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S. C. Littlechild, The Problem of Social Cost - Louis M. Spadaro, New Directions in Austrian Economics 
New Directions in Austrian Economics, ed. Louis M. Spadaro (Kansas City: Sheed Andrews and McMeel, 1978).
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The Problem of Social Cost
It is difficult to overestimate the role which social cost plays in modern welfare economics. The ideas of social cost and product lie behind the surplus-maximisation criterion frequently urged upon public utilities, the consequent computation and comparison of social rates of return on road and rail investments, and the philosophy of marginal cost pricing. Following Pigou, the possibility of divergencies between private and social cost or product provides a basis for peak-hour congestion taxes or prices on roads, airports, and telephone systems; for subsidised entrance into the telephone network on the grounds that other subscribers thereby benefit; for regional investment and subsidies or taxes on labour to counter hidden unemployment or social costs of urban growth not reflected in the private calculus; for reduced prices of educational and health services; for subsidies to invention, research and development, and so on.
The criticism of Pigou provided in Coase’s article, “The Problem of Social Cost,” and the reformulation provided there, have to some extent directed attention away from divergencies between private and social cost towards the possibility of solving social problems through the market by means of an improved definition or reallocation of property rights. Despite this change in approach, the concept of value of social product is retained by both Coase and Pigou, and indeed by the majority of present-day economists, as the basic criterion for comparing alternative social systems. The purpose of the present paper is to examine these notions of social cost and social product from a “subjectivist” or “Austrian” point of view. Apart from its intrinsic importance, the concept of social cost is of particular interest to subjectivists, for Buchanan has suggested that Coase’s own work on this topic is the major success story of the L. S. E. subjectivist school.
Perhaps the most significant L.S.E. impact on modern economics has come through an indirect application of opportunity-cost theory rather than through an undermining of basic cost conceptions. “Marginal social cost,” enthroned by Pigou as a cornerstone of applied welfare economics, was successfully challenged by R. H. Coase a quarter-century after his initial work on cost. His now classic paper on social cost, which reflects the same cost theory held earlier, succeeded where the more straightforward earlier attacks on the marginal-cost pricing norm—attacks by Coase himself, by Thirlby and by Wiseman—apparently failed (I, pp. 11–12).
However, we shall discover in the present paper that Professor Coase’s work, whatever may be its other substantial merits in correcting Pigou and in reorienting the economics profession, does not present an approach to cost which is any more satisfactory, from a subjectivist standpoint, than did Pigou. Indeed, once it is recognised (a) that social value and social cost are subjective, rather than objective concepts and (b) that they bear only a tenuous relationship to the true costs of decision-making, then it becomes questionable whether the notion of social cost is the most useful way of approaching the problem.
We shall begin with summaries of the social cost argument and of the subjectivist approach to economics.
THE NOTIONS OF SOCIAL VALUE AND SOCIAL COST
The concept of social cost is remarkably elusive. Economists unhesitatingly attribute the concept to Pigou, as expounded in his Economics of Welfare, but in fact in none of the four editions of that book, nor in his earlier Wealth and Welfare, is there any mention of the term social cost itself. It is perhaps not entirely coincidental, then, that Coase’s own paper, “The Problem of Social Cost,” contains no mention either of the term social cost. The analyses of both authors are, in fact, conducted almost entirely in terms of social product. (I have not yet been able to discover the origin of the term social cost. Knight (VI) used it in his criticism of Pigou without any suggestion that it was original. A. A. Young (XIV), in reviewing Wealth and Welfare, referred to a social view of cost. Perhaps this odd situation lends some support to Coase’s suggestion that the Pigovian doctrine on these matters was largely the product of an oral tradition.)
Pigou admitted that the elements of welfare were ultimately states of consciousness, but in order to achieve something practicable he felt it necessary to limit his subject matter to “that position of the field in which the methods of science seem likely to work at best advantage,” namely, “... to that part of social welfare that can be brought directly or indirectly into relation with the measuring-rod of money. This part of welfare may be called economic welfare (VII, p. 11).
The “objective counterpart of economic welfare which economists call the national dividend or national income” was “composed in the last resort of a number of objective services, some of which are embodied in commodities.” In order to preserve the measuring rod of money, Pigou decided to include in the national dividend only those goods and services actually sold for money, and for the same reason he rejected consumer surplus as a measure of a change in the national dividend.
