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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 Predictive Science of Economics

From its classical origins, economics has laid claim to classification as a predictive science. This means that conceptually refutable hypotheses are embodied and that the refutations of these hypotheses can command ultimate recognition by competent professional scientists. To qualify under this restriction, the science must have objective, empirical content. Something must be measurable—at least conceptually—which will allow either the corroboration or the refutation of the central propositions. The basic elements of economic theory are, of course, the actions of human beings. The science consists in the efforts to predict the effects on human behavior induced by specific changes in environment. Operationality dictates that the behavioral responses be objectively measurable.

Consider the elementary proposition that relative prices rise when relative costs increase, subject to the standard ceteris paribus qualifications. This proposition is derived from the postulate that individuals behave “economically,” that they seek to minimize “costs” and to maximize “benefits” or “revenues.” But this postulate remains empirically empty until specific descriptive content is given to “costs” and to “benefits” or to “revenues.” The behavioral postulate is that of economic man. If this is dropped, the predictions are drained of power.

It is important that the limitations as well as the strengths of this predictive theory be noted. There is no implied presumption that men should behave economically. Properly interpreted, the theory’s claim is limited to making predictions on the “as if” assumption that men do so behave in some average or representative sense. The motivational assumption is vital in that this allows the scientist to use the objectively observable magnitudes of money cost and money revenue streams as representations of the subjectively evaluated alternatives of choice in individuals’ behavior patterns. As experience has shown, considerable success has been achieved in this genuinely scientific theory of economic behavior. Men do behave economically in sufficient degree to allow many predictions to be corroborated. But the oversight of the basic limitations of the predictive theory has led to major error in normative application.

The orthodox neoclassical model of market process is one in which the acting units behave economically. To the extent that the model approximates reality, the objectively observed cost and revenue streams accurately represent the dimensionally different and subjectively evaluated alternatives among which choices are actually made by individuals. To this same extent, and only to this extent, specific relationships among costs, as objectively observed, and prices, as objectively observed, can be predicted to describe the equilibrium toward which the whole process converges. Note especially that these relationships, these conditions of equilibrium, are themselves derivative predictions based on the motivational postulates of the model. For example, equalities between prices and marginal costs, as objectively observed quantities in fully competitive equilibrium, are inferred predictions which depend on the behavioral assumptions upon which the whole theory is constructed. These equalities have no normative significance, and they have no direct relationship to allocational efficiency. The methodological muddle in modern economics is perhaps most clearly revealed by the unwarranted crossing of the bridge between the inferential predictions of the genuinely scientific theory and the normative conclusions about efficiency that are so often drawn.

This may be illustrated in a variation, similar to that used by Knight in his papers previously cited, upon the simplest of models, Adam Smith’s deer and beaver model. The objective conditions of the model remain as before. One day’s labor is required to kill a deer and two days’ labor to kill a beaver. Objectively measurable costs are in a one-for-two ratio. The prediction is made that exchange values will settle in a two-for-one ratio, a ratio which will be described by the equalities between marginal costs and prices. Let us suppose, however, that the relative price ratio exhibits no tendency to move toward the equilibrium level that is predicted; prices do not tend toward equality with marginal costs. Only the most naive of welfare economists should conclude from this that the allocation of resources is inefficient. Instead he probably would introduce, as Knight did, the possibility that hunters, generally, may have some nonpecuniary or noneconomic arguments in their utility functions. Marginal costs, as these affect choice behavior, may then not be the same as the simply observed ratios of labor time. The welfare economist, presuming only that the market is competitively organized, then concludes that the price-marginal cost equalities are satisfied in the equilibrium that he observes, despite the variations from objectively based predictions.

In resorting to noneconomic arguments in the utility function to rectify his falsified predictions, however, the economist has shifted the whole analysis from a predictive to a nonpredictive and purely logical theory. Objectively observable cost-revenue streams cannot serve as surrogates for the subjectively evaluated alternatives in which noneconomic elements are influential. The inferred predictions of relationships that characterize equilibrium positions are falsified. No potential gains-from-trade are indicated if these predictions are not fulfilled. No welfare improvements could, therefore, be expected from rearrangements designed to ensure that the predicted relationships will be produced.

The implications of all this for modern welfare economics could scarcely be underestimated. My argument suggests that almost all of this subdiscipline has been based on simple methodological confusion. It has converted predictive propositions into allocative norms which have then been used to make policy proposals. Some of the more specific instances of this confusion will be discussed in subsequent chapters.

In one sense it might be said that the neoclassical economist has succumbed to the temptation to make his whole theory more general than its methodology warrants. This temptation has been increased by the parallel, and equally confused, logical theory of economic choice, which itself is completely general but which lacks predictive content. This purely logical theory, sharply distinct from the classical in its predictive implications, finds its origins in the subjective-value theorists, but its more explicit sources are Wicksteed, the later Austrians, and the economists associated with the London School of Economics. In full flower, this is the “subjectivist” economics espoused by Hayek and Mises to which I earlier made reference. Some reconciliation between the genuinely scientific theory of economic behavior and the pure logic of choice is required. The achievement of this reconciliation is one of the major purposes of this exploratory study in which the notion of opportunity cost becomes the analytical coupling device.