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• Foreword
• Preface
• Acknowlegments
• Cost and Choice
• 1.: Cost In Economic Theory
• Classical Economics
• Marginal-utility Economics
• The Marshallian Synthesis
• Frank Knight and American Neoclassical Paradigms
• 2.: The Origins and Development of a London Tradition
• Wicksteed and the Calculus of Choice
• H. J. Davenport
• Knight On Cost As Valuation
• Robbins, 1934
• Mises, Robbins, and Hayek On Calculation In a Socialist Economy
• Hayek, Mises, and Subjectivist Economics
• The Practical Relevance of Opportunity Cost: Coase, 1938
• G. F. Thirlby and “the Ruler”
• Mises’ Human Action
• The Death of a Tradition?
• Appendix to Chapter 2: Shackle On Decision
• 3.: Cost and Choice
• The Predictive Science of Economics
• Cost In the Predictive Theory
• Cost In a Theory of Choice
• Choice-influencing and Choice-influenced Cost
• Opportunity Cost and Real Cost
• The Subjectivity of Sunk Costs
• Cost and Equilibrium
• 4.: The Cost of Public Goods
• The Theory of Tax Incidence
• Costs and Fiscal Decision-making: the Democratic Model
• Costs and Decision-making: the Authoritarian Model
• Costs and Decision-making: Mixed Models
• The Choice Among Projects
• The Costs of Debt-financed Public Goods
• Ricardo’s Equivalence Theorem
• Tax Capitalization
• 5.: Private and Social Cost
• Summary Analysis
• A Closer Look
• Internal Costs, Equilibrium, and Quasi-rents
• An Illustrative Example
• Pigovian Economics and Christian Ethics
• Narrow Self-interest and Alternative-opportunity Quasi-rents
• Conclusion
• 6.: Cost Without Markets
• Prices, Costs, and Market Equilibrium
• Resource-service Prices As Final-product Costs
• Market Equilibrium, Costs, and Quasi-rents
• The Cost of Military Manpower: an Example
• The Cost of Crime: Another Example
• Artificial Choice-making
• Socialist Calculation and Socialist Choice
• Costs In Bureaucratic Choice

Classical Economics

If among a nation of hunters ... it usually costs twice the labour to kill a beaver which it costs to kill a deer, one beaver should naturally exchange for or be worth two deer.1

The classical theory of exchange value is summarized in this statement. Adam Smith was not so careful as his modern counterpart who states his assumptions precisely, but perhaps this is why we still enjoy reading The Wealth of Nations. Normal or natural value in exchange is determined by the relative costs of production. This answers the central questions of classical economics.

Costs are calculated in units of resource input. “It usually costs” means that a specific resource outlay is required, an outlay that can be estimated in advance with some accuracy and measured ex post either by the resource owner or by an external observer who doubles as cost accountant. The relative costs of producing are objectively quantifiable, and no valuation process is necessary. Given a standard for measurement, relative costs can be computed like the relative weights of apples or potatoes. In Smith’s elementary and conjectural model, the standard for measurement is a unit of homogeneous labor time. There are no nonlabor inputs (no other “negative goods”). The production functions for both deer and beaver are linear and homogeneous; that is to say, deer and beaver are available in unlimited supply at prevailing relative cost ratios.

Even in so simple a model, why should relative costs determine normal exchange values? They do so because hunters are assumed to be rational utility-maximizing individuals and because the positively valued “goods” and the negatively valued “bads” in their utility functions can be identified. If, for any reason, exchange values should settle in some ratio different from that of cost values, behavior will be modified. If the individual hunter knows that he is able, on an outlay of one day’s labor, to kill two deer or one beaver, he will not choose to kill deer if the price of a beaver is three deer, even should he be a demander or final purchaser of deer alone. He can “produce” deer more cheaply through exchange under these circumstances. By devoting one day’s time to killing a beaver and then exchanging this for deer, he ends up with three deer, not two. Since all hunters can be expected to behave in the same way, no deer will be produced until and unless the expected exchange value returns to equality with the cost ratio. Any divergence between expected exchange value and expected cost value in this model would reflect irrational behavior on the part of the hunters.

In this interpretation, the classical theory embodies the notion of opportunity cost. To the hunter at the point of an allocative decision, the cost of a beaver is two deer and the cost of a deer is one-half a beaver. At an expected exchange ratio of one for two, each prospective hunter must be on the margin of indifference. Physical production and production-through-exchange yield identical results. Labor time, the standard for measurement, is the common denominator in which the opportunity costs are computed.