Pigou’s main instrument of analysis was marginal product, defined as follows:
The marginal social net product is the total net product of physical things or objective services due to the marginal increment of resources in any given use or place, no matter to whom any part of this product may accrue ... The marginal private net product is that part of the total net product ... which accrues in the first instance—i.e., prior to sale—to the person responsible for investing resources there ... The value of the marginal social [and private] net product of any quantity of resources employed in any use of place is simply the sum of money which the marginal social net product is worth in the market (VII, pp. 134–35).
If private and social net products coincide, then “the free play of self-interest, so far as it is not hampered by ignorance, will tend to bring about such a distribution of resources ... as will raise the national dividend and, with it, the sum of economic welfare to a maximum” (VII, p. 143). But if there is a divergence between private and social products (i.e., if there are externalities), then “specific acts of interference with normal economic processes,” by means of bounties and taxes, will remove the divergence and increase the dividend (VII, p. 172).
We need not be concerned here with Knight’s observation that divergencies between private and social cost depend upon whether or not the road (or other means of production) is privately owned, nor with Coase’s suggestion that Pigou was ignorant of the legal position and in any case failed to take into account the response of the party affected by externalities. There are, however, two aspects of Coase’s analysis which deserve mention. First, he observed that Pigou’s measurement of national dividend in terms of goods and services actually sold “means that the value of social product has no social significance whatsoever” (III, p. 40). Coase preferred to value production at its market value regardless of whether payment actually took place. Second, he recommended that
When an economist is comparing alternative social arrangements, the proper procedure is to compare the total social product yielded by these different arrangements. The comparison of private and social products is neither here nor there (III, p. 34).
He later compares this to the opportunity cost approach used in the analysis of the firm. It seems reasonable to infer that the social (opportunity) cost of choosing one social arrangement would be defined as the market value of total product corresponding to the best alternative arrangement not chosen.
THE SUBJECTIVIST APPROACH
For those who are not familiar with the writings of the Austrian school or the L.S.E. subjectivist school, it will be useful to summarise the relevant parts of this approach, beginning with Hayek’s work in the 1930s and 1940s, which Buchanan (I, p. 24) has described as laying down the central features of the subjectivist methodology.
In the papers reprinted as Part One of The Counter Revolution of Science,Hayek emphasised that the “facts” of the social sciences are human perceptions of the world, beliefs held by people “irrespective of whether they are true or false, and which moreover, we cannot directly observe in the minds of the people but which one can recognise from what they do and say merely because we have ourselves a mind similar to theirs.” The objects of human action are not “objective facts” and cannot be defined in purely physical terms. “So far as human actions are concerned, the things are what the acting people think they are.” Moreover, “the knowledge and beliefs of different people, while possessing that common structure which makes communication possible, will yet be different and often conflicting in many respects.” The term “subjective” thus reflects the idea that actions depend upon perceptions and also the idea that different people will generally have different perceptions.
For present purposes, two implications of this basic insight are of particular relevance. First, as Kirzner (V) has argued, it is no longer appropriate to restrict definition of the “economic problem” to that of allocating scarce resources between competing ends, in the way that Robbins (VIII) had proposed. It is necessary to include the perception of ends and means, rather than to take these as given. Hence we are led to the concept of “entrepreneurship,” or alertness to advantageous changes in means or ends, and to Mises’ “acting man” rather than to Robbins’s “economising man.” In turn, the entrepreneurial element in human action can be identified as that which generates a process of change, and indeed the emphasis of the whole Austrian approach is on the market process rather than upon the state of equilibrium.
Kirzner himself has used this notion of perception in commenting upon Coase’s analysis of property rights in the social-cost paper already referred to. Coase had argued that, in the absence of transactions costs, market transactions would transfer property rights and allocate resources so as to maximise the value of production, independent of the legal position. Kirzner (V, p. 227) objected that zero transactions costs were neither necessary nor sufficient to ensure that all participants would notice the mutually profitable contracts which could be entered into.
The second implication of the subjectivist approach is that cost must be thought of as a subjective, rather than objective, concept, because the elements of individual choice evidently depend upon the alternatives imagined and thought worthy of consideration by the decision-maker, and the choice actually made depends upon his preferences. Buchanan has argued that economists at the L.S.E. (including Coase) have played an important role in developing this subjective theory of cost, and he summarises the theory as follows:
Cost is that which the decision-maker sacrifices or gives up when he selects one alternative rather than another. Cost consists therefore in his own evaluation of the enjoyment or utility that he anticipates having to forgo as a result of choice itself. There are specific implications to be drawn from this choice-bound definition of opportunity cost:
In any general theory of choice cost must be reckoned in a utility rather than in a commodity dimension. From this it follows that the opportunity cost involved in choice cannot be observed and objectified and, more importantly, it cannot be measured in such a way as to allow comparisons over wholly different choice settings (I, pp. 14–15).
