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

Frank Knight and American Neoclassical Paradigms

In sharp contrast to Marshall stands Frank Knight whose “main concern is the correct definition of the problem....” He sensed the ambiguities that were present in the neoclassical, essentially Marshallian, treatment of cost. In a series of important papers written in the late 1920’s and early 1930’s, he established the conception of opportunity or alternate-product cost that became the paradigm for modern price theory, notably in its American-Chicago variant. Starting with Adam Smith’s deer-beaver model, Knight demonstrated its inherent opportunity-cost content along the lines that I have sketched at the beginning of this chapter. “[T]he cost of beaver is deer and the cost of deer is beaver, and that is the only objective and scientific content in the cost notion.”3 The opportunity cost of a commodity is measured in units of alternate or displaced product and “all references either to ’sacrifice’ or ’outlays’ [should be] simply omitted.”4 “[C]ost must be measured in terms of products, and not of pains or outlays.”5

In this 1928 statement of what he considered to be the “correct” definition, Knight was following what he later acknowledged to be the standard Austrian position, especially that represented in Wieser. He also indicated in a later paper that this position was shared by Wicksteed. The cost of producing a unit of a commodity is simply measured by the alternative real product that might have been produced had the resource inputs used in production been rationally reallocated to other uses. The market value of these alternate products provides a common denominator for estimation, a value that is determined in the exchange process. Knight seems to have been correct in claiming this approach akin to that of Wieser who said: “Since each productive process diminishes this possession, it reduces utility—it costs, and it costs exactly as much as the value which the material and labor required would have produced if rationally applied.”6

Within a few years, however, Knight sensed that something was wrong with his straightforward alternate-product measure of opportunity cost. In papers published in 1934 and 1935, he tried to spell out his misgivings, but without great success.7 He tried to modify the alternate-product definition of cost to take account of the differences in the irksomeness of different resource uses, especially with application to the allocation of labor. In an extremely complex argument, Knight claimed that to the extent that resource owners do not equalize pecuniary returns to resource units in all uses, the principle of alternate-product cost does not wholly apply. If the deer hunter accepts a relatively lower pecuniary reward for his more pleasant work, a dollar’s worth of resource payment withdrawn from deer production and transferred to beaver production will increase “social” product by more than one dollar. Hence, the opportunity cost of the resultant increase in beaver production is more than the market value of the deer that the resource inputs might have produced before the transfer. Thus, the net change in irksomeness must also be acknowledged and counted.

This is surely a reasonable and fundamentally correct observation. It reflects, nonetheless, a notion of opportunity cost quite different from that which Knight had earlier advanced. The introduction of nonpecuniary advantages and disadvantages of resource uses severs the critically important link between the objectively measured market value of alternate product and the cost that enters into the subjective calculus of the decision-maker. This linkage is essential if the theory of value is to retain scientific content in any predictive sense. Without realizing it, Knight necessarily shifted from a positive model of behavior in which costs are objectively measurable into a logical model of choice in which costs are purely subjective. In the latter model, which has no predictive content, the market value of the displaced or alternate product has no direct relevance for the resource owner’s decision. Hence, this value cannot in any way be considered as the measure of his cost. Properly interpreted, as Wicksteed came close to saying, the predicted or expected value of the alternate product at the moment of decision and as estimated by the chooser is the cost. And, under this definition, the nonmarket value of the alternate conditions of employment is included as an essential part of cost.

The initial position taken by Knight became the orthodox one, and it remains so in the major part of modern price theory. The opportunity-cost notion is central. “The cost of any alternative (simple or complex) chosen is the alternative that has to be given up; where there is no alternative to a given experience, no choice, there is no economic problem, and cost has no meaning.”8 “Economic cost, then, consists in the renunciation of some ’other’ use of some resource or resource capacity in order to secure the benefit of the use to which it is actually devoted.”9 “The only general-cost theory which can be maintained will, after all, be that of alternative cost, best formulated as displaced product cost, but this must be stated subject to the qualification that it is true only ’in so far’ as at equilibrium the indicated conditions obtain.”10

In the context of most theoretical discussion, these are perfectly acceptable and wholly correct statements. Cost is measured by the market value of displaced product. Cost is objective in that it can be estimated, at least in ex post terms, by external observers, despite the fact that market values are set, generally, by the subjective evaluations by many producers and consumers. Market prices measure collective evaluations at the margins of production, and prices are themselves objective.

These statements about cost are widely and uncritically accepted by most modern price theorists, most of whom fail to see that opportunity cost, so defined, has no connection with choice at all. It is precisely for this reason that the simple but subtle differences between this orthodoxy and the alternative London theory provide suitable subject matter for a small book.

2.

The Origins and Development of a London Tradition

[3. ]Frank H. Knight, “A Suggestion for Simplifying the Statement of the General Theory of Price,” Journal of Political Economy, XXXVI (June 1928), 359.

[4. ]Ibid., 355.

[5. ]Ibid., 363.

[6. ]F. von Wieser, “The Theory of Value,” Annals of The American Academy of Political and Social Science, II (March 1892), 618. See also F. von Wieser, Über den Ursprung und die Hauptgesetze des wirtschaftlichen Werthes (Wien, 1884), p. 100.

[7. ]Frank H. Knight, “The Common Sense of Political Economy (Wicksteed Reprinted),” Journal of Political Economy, XLII (October 1934), 660-73, reprinted in Frank H. Knight, On the History and Method of Economics (Chicago: University of Chicago Press, Phoenix Books, 1963), pp. 104-18. This is a review article of the two-volume edition of Wicksteed. Frank H. Knight, “Notes on Utility and Cost” (Mimeographed, University of Chicago, 1935). Published as two articles in German in Zeitschrift für Nationalökonomie (Vienna), Band VI, Heft 1, 3 (1935).

[8. ]Knight, “Notes on Utility and Cost,” op. cit., p. 18.

[9. ]Ibid., p. 19.

[10. ]Knight, “The Common Sense of Political Economy (Wicksteed Reprinted),” op. cit., p. 116.