The Online Library of Liberty

A project of Liberty Fund, Inc.

• 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

Marginal-Utility Economics

A revolution in value theory took place after 1870. The classical cost-of-production theory was replaced by the marginal-utility theory, as the latter was variously developed by William Stanley Jevons, Karl Menger, and Leon Walras. These theorists were somewhat less obligated than their classical predecessors to define costs precisely for the simple reason that costs assumed much less importance for them in explaining exchange value. At least in the elementary stages of analysis, they seemed willing to accept classical definitions: Their quarrel with the classicists was not centered on the notion of cost. They considered their differences to be more profound. Regardless of the manner in which costs were defined, however, the marginal-utility theorists rejected classical analysis.

The development of a general theory of exchange value became a primary concern. Classical analysis was rejected because it contained two separate models, one for reproducible goods, another for goods in fixed supply. The solution was to claim generality for the single model of exchange value that the classical writers had reserved for the second category. Exchange value is, in all cases, said the marginal-utility theorists, determined by marginal utility, by demand. At the point of market exchange, all supplies are fixed. Hence, relative values or prices are set exclusively by relative marginal utilities.

If the revolution had amounted to nothing more than this, it would have scarcely warranted notice. The contribution of these theorists was not the mere substitution of a utility for a cost theory of exchange value. In the process of effecting this substitution, they were forced to develop the idea that values are set at the margin. In this manner, they were able to resolve the diamond-water paradox; value-in-use and value-in-exchange were no longer possibly contradictory. The economic calculus was born.

Nonetheless, there were losses in discarding the classical apparatus. In their search for a general theory, the marginal-utility economists largely abandoned a predictive theory of normal exchange value. They provided a satisfactory explanation of realized value; they did little toward developing analysis of expected or natural value. In the strict sense, theirs is a logical theory, not a scientific hypothesis capable of refutation. And as with all general theories, the marginal-utility theory explained too much.

The generality carried some secondary benefits, however, and a logical extension was the marginal-productivity theory of distribution. Since goods are valued in accordance with relative marginal utilities, resources should also be valued in accordance with the values of their final-product components. There was no call to go beyond the fixed supply of resources in a first approximation. For almost a century, the theory of population was dropped from the economist’s kit of tools.

Marginal-utility economics is often called “subjective-value” economics, and the doctrinal revolution also carries this name. The classical cost-of-production theory was objective in the sense that external measurements of comparative costs were thought to provide predictions about normal exchange values of commodities. The replacement of this with a theory that explained relative exchange values by relative marginal utilities necessarily implies a loss of objective empirical content. Marginal utilities, however, were acknowledged to be dependent on quantities, and, for the whole group of demanders, on the supplies put on the market. Hence, even with a full knowledge of demand conditions, normal exchange values could not be predicted until and unless predictions were made about relative supplies. The cost or supply side of value had to be brought in. A one-sided explanation was no longer possible; demand-supply economics became a necessity.

Given a supply of a commodity, exchange value was determined by marginal utility, as worked out in a market interaction process. But utility is a subjective phenomenon, and it is not something that can be externally or objectively measured, as can classical cost-of-production. To understand this, let us think of a world of two commodities, each of which is in fixed supply, say, the world of bear and raccoon. Both are “goods,” and each good is available in predictably fixed quantity in each period. If we know with accuracy the demand or marginal-utility schedules for all demanders, exchange value can be predicted. Note, however, that this prediction does not emerge as an outcome or result of a rational behavior postulate, at least in the same sense as the classical deer-beaver model. Suppose, given the fixed supplies along with the demand patterns, it is predicted that one bear will exchange for two raccoons. If realized values are observed to be different from those predicted, it is the result only of inaccuracy in the initial data upon which the predictions were made. No equilibrating mechanism is set in motion; there is no sense of error as there is in the deer-beaver model. No corrective process will emerge; values as realized are always “correct”; errors arise only in the data used by the observer. The marginal-utility theory in its elementary methodology here is akin to the simple Keynesian model of income determination. By contrast and despite its flaws, the classical cost-of-production theory is more closely analogous to the Swedish theory of income determination where expectations can explicitly enter the analysis.

To introduce elements of a predictive theory of exchange value required a return to quasi-classical analysis. Costs of production were acknowledged to influence exchange value through their effects on supply. And in discussing costs, the marginal-utility theorists could accept a money measure without ambiguity since they had no reason to search for a common denominator of physical resource inputs. The necessity of paying for inputs arises because these represent components of value in final products. This approach leads almost directly to opportunity-cost reasoning.

The value or price of resource units represents, especially for the Austrians (Menger, Böhm-Bawerk, Wieser), the value of product that might be produced by the same resource units in alternative uses or employments. This is the price that the user or employer of resources must advance in order to attract the resources away from such alternative opportunities. At the level of decision for the resource owner, the implicit opportunity-cost notion is identical to that which is present in Smith’s deer-beaver model. To the Austrians, and notably to Wieser, rational behavior on the part of resource owners ensured the equalization of return in all employments.

Jevons was unique among the subjective-value theorists in his treatment of cost, and he is considerably more classical than Austrian. The cost of producing involves “pain,” a concept that was almost entirely absent from Austrian discussion. This pain cost can be discussed in terms of marginal disutility. Jevons was thus the complete marginalist, and, for him, all choice reduced to a comparison of utilities and disutilities at the margin. He was able to resolve the diamond-water paradox through the use of, essentially, the classical apparatus. Because he did not sufficiently generalize the alternate-product conception, his cost theory was inferior to that of the Austrians or even to that which was implicit in Smith. Nonetheless, Jevons did concentrate attention on the act of economic choice, and this might have influenced Wicksteed in his major advances toward his wholly modern conception.

To the early Austrian theorists, costs of production are measured in money, and these reflect the value of output that might have been produced if the same resource inputs had been rationally applied in alternative employments. This is indeed an opportunity-cost notion, but it is subjective only in the sense that values of goods are set by their relative marginal utilities to demanders. Since these values are set in organized markets, they can be objectively measured.