Cost and Choice: An Inquiry in Economic Theory

Cost and Choice

A century has elapsed since the subjective-value revolution in economic theory, but the subjective theory of value has not been fully reconciled with the classically derived objective theory. As the notes on the development of the concept of opportunity cost indicate, economists have not drawn carefully the distinction between a predictive or scientific theory and a logical theory of economic interaction. As subsequent chapters will demonstrate, this methodological confusion is the source of pervasive error in applied economics. The treatment and discussion of cost, especially in its relation to choice, provides a usefully specific context within which the more general methodological issues can be examined.

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.

Cost in the Predictive Theory

If we remain strictly within the predictive science of economics, cost can be considered to be properly defined in most of the modern textbooks, and there is little need to elaborate on these standard definitions. This is the cost of the familiar textbook diagrams, the objectively identifiable magnitude that is minimized. It is the market value of the alternate product that might be produced by rational reallocation of resource inputs to uses other than that observed. This market value is reflected in the market prices for resource units; hence, cost is measured directly by prospective money outlays.

For whom is this cost relevant? This becomes a critically important question. Cost as just defined is faced in the strict sense only by the automaton, the pure economic man, who inhabits the scientist’s model. It is the behavior-inhibiting element that is plugged into the purely mechanistic market model. The conversion of objective data reflecting prospective money outlays into the subjective evaluations made by real-world decision-makers is of no concern to the predictive theorist. In the strict sense, this theory is not a theory of
choice at all. Individuals do not choose; they behave predictably in response to objectively measurable changes in their environment.

Cost in a Theory of Choice

The distinction between the concept of cost in the predictive context, as sketched out above, and the concept of cost in a more general theory of choice, as articulated—though not fully—in Chapter 2, can best be emphasized at this point by elaborating this second concept. The essential element in this concept is the direct relationship between cost and the act of choice, a relationship that does not exist in the neoclassical predictive theory. In the London-Austrian conception, by contrast, cost becomes the negative side of any decision, the obstacle that must be got over before one alternative is selected. Cost is that which the decision-taker sacrifices or gives up when he makes a choice. It consists in his own evaluation of the enjoyment or utility that he anticipates having to forego as a result of selection among alternative courses of action.

The following specific implications emerge from this choice-bound conception of cost:

1.  Most importantly, cost must be borne exclusively by the decision-maker; it is not possible for cost to be shifted to or imposed on others.

2.  Cost is subjective; it exists in the mind of the decision-maker and nowhere else.

3.  Cost is based on anticipations; it is necessarily a forward-looking or
ex ante concept.

4.  Cost can never be realized because of the fact of choice itself: that which is given up cannot be enjoyed.

5.  Cost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed.

6.  Finally, cost can be dated at the moment of decision or choice.

In a theory of choice, cost must be reckoned in a
utility dimension. In the orthodox predictive theory, however, cost is reckoned in a
commodity dimension. This distinction can be applied to each of the six attributes listed above. In a theory of choice, cost represents the anticipated utility loss upon sacrifice of a rejected alternative. Because utility functions are necessarily personal, cost is tied directly to the chooser and cannot exist independently of him. In the predictive theory of economic behavior, the cost of producing one “good” is the amount of another that could be produced instead. Cost, as such, exists independently of the choice process, and there is no direct linkage between choosing and bearing cost.

Cost, then, is purely subjective in any theory of choice, whereas cost is objective in any theory that involves genuine prediction. If cost is to influence choice, it must be based on anticipations; it cannot be based on realized experience—at least directly. On the other hand, once cost is divorced from choice, it is a physical concept; it becomes irrelevant whether cost is measured before, at the moment of, or after actual commitment. In the Smithian model, the cost of a beaver is two deer, and this holds so long as the postulated physical relationships hold; there is no point in distinguishing
ex ante and
ex post measurements. Because of the technological or physical nature of cost, derived from the transformation function in commodity space, the alternatives facing the actor can be “costed” by an external observer. There is no need for the observer to psychoanalyze the hunter in Smith’s model. And the problem of dating does not arise in the objective definition implicit in the predictive theory. On the other hand, cost must be precisely dated in any theory of genuine choice because it is tied to the moment of choice as such. Before choice, cost exists as a subjective experience. After choice, cost vanishes in this sense. What happens to the chooser after he has chosen remains to be considered.

