Front Page Titles (by Subject) An Illustrative Example - Cost and Choice: An Inquiry in Economic Theory, Vol. 6 of the Collected Works
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An Illustrative Example - James M. Buchanan, Cost and Choice: An Inquiry in Economic Theory, Vol. 6 of the Collected Works 
The Collected Works of James M. Buchanan, Foreword by Geoffrey Brennan, Hartmut Kliemt, and Robert D. Tollison, 20 vols. (Indianapolis: Liberty Fund, 1999-2002). Vol. 6 Cost and Choice: An Inquiry in Economic Theory.
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An Illustrative Example
Much of the critical analysis may be clarified by a simple illustrative example. Let us suppose that I enjoy foxhunting and that I maintain a kennel of hounds near my residence. I am considering adding one more hound to my already-large pack, and I know with reasonable accuracy the market price for hounds. This price is, let us say, $100.
My neighbor lives within sound range of my kennel, and he (and his family) will suffer some predictable utility loss if I decide to purchase the additional dog. For purposes of analysis here, let us say that this external damage can be reasonably evaluated at $45, presumably by an expert observer and also by both my neighbor and myself. Now let us suppose that I anticipate the incremental benefits of the additional dog at $160. This substantially exceeds the price of $100. Let us also assume that there are no alternative spending outlets where I can secure net marginal benefits. In such circumstances, the opportunity costs arising from the enjoyments that I must avoid by the fact of making the outlay can roughly be measured at $100. However, in addition to these costs, I may well, in my calculus of decision, place some value on the enjoyments that my neighbor must also forego as a consequence of my purchasing the dog. His anticipated suffering, as well as my own, can be an obstacle to my decision.
Suppose that I try as best I can to place a value on this expected loss in utility for my neighbor and that I arrive at a figure of $45, which, as noted above, does roughly represent the value that he himself places on the action. The obstacle to my choice, my choice-influencing cost, will embody two elements. First, there is the evaluation of the alternative uses of the anticipated $100 outlay, which, under the conditions postulated, we measure at $100. Second, there is the evaluation that I place on the anticipated enjoyments that my neighbor must forego, in this case $45. Under such circumstances, I will proceed to carry out the purchase since the anticipated marginal benefits, $160, exceed the evaluation of foregone alternatives, $145.
Note that in the behavior postulated, I am acting in accordance with the Pigovian criterion, treated here as an ethical norm for private behavior. Quite literally, I am treating my neighbor as myself, and my internal decision calculus accurately reflects “marginal social cost” as the obstacle to decision, despite the absence of any corrective tax. Note also, however, that for the discrete choice in question, I shall be observed to impose an external cost on my neighbor for which I do not compensate him. If a Pigovian-trained economist should be called in to advise the government, he would likely recommend that I be subjected to a corrective tax, levied in the amount of the external costs, in this example $45. It is clear that, unless the components of my subjective opportunity costs are directly modified by such a tax, the effect will be to change my decision. Costs that a positive decision embody will now be approximated at $190. Facing these, I shall refrain from purchasing the hound despite the “social” or allocative distortion that my failure to do so generates. In this example, the corrective tax tends to convert a socially desirable choice outcome into a socially undesirable one.
My internal opportunity-cost components may be modified by the imposition of the tax. If I am fully aware that I am being taxed for the express reason that my behavior generates the external economy, I may reduce the valuation that I place on my neighbor’s foregone enjoyment of silence. This reaction may be especially likely if the proceeds of the tax are earmarked for direct transfer to my neighbor. Such a direct linkage, and more importantly such a consciousness of the purpose of corrective taxes, has not been emphasized in the Pigovian literature and does not seem remotely descriptive of choice behavior. At best, we may acknowledge some substitution between the tax and the subjective valuation of the “external” component of opportunity cost; surely there is no reason to expect anything like a full offset.
In the simplified example, it is assumed that I value the foregone alternatives of others more or less equally with my own. This extreme altruism need not, of course, be assumed in order to reach the conclusion that the corrective tax produces inefficient outcomes. In the discrete choice discussed in the example, even if I place a valuation of only $16 on the foregone enjoyment of my neighbor, the corrective tax of $45 will cause me to choose the inefficient outcome ($100 + $16 + $45 = $161 > $160). This valuation figure becomes even smaller as the personal “quasi-rent” or “marginal surplus” is reduced. Suppose, for example, that my estimate for marginal benefits is only $146, and that I place only a $2 valuation on the foregone enjoyment of my neighbor. My choice-influencing costs after the tax are then $147 ($100 + $2 + $45), which exceed my anticipated marginal benefits. I shall be led to the inefficient social choice, although the differential inefficiency here will be lower than in those cases where I place a somewhat higher valuation on the prospective utility losses of others.