L.S.E. Essays on Cost

1

Introduction: L.S.E. cost theory in retrospect

by JAMES M. BUCHANAN

In his paper, ‘Economics and Knowledge’, included in this volume, Hayek scarcely mentioned ‘cost’. Nonetheless he provides indirectly the strongest argument for attempting, through the publication of this collection of essays, to focus the attention of modern economists on the elementary meaning of cost. Hayek emphasized the differences, in principle, between the equilibrium position attained by a single rational decision-maker in his own behavioural adjustments, given his preference function and the constraints that he confronts, and the equilibrium potentially attainable through the interaction of many persons. To Hayek the latter ‘is not an equilibrium in the special sense in which equilibrium is regarded as a sort of optimum position’.

Despite Hayek’s warning, since the 1930s, when his essay along with some of the others in this collection was written and when the L.S.E. tradition in cost theory was developed, economists have increasingly analysed equilibrium states in terms of their optimality or non-optimality properties, defined by criteria for maximizing some objective function. It is somewhat paradoxical that Robbins, whose contribution to London cost theory cannot be questioned, should also have been at least partially responsible for the drift of modern economic theory towards the mathematics of applied maximization, variously elaborated, and away from the analysis of exchange processes. In
The Nature and Significance of Economic Science,*1 Robbins supplied the methodological paradigm within which modern micro-economics has been developed. Elementary textbooks throughout the world soon came to define ‘economics’ in terms of ‘the economic problem’,
the allocation of scarce resources among alternative ends. So defined, the ‘problem’ faced by the individual on the desert island, the Crusoe so familiar to us all, is, at base, quite similar to that faced by the society or the community of persons. The paradigm was somewhat differently put, but with the same effect, by Paul A. Samuelson in his influential
Foundations of Economic Analysis, when he stated:

They [meaningful theorems in diverse fields of economic affairs] proceed almost wholly from two types of very general hypotheses. The first is that
conditions of equilibrium are equivalent to the maximization (minimization) of some magnitude.
*2 [Italics supplied.]

The increasing conceptual quantification in economic theory was almost necessarily accompanied by increasing conceptual ‘objectification’. Once the magnitude to be maximized is symbolically defined, attention is quite naturally diverted to the manipulation of the symbols and away from the initial leap into presumed objectivity itself. The increasing conceptual quantification need not have introduced confusion save for the simultaneous developments in theoretical welfare economics. Within what Hayek called the ‘Pure Logic of Choice’, the formal theory of utility maximization, mathematical rigour has offered aesthetic satisfaction to the sophisticated without loss of explanatory potential. More importantly, the increasingly elegant and formalistic content of general-equilibrium theory, and notably its emphasis on existence proofs and stability conditions, yields pleasure to the talented, criteria to the critical, and convictions to some who have remained unconvinced about the overall efficacy of market order.

So long as the object for discussion, and for theorizing, is either the individual decision-maker or the interactions of separate decision-makers
in markets, no harm is done and perhaps some good is added by conceptual objectification. Confusion arises only when the properties of equilibrium, as defined for markets, are
transferred as criteria of optimization in
non-market or political settings. It is here that the critical distinction between the equilibrium of the single decision-maker and that attained through market interaction, the distinction stressed by Hayek, is absolutely essential to forestall ambiguity and analytical error. The theory of social interaction, of the mutual adjustment among the plans of separate human beings, is different in kind from the theory of planning, the maximization of some objective function by a conceptualized omniscient being. The latter is equivalent, in all respects, to the problems faced by Crusoe or by any individual decision-taker. But this is not the theory of markets, and it is artificial and basically false thinking that makes it out to be. There are properties or characteristics of equilibria in markets that seem superficially to be equivalent to those attainable by the idealized optimization carried out by the planner. But shadow prices are not market prices, and the opportunity costs that inform market decisions are not those that inform the choices of even the omniscient planner. These appear to be identical only because of the false objectification of the magnitudes in question.