Choice-Influencing and Choice-Influenced Cost

The six attributes of cost listed above are relevant to any particular choice. If cost is to be influential in affecting
that choice, it must be defined in terms of these attributes. Nonetheless, we must also recognize that choice has consequences: things happen as a result of decisions. Having committed himself to one course of action rather than another and having presumably made some rational estimation of the costs that this would embody, the individual “suffers” the consequences. He may not regret his prior decision, but, at the same time, he may undergo “pain” or “sacrifice” when he is required to reduce his utility levels. Whether or not choices were rightly or wrongly made has little direct relevance to the existence of this choice-influenced “cost.”

It is this “cost” consequent to choice which helps to create a part of the confusion between cost in the predictive theory and cost in the logic of choice. That which happens after choice is made is what economists seem to be talking about when they draw their cost curves on the blackboards and what accountants seem to be concerning themselves with. It is necessary that this choice-influenced “cost” be more thoroughly examined.

If we bend linguistic principle to accommodate orthodox usage here, it seems best to allow the word “cost” to be used in these two quite separate senses within any theory of choice, while continuing to employ this same term in its single usage in the predictive theory of economic behavior. Hence, we have both “choice-influencing cost” and “choice-influenced cost” within the theory of choice and defined in
utility space, and we have “objective cost,” defined strictly in the commodity space of the predictive theory. Let us now neglect the objective cost of the predictive science and concentrate on choice-influencing and choice-influenced cost. Every choice involves both of these. First, there is the genuine obstacle to choice, the opportunity cost that was central to the thoughts of those economists whose contributions were summarized in Chapter 2. Second, there are the utility losses that are always consequent to choice having been made, whether these be suffered by the chooser or by third parties and whether there may or may not be objectively measurable surrogates for these losses, e.g., payouts. These losses are the result of decision and never its cause. In the one case, cost inhibits choice; in the other, cost results from choice. These concepts of cost can be discussed more fully in connection with several of the familiar, but ultimately misleading distinctions.

Opportunity Cost and Real Cost

Strictly speaking, only choice-influencing cost represents an evaluation of sacrificed “opportunities.” It might therefore be reasonable to limit the term
opportunity cost to this conception and to invent other descriptive appellations to refer both to choice-influenced cost in a logic of choice and to the objective cost of the predictive theory. In a more general sense, however, any one of the three conceptions may be meaningfully treated in opportunity-cost terms. In the orthodox price-theory conception where cost is measured objectively by money outlays, it is helpful, for explanatory purposes, to equate these outlays to the values that members of society place on the alternate end products that might have been produced by the same outlays differently directed. In a certain ambiguous sense, therefore, cost here does reflect “opportunities lost.” But it is noteworthy that the “opportunities lost” in this context more accurately reflect the value of potential alternatives as judged by others rather than by the chooser himself.

The notion of “opportunities lost” can also be applied to the results of choice, or to choice-influenced cost. Here the concept is tied to the choice and the opportunities represent those things that “might have been,” as these are viewed after decision has been made. Given this hindsight, alternatives can be viewed differently than they were viewed before a commitment was made. Within a before-choice, or choice-influencing context, the opportunities lost are those that “might be,” as considered and evaluated at the moment of choice itself and as reflected in the presently anticipated value of utility losses expected to be incurred. Within the post-choice or choice-influenced context, by comparison, the opportunities lost are those that might have been enjoyed, as these are reflected in experienced utility losses or sacrifices. There can be an important psychological difference in the utility losses involved in choice-influencing and in choice-influenced cost. At the moment of choice itself, cost is the chooser’s evaluation of the anticipated enjoyments that he must give up once commitment is made; it is also that which he can avoid by choosing another alternative. Cost in this setting must be and remain a purely mental event. The chooser’s utility is reduced only in the sense that it is functionally dependent on
expected utility in post-decision time periods. After the choice is made, cost may still reflect the evaluation of enjoyments that were sacrificed and cost remains a mental event, but there is more to it than this. Among the experiences that might have been avoided may be those requiring an explicit submission to pain, to suffering, to deprivation, in some physically relevant meaning of the terms. Having made a charge-account commitment, the buyer must pay his bills when they come due. Despite his possibly rational anticipation of this cost at the moment of choice, he still suffers pain when these bills must be met. This purely physical exposure to negative choice-determined effects enters into his subjective evaluation of the alternative that might have been. In a certain sense, therefore, the nature of cost is different in the choice-influencing and the choice-influenced contexts, although both remain in utility space.