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

Cost and Equilibrium

Given presumably objective data drawn from nonutility space, neoclassical economics makes predictions about properties of the equilibrium relationships that will tend to be established behaviorally by participants in the market-interaction process. To what extent does the equilibrium emphasis allow for some reconciliation between the two cost conceptions, between the objective cost of the predictive science and the purely subjective cost in the logic of choice? Do objectively measurable outlays reflect foregone opportunities only under conditions of full equilibrium?

If the whole economy is not operating at full competitive equilibrium, profits-losses may occur and, hence, observed outlays cannot be taken to reflect foregone opportunities of the actual decision-takers in any general setting. In full equilibrium, on the other hand, observed outlays directly represent the maximum contribution of resources in different uses. Therefore, to the extent that decision-takers behave economically, the observed outlays reflect genuine “opportunity costs,” even if somewhat indirectly. The apparent reconciliation here verges on the tautological, however, since the whole purpose of the economic theory in which cost is relevant is to demonstrate how choices made in nonequilibrium settings will generate shifts toward equilibrium. And choices in disequilibrium must be informed by opportunity costs that cannot, even indirectly, be represented by measured outlays. In disequilibrium, the opportunity costs involved in taking the “wrong” decision must include the profits foregone in the rejection of the alternative course of action.

Marginalism provides only a partial rescue here. If an individual behaves economically, and if no profit opportunities exist elsewhere in the whole system, and if all decisions can and must be made marginally, the marginal-cost derivation of orthodox theory can be taken to represent the genuine “opportunity cost” of an output decision. This means that all choices are made at equilibrium in the short-term planning context where output decisions within the firm are conceptually divorced from the rest of the economy. It is essential, however, for each of the qualifying conditions to be satisfied if measured marginal cost is to be employed as an objective representation of the subjective element that actually enters the individual’s choice calculus.

If, on the other hand, the individual incorporates nonpecuniary or noneconomic considerations in his decision, if there are profits to be secured elsewhere than in the activity in question, if discrete rather than marginal adjustments are possible, then objectively measured marginal outlay is not a veritable expression of genuine opportunity cost, because these “ifs” may represent inhibitions upon choice behavior which are not susceptible to objective measurement.

There is necessarily a close correlation between the relevance of objectively measured costs for a theory of choice in either long-term or short-term equilibrium and the presence or absence of uncertainty. In the face of uncertainty, the evaluation of alternatives by the actual decision-taker may differ from the evaluations of any external observer, even if the qualifying conditions are met. The inherent subjectivity of cost in any theory of choice reasserts itself here.

The equilibrium concepts introduced in this section up to this point are those of the predictive neoclassical theory. This implies that descriptions of equilibrium take the form of objectively defined relationships among variables in nonutility dimensions. Prices must bear specific relationships to costs. If we are content to remain within a more general, but ultimately nonpredictive and purely logical theory of economic choice, the concept of equilibrium may be modified. The equilibrium of the “subjectivist economics” espoused by Hayek is described behaviorally. It is attained when the plans of participants in the economic interaction process are mutually satisfied. Although prices continue in this equilibrium to bear some relationship to costs, such costs carry no objective meaning and cannot, therefore, be employed as criteria for determining prices in some welfare or efficiency sense.

4.

The Cost of Public Goods

The predictive science of economics postulates that men behave “economically.” They act so as to minimize “cost” in some objectively identifiable sense. By a curious inversion, economists have applied the postulate of behavior that has proved helpful in deriving positive predictions as a norm in a theory of choice. Throughout applied economics, the theory of economic policy, or welfare economics, we find norms that are defined in terms of specified relationships between “costs” and “prices,” relationships that embody conceptually measurable objective magnitudes. In effect, though perhaps inadvertently, the applied economist and the welfare theorist alike accept the behavior of Homo economicus as a value criterion. In their zeal to apply economic theory not to an analysis of institutional interactions but to real choice, they indirectly propose that decision-takers, singly or in the aggregate, should minimize objectively measurable outlays. This error is fundamental, and it extends from the estimation of national income to the economics of defense.1

Only a few of the many applications can be discussed in detail here, but these will perhaps be sufficient to indicate the importance of the methodological distinctions that I have emphasized. Somewhat arbitrarily I shall limit my discussion to three separate areas. In this chapter, I shall examine the various problems that arise when the concept of “cost” is applied to public or collective goods. A discussion of some of the difficulties in Pigovian welfare economics and in nonmarket decision-making follows this.

[1. ]For a critical discussion of the measurement of national product which is grounded on analysis that is related to, although quite different from, the analysis developed here, see S. H. Frankel, The Economic Impact on Under-Developed Societies (Cambridge: Harvard University Press, 1953), esp. Chapter III.