Realized exchange value need not be equal to realized cost value in the elementary deer-beaver model or in the classical model generally. As interpreted here, there must be competitive indeterminacy in the allocation of resources to deer and beaver production. If, relative to prevailing demand patterns, a large number of hunters choose to produce beaver on a particular day, the price or market value of beaver will fall below cost. Or, alternatively, if the demand pattern shifts suddenly while the allocation of resources remains substantially unaltered, the same result can be forthcoming. Price, which is realized exchange value, can and will diverge from realized cost value. When this happens, however, some of the hunters will look back at the time of decision and conclude that mistakes were made.

There is one-way causality in this deer-beaver model. Relative costs determine normal exchange values. Implicitly, the theory assumes that predictions about production relations, the ratios of inputs to outputs, are considerably more accurate than predictions about demand patterns. This converts the theory into an elegant operational hypothesis. Objective, external measurements can be introduced which should yield predictions about normal exchange values. These predictions can be falsified.

The theory contains no prediction of normal exchange value when production is not possible, that is, when supply is fixed. Here normal exchange value, like realized exchange value in all cases, is set by the forces of demand. But to Adam Smith, this would not have embodied a predictive theory. No behavioral tendency can be introduced that relates the values of “goods” one to the other in terms of some objectively identifiable common denominator. For such fixed-supply goods, Smith would have said, simply, that no theory of value exists. Viewed in this context, J. S. Mill’s infamous statement that nothing more could be said on the theory of value can be interpreted somewhat more sympathetically than modern economists have been wont to do.

Exchange value tends to equality with objectively measurable cost of production. This is a positive proposition and carries with it no normative content. Nothing is said or implied to the effect that market price should equal cost of production. In the direct sense, classical economics does not contain a normative theory of allocation. The equalization of return to similar units of resources tends to emerge from the basic postulate of rational behavior along with the implicit identification of “goods” and “bads” in the utility functions of individuals.

The interpretation sketched out above is unfair to those who have criticized classical economics. Confusions abound on many points of analysis. Once the extreme simplifications of Smith’s homogeneous and single input model are dropped, the problems commence. The intricacies of classical reasoning are centered around the search for a comparable common denominator of value when inputs (negative goods) are heterogeneous. Ricardo’s genius was not up to this challenge despite valiant efforts. Rent theory explained away, though somewhat unsatisfactorily, the return to land. But differing labor-capital ratios remained, and Marx’s resort to “socially necessary” labor time was a retreat into the circularity that the whole classical theory was designed to circumvent.

Smith and, finally, Ricardo were both forced to rehabilitate the theory’s pragmatic relevance at the expense of its elegance. Heterogeneous units of input were measured in the money prices established in factor markets. The cost of production for a good was computed in money. As an elementary explanation of the normal or natural exchange value for a specific good, the essential features of the deer-beaver model continue to hold. The normal exchange value of a pair of shoes tends to equal $10 if $10 is the money cost of producing shoes, the necessary outlay made to owners of all resource inputs. Unfortunately, the elegance and the objectivity of the deer-beaver world have disappeared in this more realistic cost-of-production model. The objective opportunity cost of a beaver in Smith’s model is two deer because it “usually” takes twice as much physical input to produce a beaver. In the more realistic setting, what is the opportunity cost of a pair of shoes? Costs are measured in a numeraire and these reflect values of physical inputs. The direct connection between these inputs and alternative outputs is gone. To say that payments to resource owners amount to $10 does not, at least directly, imply that alternative products valued at $10 could be produced.

If costs are $10, the producer must expect a value of at least $10. The postulate of rational behavior along with the presumption that the numeraire is positively desired still implies that expected value be equal to or above costs. But what now determines costs? No longer is the theory simple enough to concentrate our attention on one moment of decision, one act of choice. Instead of this, we now must think of a chain of interlinked decisions over varying quantities of output, over separate time periods, and over many decision-makers. The producer, facing a near-certain outlay of $10, must expect a value in excess of this figure if he is to choose to produce. But resource owners, who are now conceptually separated from the producer-entrepreneur, must also make choices. Why does the unit mix of inputs sum to $10? Exchange values are established for resource units in markets, and each owner must be assumed to expect values in excess of costs when he makes a unit of resource available. But what are his costs? The classical economists were forced to discuss the costs of producing primary resources.