Thirlby (1946, 1960) and Wiseman (1953, 1957) have pointed out some of the difficulties of supervision which now arise. Suppose a manager is instructed to maximise net revenue. (We must not say “revenue less cost,” since these two concepts are incommensurate: Revenue is measured in terms of money and cost in terms of utility.) Since it is not possible to know with certainty the outcomes of all possible courses of action, it is not possible to make a direct check on the efficiency of the manager. One may make indirect checks by ascertaining which alternatives he considered (i.e., by examining his “plan”), by assessing the actual outcome (i.e., by examining his “account”), and by checking the accuracy of his forecasting (i.e., by comparing his plan with his account). But it is never possible to know whether there were better alternatives which should have been considered or whether the outcomes of alternatives not chosen were correctly forecast. Moreover, when indirect checks of this kind are used, the manager is led to modify his actions to take account of them, for the simple reason that the cost, to him, of taking one decision is necessarily his own evaluation of the alternative outcome foregone. It is not net revenue itself, but the significance to him of net revenue, which determines his actions.
Let us now apply some of these ideas to the concepts of social value and cost.
SOCIAL COST AND PRODUCT—A RECONSIDERATION
For both Pigou and Coase, social product and social cost are evidently objective concepts. Social product is defined as a stock or flow of specified physical services. The question of what constitutes a good or service, i.e., who perceives it and how, is not raised. There is no uncertainty about the goods and services associated with each possible decision, hence there are no conflicting expectations. Finally, the question of whose valuation is to be used is avoided by reference to the “market value.” In these circumstances, the optimal choice is simply a matter of computation and social (opportunity) cost is objective.
It might be conceded that, in practice, the likely outcomes of any particular measure are unsure, as are the likely market prices, but it is necessary to make a “best guess.” This element of subjectivity of course raises the difficulties referred to in the last section. Whose guess is appropriate for policy purposes, and how is the efficiency of the guessing procedure to be ascertained? Moreover, there is a crucial difference between this situation and that of the private firm in that no ultimate objective check on efficiency is available: If the decision-making procedure is inefficient, there is no direct feedback comparable to that of financial loss and bankruptcy.
But now suppose that we recognise the full degree of subjectivity of beliefs about situations and no longer assume an objectively specified set of physical products or a market price for these. In this general case, what becomes of the notion of value of social product? Is it possible to reconcile social product and social cost with the subjective theory of cost and choice?
Take first the Pigovian approach. A decision by one person may also affect other people. It is conventional to describe this as a collection of changes in utility levels. The value of (marginal) social product is, then, in some sense, the net change in total utility, but this raises the obvious well-known objections that utilities are ordinal and cannot be aggregated. One therefore attempts to derive a cardinal measure by asking what the change in utility is worth in money terms. This is done by constructing a collection of artificial choice situations, one for each person affected, and asking oneself what this person would be prepared to pay for the decision in question to be taken or not to be taken. The optimal decision depends upon the total sums of money thereby calculated.
Evidently the situation envisaged by Coase does not differ significantly from this. Attention is not focused on a single individual decision-taker, but rather all persons are allowed to respond to each social arrangement (say, legal position) under consideration, with corresponding changes in utility levels which are to be valued in money terms. The optimal choice of social arrangement then depends upon the sum of money values thus obtained.
To what extent is this artificial choice interpretation just described compatible with the subjectivist approach? In effect, we are asking whether it is possible to attach a meaning to the notion of damage or benefit as valued by the person damaged or benefited by the action of another person. If this action had been the result of a contract between the two persons, then we could, in principle, have measured the effect (more precisely, the expected effect) with respect to the alternative choices available, i.e., to the cost of the contract. In the case where no contract is made, we are considering a hypothetical choice and asking how attractive a hypothetical alternative would need to have been in order to be preferred (or how unattractive it could have been and still have been preferred).
The first point to emphasise is that the proposed procedure does not involve choices, albeit hypothetical, by the person in question but rather by an outside observing economist, government official, judge, or politician. As argued earlier, the costs of his choice involve the significance to him of the different answers—for example, whether the answers seem plausible to his peers and supervisors. The valuation put on damage to another person is thus not a cost to that person at all. Moreover, even if the artificial choice were made by the person in question, his costs would involve the benefits of choosing a higher or lower figure in a laboratory situation, and would not measure the costs involved in the intended choice situation (cf., IX).
