Economic theory came to crossroad in the third decade of the century. A general dissatisfaction was expressed by J.H.Clapham in his ‘Of Empty Economic Boxes’ in 1922. Logical accomplishment of the marginalist approach had denuded economic analysis of its real content. Formal refinements were achieved at the cost of substance. A critique of the theory was presented by Sraffa in his ‘laws of Returns under Competitive Conditions’ in 1926. Joan Robinson took up the new approach suggested by Sraffa and presented an alternative ‘theory of imperfect competition’ in 1933 to replace the age-old hypothesis of perfect competition. In America Chamberlin, perhaps independently of the development in British thought, presented his full-grown ‘theory of monopolistic competition’ on a similar line and in the same year, 1933. In England , again, Harrod, Shove and Kahn also worked on the idea at the same time.

The main plank of the new approach was the downward slope of the demand curve, which a business unit faces for its product. Its shape is shown similar to that of the market demand curve and that of the particular demand curve is fundamental: the one is downward sloping and the other is horizontal. Market demand curve is an instantaneous concept. It shows the prices at which various quantities of a commodity can be sold under given conditions. Price is determined at its point of intersection with the supply curve. It flexes the position of the demand curve faced by a firm. The latter, at its point of intersection with the firm’s cost curve, determines output of the individual firm. Time is important both for demand and supply. Production, however, is more time-absorbing than adjustment in consumers’ budgets. An instantaneous supply curve can be constructed on the basis of wide stock accumulation possibilities and output elasticity. Since stocks involve heavy carrying costs, producers and traders don’t hold large stocks in a competitive market. Nor would actual output be less than the optimum in conditions of perfect competition. An instantaneous demand curve was, therefore, juxtaposed against a time-dimensional supply curve.

Horizontal shape of the demand curve faced by the firm served to unify economic analysis: the macro quantities were simple summation of micro-quantities. Aggregate consumption was the sum of firms’ sales of consumers’ goods. Given total consumption, aggregate savings were at once known: the excess of output over consumption. Normal rate of profit was assured to any new firm whose cost curve could meet the horizontal demand curve. Any existing firm in an industry could increase its amount of profits by extension of its plant or rise in its efficiency so as to shift its cost curve to the right or downwards. With the normal rate of profit assured, the only constraint on investment was the supply of savings. Investment would, thus, absorb all the savings available, at the appropriate rate of interest. There would be no deficiency in effective demand. Relative prices and the price level would be co-determined by the choice between goods and between goods and money. Both money and real wage rates would at once be determined.

Once the demand curve faced by the firm was shown as downward sloping, the unity of economic analysis was destroyed. Macro-equilibrium analysis had to be separated from micro-equilibrium. Keynes pursued this line of thought though he retained the assumption of perfect competition in crucial parts of his work. With his rich background of monetary economics method of stock equilibrium came handy to him. Price was turned into an exogenous variable. Theory of value was divorced from the theory of employment and output. Keynes’ macro-equilibrium analysis in his ‘General Theory’ in 1936 was another expedient to meet the crisis in economic theory. The two expedients, downward sloping demand curve faced by the firm and aggregate supply and demand functions with possibilities of under-employment equilibrium, have served the science for over three decades. The crisis is not yet resolved, however. There is no direct line of communication between the different branches into which economic theory is divided today. Each branch runs at a tangent. The result is that there are often wrong assumptions and faulty constructions.

Fall of the hypothesis of perfect competition came on two crucial grounds. First, the importance that the firm has in economic life was lost in theoretical analysis. It has no importance as a decision-making unit in a perfect market with standard goods. There is very little to decide. Choice about size of plant and output is too simple to involve any decision. Secondly, the hard fact of marginal and average cost diminishing, or remaining constant, with increase in output could not be reconciled with equilibrium under perfect competition. Diminishing return alone was compatiable with such equilibrium. Theory had to conform to reality, however. The new approach came to accommodate into analytical frame these two facts. Falling demand curve faced by the firm was shown to meet these requirements. It was no innovation. It was merely adoption of a technique of the old theory of monopoly for general use in the whole field of price formation. It was a major analytical step nevertheless. What a monopolistic monopolist faced was the market demand curve. A firm in monopolistic competition faces only apart of the market demand curve. A small part is shown to have the same shape as the whole.

