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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

The Practical Relevance of Opportunity Cost: Coase, 1938

Alongside the more abstract and methodological contributions to cost theory made by Robbins, Hayek, and Mises, other elements of perhaps a more authentic LSE tradition emerged in the 1930’s. These reflect the direct application of some of the basic Wicksteed notions to problems that confront the businessman. This “common sense” approach had its roots at LSE in the work of Cannan who continually insisted on starting with problems as they exist. Cannan does not seem to have made specific contributions to cost theory, although he accepted opportunity-cost notions readily.21

This practical-business approach was further promoted by Arnold Plant who seems to have contributed significantly, but indirectly, to the development of the London tradition. Plant did not, to my knowledge, treat cost theory explicitly in any of his published works, but the contributions made by his students and colleagues reflect his influence. Both R. H. Coase and G. F. Thirlby, whose contributions are summarized below, were Plant’s students.

The contrast between the accountant’s definition-measure of cost and that of the neoclassical economist is standard fare. But this contrast—when the full meaning of opportunity cost is incorporated—takes on features that are even now outside the orthodox economist’s kit of tools. This can be seen clearly in a series of articles by R. H. Coase, published in 1938, which were written specifically for the enlightenment of accounting practitioners.22 These papers remain known to relatively few modern economists despite their exceptionally clear discussion of definitional problems involved in using the term “cost” and their necessary and emphatic insistence that cost be related to the choice process.

“The first point that needs to be made and strongly emphasized is that attention must be concentrated on the variations which will result if a particular decision is taken, and the variations that are relevant to business decisions are those in costs and/or receipts” (p. 106). “It should be noted that accounting records merely disclose figures relating to past operations. Business decisions depend on estimates of the future” (p. 108). “[C]osts and receipts cannot be expressed unambiguously in money terms since courses of action may have advantages and disadvantages which are not monetary in character, because of the existence of uncertainty and because of differences in the point of time at which payments are made and receipts obtained” (p. 116). “The cost of doing anything consists of the receipts which could have been obtained if that particular decision had not been taken. When someone says that a particular course of action is ’not worth the cost,’ this merely means that he prefers some other course—the receipts of the individual, whether monetary or nonmonetary does not matter, will be greater if he does not do it. This particular concept of costs would seem to be the only one which is of use in the solution of business problems, since it concentrates attention on the alternative courses of action which are open to the businessman. Costs will only be covered if he chooses, out of the various courses of action which seem open to him, that one which maximizes his profits. To cover costs and to maximize profits are essentially two ways of expressing the same phenomenon” (p. 123) (italics supplied).

A careful, modern reading of these early papers by Coase indicates that the concept of cost embodied in them is conceptually distinct from the neoclassical paradigm. Coase quite explicitly ties cost to choice, and he rejects any attempt to classify costs into categories—e.g., fixed and variable—independently of the identification of the decision under consideration. Perhaps the most significant contribution, for our purposes, is contained in the italicized statement cited above. Any profit opportunity that is within the realm of possibility but which is rejected becomes a cost of undertaking the preferred course of action. Despite the necessity of accepting this straightforward result of apparently consistent opportunity-cost reasoning, economists were—and are—extremely reluctant to take this step. To include all foregone profits as costs plays havoc with the whole cost-curve apparatus that is a part of our stock-in-trade. And without this how could we teach elementary price theory?

In the strict neoclassical model, costs are distinguished sharply from foregone profits because they are not tied directly to choice. Costs are objectively measurable outlays, approximated by the value of alternate product. It is useful to keep the classical foundations of the analysis in mind here. Costs, to the extent that they are objective and, hence, externally measurable by an outsider who stands apart from the choice process, provide the basis for a predictive hypothesis about the behavior of acting individuals (firms) and, through this, a hypothesis about prices. The neoclassical objectivist world and the London-Austrian subjectivist world cannot readily be reconciled.

Confusion was confounded by the Robinson-Chamberlin and related contributions in the early 1930’s just when the more basic notions in cost theory seemed on the way to being clarified. These contributions elevated the theory of the firm to a position of undue importance in a model that apparently embodied the objectivist rather than the subjectivist notions of cost. If the purpose of analysis is to “explain” the behavior of the firm, choice must be the subject of attention, and costs cannot be objectified. The whole marginal-revenue-marginal-cost apparatus, strictly speaking, remains a part of a central logic of choice and nothing more because, to the effective decision-taker, both costs and benefits are evaluated in purely subjective terms. It is little wonder that modern developments in the theory of the firm have been concerned with relaxing the artificial and apparent objectivity of cost and revenue streams by substituting more plausible, even if largely nonoperational, utility indicators.

Coase’s early work on the theory of the firm was within a choice-explanatory context and without the constraints of the more widely acclaimed contributions of the imperfect and monopolistic competition models. In this context, Coase was fully correct in his argument that foregone profits must be included in opportunity cost and in his insistence that cost be considered as that which can be avoided by not taking a particular decision.

Despite his major contribution toward clarifying the concept of opportunity cost in the context of the theory of the firm, Coase did not in his 1938 papers fully incorporate the “subjectivist economics” of Hayek and Mises into his analysis, nor did he draw the distinction between his concept and that embodied in neoclassical orthodoxy.23

[21. ]See esp. his review of Henderson’s Supply and Demand, reprinted in Edwin Cannan, An Economist’s Protest (London: P. S. King, 1927), pp. 311-14.

[22. ]R. H. Coase, “Business Organization and the Accountant,” The Accountant (October-December 1938). These articles are reprinted in David Solomons (ed.), Studies in Costing (London: Sweet and Maxwell, 1952), pp. 105-58.

Along with Coase, other members of Plant’s group of young business economists were R. S. Edwards, R. F. Fowler, and David Solomons. This group was interested in making economic theory of greater practical relevance for business operations and especially for accounting practice.

[23. ]In his later, and more widely known, paper on marginal-cost pricing, Coase’s argument for the multi-part tariff was informed throughout by the conception of opportunity cost developed in his earlier papers. His emphasis, as it has been interpreted by later writers, was, however, on the familiar conflict between marginal-cost and profitability criteria. His opportunity-cost defense of multi-part pricing has been largely overlooked. See R. H. Coase, “The Marginal Cost Controversy,” Economica, XIII (August 1946), 169-82. In a comment on Coase’s paper, G. F. Thirlby criticized the implied objectivity of cost. See G. F. Thirlby, “The Marginal Cost Controversy: A Note on Mr. Coase’s Model,” Economica, XIV (February 1947), 48-53.