Second, since this evaluation is not a choice actually made in the market, there is room for considerable uncertainty as to what value would be appropriate. To use the standard terminology, one is simply guessing where the relevant indifference curves lie (I, p. 72). Different observers could come up with different evaluations, none of which could be proved objectively correct or incorrect.
Third, the intention of the hypothetical choice scheme is to evaluate a person’s response to a situation while taking as given his perceived opportunities and objectives. But we have mentioned that, in the subjectivist approach, economics is not simply a matter of known means and ends, but also involves the perception of new possibilities, which in general change one’s evaluation of previously perceived opportunities. Suppose that the alternative under consideration by the policymaker had not been conceived by the person whose evaluation it is required to estimate. Then an evaluation can only be obtained by (conceptually) changing his existing perceptions. This, of course, raises two problems: how the new alternative should (again conceptually) be presented to the person, and what his reaction would be. The problem applies more generally: Even if he is aware of the possibility of the decision under consideration, he will generally have a different impression of its nature, implications, and likelihood than another person will have. Should the observer/economist take as given his initial, perhaps “incorrect,” perceptions or should he (conceptually) modify them? What is a “correct” perception of the consequences of any act?
Even if it were possible to specify the initial reactions of people to a proposed action, what position should be taken concerning subsequent changes in their perceptions and plans? Coase is evidently aware of this difficulty. He refers to the use of bluff in order to induce the other party to make a larger payment, but comments “such manoeuvres are preliminaries to an agreement and do not affect the long run equilibrium position” (III, p. 8). Evidently, he takes the view that it is not the immediate response to a situation which is relevant, but the “equilibrium” response, after appropriate information has been acquired. The difficulty with this position is the precariousness of the notion of equilibrium once economic activity is viewed as a process rather than a state.
Let us attempt to summarise the argument of this paper.
It was found that the concept of social cost itself, although widely used, was not used by Pigou and Coase, who preferred to work instead in terms of social product. Despite differences in their usage of this concept, they essentially proposed to use value of social product as a criterion for choosing between alternative situations. This notion depended upon “physical product” composed of specified objective goods and services, to which objectively defined prices were or could be attached.
This approach was shown to lead to certain difficulties. Briefly,
In this discussion I have tried to show that social cost and product are not objective concepts. This does not mean to say that any particular observer cannot make an estimate of the damage or benefits accruing from any action, but rather that this estimate will necessarily embody elements of his own evaluation and will depend upon his own perceptions and assumptions of what is appropriate. Different individuals will, therefore, make different estimates, and no objective check on efficiency is possible.
This raises the question of whether social product as traditionally conceived is the best concept for use in government decisions. We may, in fact, use Coase’s argument against himself. The proper question to ask is not whether this or that social arrangement maximises value of social product, but rather whether using social product as a criterion is preferable to using some other approach. In order to answer this question, it is necessary to know more about how those who have been urged or required to use this criterion have behaved in the past. Here we might examine the decisions of nationalised industries in Britain, and government response to cost-benefit analyses of roads, railways, and airports. Second, it is necessary to know how effective other objective controls have been, such as breakeven requirements or specific constraints on spending or provision of services. Finally, it is necessary to compare government controls of any kind with those imposed by the market. A fruitful start on these problems has been made by Alchian, Stigler, Posner, and others, and one would expect that Coase would sympathise with such an approach.
However, it would seem that social product cannot be used as the final criterion of evaluation, for the reasons given. What other criterion is available? I simply mention here Kirzner’s suggestion (V, pp. 216 ff.) that alternative institutions or arrangements can be evaluated in terms of their success in bringing about mutually beneficial contracts. The effectiveness of such a criterion remains to be explored.
I wish to add a brief comment on the definition of social cost in the literature and a more extensive discussion of social cost as the criterion for action by a public organisation.
Coase implicitly defines the cost of any social arrangement as the market value forgone under an alternative arrangement. This is indeed a cost, in the sense defined by Buchanan, if we think of society as an entity choosing alternative arrangements with the aim of maximising market value (though how these alternatives are generated and evaluated is not specified). However, not all economists adopt this definition. Stigler, for example, discusses a chemical plant which discharges waste into a stream, and says that “the sum of costs to everyone is called the social cost of waste disposal” (Theory of Price, 1966). Such a concept is not a cost in Buchanan’s sense—indeed, an action by one person cannot impose costs on others. This is not to say that the one definition is superior to the other, of course, but rather that one is (or can more easily be made) consistent with the L.S.E. tradition.