The descending demand curve faced by a firm is explained by Chamberlin in terms of buyers’ preferences. Downward slope of market demand curve for a commodity is explained by the commodity having no close substitute. Buyers’ preferences create gaps in the chain of substitution and, thus, determine negative slope of the demand curve faced by a firm. Such preferences may be rational or irrational. It is rational if there is real, physical differentiation in products. Any rival firm can, in this case, produce identical product and cancel the price advantage of the original firm. If buyers’ preferences are irrational, the gaps in the chain of substitution must be short-lived. A large portion of total purchases is always done by businessmen who cannot afford to be irrational. Their rivals and customers compel them to be rational in their purchases. Among general consumers even a small minority may be price and quality conscious. It is this minority of alert buyers who keep the sellers disciplined. No businessman, not even monolithic monopolist or oligopolist can protect his market against new rivals, if he depends too much on his buyers’ loyalty. If an established firm of another industry decides to enter into an industry dominated by monopolist, oligopolists or monopolistic competitors, price advantage built on buyers’ loyalty would disappear even in a short period.¹ Artificial gaps in the chain of substitution, whether in the short or the long run, would not subsist.

Even the conception of descending demand curve for a firm’s product is dubious. It is introduced primarily for its use in study of the equilibrium value of firm’s output. It has, however, no existence of its own, apart from the cost curves of competing firms. Elasticity of demand for a firm’s product depends on the availability of its substitutes. It is determined by the elasticity of supply from competing sources. The highest price a firm can charge for its product is the lowest at which it can be offered by other firms.² The demand curve for a firm’s product does not represent the demand of buyers as such. It shows its rival’s strength to compete with it. It reflects its rivals’ cost of production. It depends on the actual, or potential, supply function of other producers. With the possibility of new entry in an industry of an established firm from another industry, cost functions of various firms in different industries acquire increased interdependence even in the short run. Such interdependence has its impact on investment policies of different firms. Investment activities of the firms, in their turn, determine the long-term interdependence of their cost functions. The demand function for a firm’s product depends on supply functions of rival firms as even market demand function does on the industrial supply function. The demand curve faced by the firm is the result of interactions among firms’ cost curves. It lacks the independence it would require in order to be employed, in juxtaposition against the cost curve, to determine equilibrium of the firm.

Theory of value can acquire generality, Instead of classification of market conditions into monopoly, oligopoly, monopolistic, pure and perfect competition, the whole situation can be described by the ‘degree of monopoly’ which wold be zero in perfect competition. Such a mode of analysis has been established by Kalecki. ¹ It has to be extended. Price formation may be explained in terms of degree of monopoly within the limits set by cost functions of various firms. The degree of monopoly in an industry is the average of monopoly power exercised by various firms in the industry. Demand for an industry’s product is the input requirements ² of different industries in respect to that industry’s output. Firms can exercise monopoly power against one another in the degree consistent with fulfillment of their own input requirements. They can charge from one another prices, which cannot remain inconsistent with their rates of profit and wages and technical conditions (capital labour ratios) of their plants. An undue exercise of monopoly power would cause progressive contraction of output, increasingly large idle capacity, disequilibrium, among industries reflected in divergent rates of profit and divergence of market prices from of production (normal prices), mal-allocation of resources, and distortions in the channels and reductions in the rate of investment. The long chain of links between the monopoly power unduly exercised by firms, on the one hand, and rate of investment and level of effective demand, on the other, was missed by Keynes who prescribed as a remedy a blanket increase in the rate of investment without any effort to correct the mechanism of resource allocation.