They thought themselves successful to an extent with respect to labor of an unskilled or common variety. In Smith’s elementary model, the cost of a beaver is two deer, which for comparative purposes is measured as a day’s labor, the time required to kill either of the alternatives open to the hunter. The cost of common labor time is the corn that is required to nourish the laborer and to allow him to reproduce his kind. Again, this corn can be measured in labor time required to produce the corn. But the analytical difference between these two statements is great, and in the latter we see a false extension of a basically correct theory of exchange value. The opportunity-cost theorem that is central to the deer-beaver model almost wholly disappears in the theory of wages for common labor. A day’s labor time measures the cost of a beaver because it represents the genuine alternative product, two deer. A half-day’s labor time presumably measures the cost of a laborer, not because it represents any genuine alternative product, but because it represents the outlay that is required to nourish him. The input-output relation has been subtly changed from that found in the simpler model. The labor input that measures the cost of a beaver is that required to produce an alternative, two deer. And no hunter would kill beaver unless the appropriate ratio of expected value holds. The outlay that may actually be required to kill a beaver is irrelevant to realized exchange value. By contrast, in the classical theory of wages, no consideration of the alternative to producing a laborer is included. Even the most sympathetic critic will find it difficult to read opportunity-cost thinking into the analysis.

It was perhaps in recognition of the difficulty here that both Smith and Ricardo shied away from rigorous analysis in discussing wages. A classical theory of sorts emerged which related wages to levels of subsistence. In this theory of wages based on Malthusian population principles, the cost theory of exchange value has lost almost all of its opportunity-cost moorings. Wages of common labor tend to subsistence levels, not because this is a predictable result of rational individual behavior, but because of the natural checks of famine and pestilence. The relationship between exchange value and individual choice behavior has been severed—and with it the essential logic of any cost-of-production theory. This classical theory of wages is almost devoid of behavioral content.

A source of some confusion that runs through and sometimes dominates classical discussion of cost has not been mentioned. This is the notion of pain cost, often called real cost. Not content with searching for a predictive theory of exchange value, the classical writers sought to “explain” the emergence of value in some basic philosophical sense. The toil and trouble, the physical pain, involved in working seemed to “justify” the payment of wages. Observation revealed that capital also received payment. Hence, the concept of abstinence developed by Senior seemed to place the capitalist alongside the wage-earner as a recipient of justifiable rewards. The importance of this real-cost doctrine in sowing confusion should not now be underestimated. Even today the theory of comparative advantage as taught by many sophisticated analysts contains its manifest nonsense, although fortunately little damage is done.2

Cost does reflect pain or sacrifice; this is the elemental meaning of the word. But we must recognize the linguistic problem which confronts economists in the use of the word “cost” to refer to quite separate things. Any opportunity within the range of possibility that must be foregone in order to select a preferred but mutually excluding alternative reflects “costs” when it is “sacrificed.” And its rejection must involve pain despite the fact that differentially greater pleasure is promised by the enjoyment of the mutually exclusive alternative. Cost and pain are far from being opposites, contrary to what loose discussion often seems to suggest; the concept of cost as pain or sacrifice is and must be central to the idea of opportunity cost. In certain aspects of the classical treatment, this pain-as-sacrifice concept was understood. As mentioned, the cost of capital accumulation was discussed in terms of “abstinence”: by abstaining from consuming, capital is allowed to accumulate. Clearly, this involves opportunity-cost reasoning.

For the most part, however, the real-cost or pain-cost notion in classical economics refers to something quite different. Pain also arises when nothing is sacrificed in a behavioral context. Pain occurs when, as a result of a past chain of events, the utility of the individual is reduced without offsetting pleasures. The required outlay of labor may involve pain, something that can within limits be measured by sweat, muscle fatigue, and tears. The transfer of capital assets to meet a debt obligation, to pay taxes, or to pay tribute to a highwayman also involves pain, again something that can be proximately measured by a decrement in net worth on the individual’s balance sheet. In this second sense, pain cost has no connection with deliberately sacrificed alternatives. The expectation of such pain may inform the comparison of alternative opportunities for choice, but the realization of such pain is irrelevant either in explaining or in justifying value. This vital distinction between the two separate notions of pain cost was not recognized by the classical economists or by many of their successors. The roots of many modern ambiguities lie in the classical failure to note this distinction, a failure that neoclassical economics did not remove satisfactorily.

[1. ]Adam Smith, The Wealth of Nations (New York: Random House, Modern Library Edition, 1937), p. 47.

[2. ]Even in 1967 economists need to be warned of the fallacy. On this, see Royall Brandis, “The Myth of Absolute Advantage,” American Economic Review, LVII (March 1967), 169-74.