie.

    Marx’s LTV argument regarding the exploitation of labour by capitalists was that it was still possible under what neoclassicals call the “perfectly competitive free market.” He dispensed with both Ricardian observations of arbitrage (especially in labour, example being outsourcing) and with what some of us know today as information asymmetry.

    Kalecki was quite right about price-setting, that firms aren’t marginalist price-takers. How do I know this? Basic business common sense and realization that most “economics” is BS. That almost all economists don’t know how to run a business is icing on the cake. If costs rise, firms will look for opportunities to raise prices.

  8. @Jacob Richer

    I am not sure I see your point here, Jacob.

    You said:

    “Marx’s LTV argument regarding the exploitation of labour by capitalists was that it was still possible under what neoclassicals call the ‘perfectly competitive free market”.”

    I fully concur with that. So much so that on 23 March 2013 at 5:03 PM, I wrote:

    “The profit margin is ‘carved out’ from labour costs: labour costs are ‘shaved’ and this is where profits come from in this **price-taking industry**.”

    Which, to me (and unless I miss your meaning), means **exactly** the same as you say above: I am not talking about arbitrage and I am talking about price-taking (i.e. competitive) industry.

    Further, I also wrote (24 March 2013 at 12:34 PM):

    “As I see things, Kaleckians should think long and hard about Marx’s exploitation theory: it not only explains profits in **competitive industries** without appealing to markup, it also gives the middle-finger to the opportunity cost thing”.

    Now, maybe you mistook what I said on my first comment (on 23 March 2013 at 8:05 AM). That’s possible and it has happened before.

    So much so that It was for that reason that I added

    “DEVIL’S ADVOCATE WARNING:
    I know this tends to confuse and sometimes upset those following these posts, but I’m acting here as the devil’s advocate **only**.
    In other words: I am not necessarily subscribing to the mainstream economists’ views; I’m just trying to elicit reasoned replies to them.”

  9. Prof. Mitchell on several issues related to inequality: “It is hard to defend the 1 per cent by claiming their contribution added value” (http://bilbo.economicoutlook.net/blog/?p=24379)

    I’m not sure he is speaking of the same process I mentioned here (and in my blog: Chronicle of a Death Foretold III, http://aussiemagpie.blogspot.com.au/2013/02/chronicle-of-death-foretold-iii.html); but, regardless, he does write about something closely related.

    Search for the string “This issue came up in a recent industrial” (it is about halfway through the text) and read the following few paragraphs.

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