Keynes built his theory of employment rather on a weak foundation. In his essentially short period analysis he assumes as unchanged the quantity and quality of labour, capital equipment, technique of production, degree of competition, consumer taste and social structure. He assumes diminishing returns in all industries and competitive prices of consumption goods and productive services. He then shows that increase in employment reduces real wage rate, though a mere reduction in real wage would not increase employment. How would real wage behave in his system? With every increase in employment, output increases, marginal product diminishes, marginal cost increases, prices of products rise and real wage rate declines. Now marginal product would decrease only when output increases beyond optimum capacity of plants. The more it goes beyond the capacity point, the more rapid is fall in marginal product. When production expands beyond the optimum, employment increases but slowly. The slow increase in employment and rapid fall in real wage may result in deficiency of effective demand. Recurrence of deficiency in effective demand could be avoided if new plants are brought into use so that there is net increase in production capacity. This is, however, ruled out by Keynes’ assumption that quality and quantity of capital equipment remain unchanged. Investment activities would not mature during the short period to which his analysis is confined. Machine producing machines are also assumed to operate beyond their optimum capacity and yield diminishing marginal product. With narrow scope for output expansion there would be small multiplier effect.

Experience shows that workers resist fall no less in real wage than in money wage rate. The latter is often linked with price index. There are what we may call price and productivity barriers,¹ lower and upper limits to the movement of real wage. Keynes was, therefore, wrong to assert that real wage is not a subject of bargain between employers and workers. Rigid money wage rate is an assumption of economic irrationality on the part of workers. Given the assumption of rational, maximizing activity, the level of money wage rates would tend towards the equilibrium level.²

Keynes’ analysis implies that optimum out put capacity in the economy is less than full employment so that plants work beyond their optimum even in conditions of unemployment. This alone would justify his explicit assumption of diminishing return. And he is cautious about perfect elasticity of the aggregate supply function before full employment and its perfect in elasticity beyond it. For a dogmatic statement of this proposition would imply that production capacity is exactly equal to full employment and land him into inconsistency with his assumption of diminishing return. Representation of his aggregate supply function by a ray at 45⁰ in what is known as ‘Keynesian cross’ is violation of his implicit assumption about optimum output capacity being less than full employment. Aggregate supply function can be represented by a straight line at 45⁰ only up to the point of optimum capacity. Beyond the optimum it would move either upward to the left or downward to the right according as output or employment is more elastic in respect to changes in Aggregate Demand.

Simultaneous existence of idle capacity and idle labour is a reasonable, realistic proposition for the Keynesian system. It contradicts, however, Keynes’ assumption of diminishing return, declining marginal efficiency of capital, rising prices and falling real wage in conditions of increasing employment.

Keynes’ greatness lies in detecting deficiency of effective demand which his great predecessors overlooked. The latter depended on price mechanism to keep effective demand equal to optimum output. For Keynes relative price system was incapable of the task. He quietly discarded it. There lies his Achilles’ heel. He saw one side of the truth and could not see the other side which Ricardo among others had seen. He failed to go deep into the cause of deficient investment and resultant deficiency in effective demand. To explain collapse of marginal efficiency of capital in terms of market sentiments and to prescribe its revival by doses of public investment is to depend too much on elements of irrationality. There is no denying that introduction into the received analytical system of uncertainties which bedevil anticipations was the other great contribution be made. He could not, however, forge weapons to tackle uncertainties. Economics would be no science if it is not raised above stock market gossip. With all his contempt for ignorance of businessmen, their ‘uncontrollable and disobedient psychology’ Keynes could not raise his system above these. In the central part of his analysis be succumbed to the vagaries of business confidence. His analytical frame was desperately in need of a mechanism to generate investment endogenously into right channels in right magnitude. An investment demand function linked to the wage-profit relation and thus to relative price structure would alone explain low levels of investment and those of aggregate demand and show the way to raise these to the heights of full employment.