Several of the participants at the Windsor Conference, while broadly sympathetic to the argument of the paper, nevertheless felt uneasy on two counts.
Consider first two ideal types: the businessman interested in maximising net private revenue and the benevolent dictator interested in maximising net social benefit. The problems they have to face are identical, although the criteria they use are different. In neither case is there any distinction to be made between subjective and objective concepts, because in both cases the world is taken to be as the decision-maker perceives it. Those goods are relevant which the decision-maker believes to be relevant; those future prices, future responses, and future values are appropriate which the decision-maker believes to be appropriate. In principle, to calculate net social benefit is no more difficult than to calculate net private revenue.
Putting plans into action generates new information which in turn makes it appropriate, sooner or later, to revise the previous plans. Investments or other commitments may have been made, yet other previous commitments may have expired, and new opportunities may have arisen. The pattern of costs and benefits, and hence the optimal actions, will generally be different from those planned earlier. Revision of plans in this way is necessary regardless of whether the objective is net private revenue or net social benefit, and there is no reason to suppose it is any easier in the one case than in the other.
Finally, suppose that the businessman and the benevolent dictator do not carry out all the actions themselves, but rather instruct subordinates to maximise the respective objectives on their behalf. In each case, it may be assumed that the subordinates have objectives and preferences of their own which they will attempt to satisfy insofar as they are not prevented or discouraged from doing so. The problem of control arises: how to ensure that the subordinates are carrying out their duties efficiently? In neither case is it possible to ascertain directly what is the optimal policy, so it is necessary to develop indirect checks by examining the process of plan preparation, the outcomes of the actions taken, and the accuracy of the forecasting.
Wherein, then, lies the difference between the objectives of net social benefit and net private revenue? It lies, I think, in the degree of difficulty in assessing the outcomes of any series of actions. Both concepts are measured in money terms, but whereas the liquid assets of an organisation at any time can be ascertained reasonably easily and objectively, this is not true of net social benefit. The whole point of a social cost-benefit analysis is to impute to people values which they do not in fact express in the market. There is no “correct” value, there are only different views about values, which may be more or less plausible to others. The problem of control is infinitely more difficult when the outcome of any action is not immediately apparent.
In order to maximise net social benefit it may, paradoxically, be more efficient not to set this as a direct objective, simply because of the difficulty of checking performance. As argued elsewhere, the market mechanism, the profit motive, and the possibility of competition provide incentives to discover and meet the wishes of consumers, with monetary success for those who succeed and replacement for those who fail. It is certainly not guaranteed that the market mechanism will ensure that the “correct” decisions are always taken, since these cannot be known, but there are reasons to believe the market is more likely, in the long run, to maximise net social benefit.
It may be objected that competition is not always possible and, indeed, that this is a major reason for replacing the market mechanism with some form of government organisation. As regards the first point, the work of Hayek, Coase, Kirzner, Alchian, Demsetz, and others has gradually provided a better understanding of the nature of competition and market failure. It is now recognised that the efficiency of the market may be enhanced (e.g., by developing property rights) if there is a will to do so. On the second point, whether market failure is the reason for government intervention is debatable. By intervention, the government is, in effect, deliberately isolating an industry from market forces and subjecting it, instead, to political forces. It is expressing the view that the industry should not maximise net social benefit, as expressed in market values, but rather should give greater weight to some particular consumers or producers. It is not surprising to find, then, that those government organisations responsible for monitoring the performance of other government organisations charged with maximising net social benefit show little enthusiasm for their task. Unlike net private revenue, net social benefit is an artificial concept of direct interest only to economists.
This suggests that operating rules for controlling public organisations should satisfy two criteria. First, they should relate to concepts and entities of direct relevance to the people or organisations concerned. Second, the rules should be couched in objective operational terms: It should be possible to check whether or not they have been obeyed.
To illustrate briefly, it is currently British policy to require nationalised industries to assess proposed investments against a “test discount rate.” Since in practice it is impossible for an outsider to tell whether the assumptions and forecasts embodied in the appraisal are reasonable (or even what they are!), this rule provides no effective check on efficiency in investment. It would be preferable to replace it by, e.g., a realistic charge for borrowing funds plus a specified rate of return on the borrowing of the industry as a whole. Requiring the industry to invest so as to maximise net social benefit provides not control but only the illusion of control.
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