In 1939 Hall and Hitch published some results of research undertaken at Oxford and aiming at the investigation of the decision process of businessmen in relation to government measures.
Their study covered 38 firms, out of which 33 were manufacturing firms, 3 were retail trading firms and 2 were building firms. Of the 33 manufacturing firms, 15 produced consumer goods, 4 intermediate products, 7 capital goods, and 7 textiles.
The sample was not random, but included firms which may well be expected to belong to ‘efficiently managed enterprises’.
The most startling results of the studies of The Oxford Economists Research Group’ reported by Hall and Hitch were that firms did not attempt to maximise their profits, that they did not use the marginalist rule MC = MR, and that oligopoly was the main market structure of the business world. Up to then the theory of monopolistic or imperfect competition of Chamberlin and Joan Robinson had been generally accepted as typical or relevant.
The firms were assumed to be able to act atomistically, ignoring their rivals’ reactions and pursuing their short-run (and long-run) profit maximisation by equating marginal cost to marginal revenue in each time period. The tangency solution in the long run implied normal profits, but excess capacity (unexhausted economies of scale), which was the main source of criticism of the regime of monopolistic competition.
Hall and Hitch’s findings may be summarised as follows:
Firstly, the firms do not act atomistically. Firms are continuously conscious of the reactions of their competitors. This behaviour, obviously in contradiction to the postulates of monopolistic competition, suggested that oligopoly was much more widespread than had been thought up to that time. Oligopolistic interdependence could not be dealt with within the framework of the traditional theory.
Duopoly theory, based on assumptions of constant reaction patterns of competitors, also seemed inadequate to cope with oligopolistic interdependence and the ensuing uncertainty regarding the demand for the product of oligopolistic firms.
Hall and Hitch found that firms do not attempt to maximise short-run profits by applying marginalistic rules (MC = MR), but aim at long-run profit maximisation. Firms set their price on the average-cost principle. That is, firms do not set their price and output at the levels determined by the intersection of the MC and MR curves, but they set a price to cover the average variable cost, the average fixed cost and a ‘normal’ profit margin (‘usually 10%’)
P = AVC + AFC + profit margin
The reasons given by Hall and Hitch for the breakdown of marginalism may be summarized as follows:
(a) Firms do not know their demand curve nor their marginal costs, hence the application of the marginalist rule (MC = MR) is impossible due to lack of relevant information,
(b) Firms believed that the ‘full-cost price’ is the ‘right’ price, since it allowed a ‘fair’ profit and covered the costs of production when the plant was ‘normally’ utilized.
Hall and Hitch reported that firms’ main preoccupation is price, and not output as the traditional theory implied. Thus the firms would set their price on the basis of the above average-cost principle and they would sell at that price whatever the market would take.
Although the firms in general would adhere to the average-cost pricing rule, they would be prepared to depart from it if they wanted to secure a big order, or if they thought that they could not set this price without damaging their goodwill and endangering their future position, in view of their rivals charging a lower price.
Finally, it was found that prices of manufacturers were fairly sticky, despite changes in demand and costs. Traditional theory predicted a change in price and output (at least in the short run) in response to changes in demand and costs. This prediction was not observed in the real world, in which ‘stickiness’ of prices was a general phenomenon. To explain this stickiness of prices Hall and Hitch introduced the Chamberlinian apparatus of the ‘kinked’ demand curve.
The kink implies the following pattern of expected reactions of competitors, witnessed by the firms that were studied. Businessmen held the belief that if they raised their price their competitors would not follow, so that they would lose a considerable number of their customers; while if they cut their price their competitors would follow suit, with the result that their sales would increase by an insignificant amount.
The price was set equal to the average cost and the kink would occur at that price. The firms would arrive at this average-cost, price independently (without collusion). Firms reported that they did not enter any collusive agreement in order to increase the market price, because of fear of potential entrants who might endanger the long-run position of established firms.
Similarly, they did not think that a collusive reduction in the price would be profitable to the ‘group’, because they believed that the market demand was price inelastic. Furthermore businessmen were aware of the fact that frequent price changes were disliked by their customers.
Thus firms prefer to keep their price constant, except in cases of general cost increases which affect all firms and lead to an increase of price by all. The ‘kink’ in the individual-demand curve, implying that above the given p the demand is very elastic while below p demand is inelastic, provides an explanation of the firms keeping their price constant.
Various writers have interpreted the device of the kinked-demand curve as a ‘theory’ of oligopolistic behaviour. This view has become so firmly established that the kinked- demand ‘theory’ has found its place in all textbooks of microeconomics. The kinked demand cannot be considered as a theory of pricing and output decisions in oligopolistic markets, since it cannot explain the level of the price, i.e. the location of the kink.
In the framework of Hall and Hitch’s approach the kinked demand makes sense as a device for explaining the ‘stickiness’ of the prices, but not their levels. Hall and Hitch suggest that the firms set their price independently of one another on the basis of the average-cost principle. And these prices, once set, tend to be sticky because of the expectations of firms about competitors’ reactions to changes in the firm’s price, which are such as to create a kink at the level of the average- cost price.
It does not seem that Hall and Hitch have developed a determinate theory of pricing in oligopoly markets, and although they mention several elements relevant to oligopolistic behaviour (long-run profit considerations, goodwill of firms, potential and actual competition and interdependence of firms, average-cost pricing procedures instead of marginalistic computations), they did not combine them into a comprehensive theory of oligopoly.
However, their conclusions constituted a serious attack on marginalism. The reported results of the study of their sample suggest the following. Firstly, short-run profit maximisation was rarely stated by businessmen to be their goal. Most firms reported that they aimed at a ‘fair’ level of profit and that they had also other goals, such as building up their goodwill, being fair to their competitors, etc.
Secondly, the demand curve and its price elasticity, on which marginalism so heavily relies, are unknown in practice, because neither consumers preferences nor competitors’ reactions are known with certainty. Most firms are oligopolists who are faced with uncertainty concerning their customers and their competitors. Given this uncertain environment the demand schedules cannot be taken as known, hence marginal revenue schedules are unknown to the businessmen.
Thirdly, marginal costs are also unknown in multi- product firms, which are typical in the modern business world. Fourthly, even if MC and MR were known, and firms aimed at the maximisation of their (short-run) profits, the adherence to this equality would require continuous changes in the price in view of the continuous changes in costs and demand. Such frequent changes in prices are not desirable, and prices have exhibited considerable stickiness despite change in short-run costs and demand.