I think that it is legitimate to trace the sources of error to
fundamental misconceptions in the theory of opportunity cost, misconceptions that the London (and Austrian) scholars were attempting to clarify, and which later I tried similarly to rectify with my little book,
Cost and Choice, in 1969.
*3 Unfortunately neither the London contribution nor my book seems to have exerted much effect on mainstream thinking in economic theory.

But I am getting ahead of my story. As I noted above, the increasing conceptual quantification, and objectification, of economic theory need not have sown confusion without the accompaniment of developments in theoretical welfare economics. Precisely at the time that methodologists were effective in formalizing economic theory within a more rigorous maximization framework, interest in ‘market failure’ rather than ‘market success’ was at its peak, and, with this, interest in the extension of economic theory to socialist organization became widespread. The Robbins definition of the allocation problem, with its implied emphasis on the universality of scarcity, supported such an extension. It was predictable that economists, trained professionally to analyse market equilibria, and increasingly adept at formalizing the maximization paradigm, should begin to discuss planning problems and solutions as if these required the same set of tools as those applicable to market phenomena. In retrospect it seems singularly unfortunate that the institutionalists should have lost favour precisely when their emphasis on and expertise in the functioning of organizational-institutional structures, and the impact of differing strutures on behaviour of decision-makers, might have, with some intrusion of analysis, yielded their highest marginal product in effective critical scholarship. Instead the mathematically sophisticated analytics of such scholars as Hotelling were allowed to go unchallenged despite their vulnerability in this most fundamental sense. And young economists everywhere learnt to appreciate the beauty of the mathematical models of what they called ‘an economy’. Theirs was not the role of sceptic, and to question quantification and objectification itself quickly came to be the mark of eccentricity rather than excellence.

Nor need we limit analysis of such a conjectural economy to the planner’s problems. As an alternative speculative exercise we may suppose that our homogeneous glob of scarce resource (putty clay or schmoos) is initially and arbitrarily parcelled out among persons under a private-property-rights arrangement. By assumption, the individual owners are completely indifferent as to just what set of final goods their own assigned input becomes in the transformation. These owners are motivated solely by their
own desire for final goods, command over which is measured by income, denominated in some commonly agreed numeraire good. The only difference between this model and the one described earlier is that this one ‘works on its own’, once private-property-rights are defined and protected. The scarce resource will be allocated among uses; final goods will be ‘produced’; prices will be set. The ‘market’ equilibrium that emerges will in this case be equivalent in all respects to the solution of the maximization problem posed for the planner in the earlier model. Prices will equal marginal costs, not because some hidden planner has now drawn on the norms of welfare economics, but because this equality is descriptive of the end of the trading process. If this equality is not satisfied, further gains from trade would be possible; potentially realizable surplus would remain unexploited. Not only can we deduce the equivalence in results between these two models on some
a priori basis. We could also
observe such equivalence in an objectively verifiable sense.

I do not think it a caricature to describe modern economic theory as being grounded on the two conjectural models that I have briefly sketched, and on the equivalence between their ‘equilibrium-optimality’ properties. Viewed in this simplistic perspective, however, the models paradoxically suggest that economic theory has advanced little, if at all, over that advanced almost two centuries earlier by the classical economists. In one respect at least, the classical writers were more honest in their efforts. They sought to explain relative prices by relative-input ratios of homogeneous labour. They fell short precisely because the deficiency in their common objective standard for measurement was revealed for all to see. This prompts the question as to why modern theorists have been so much more successful in concealing the fundamental flaw in their structure ‘Camouflage by complexity’ provides only a part of the answer here. The classical economists failed because their standard for measurement was demonstrably deficient, but also because their logical structure was not complete. One must read much into classical structure if any general-equilibrium theory of markets is to be discerned. They did not close the circle, and the lacunae in their essentially one-sided explanatory model provided
the source for the familiar normative critique associated with Marx. The circle was completed by the subjective-value theorists, by the Marshallian synthesis, and, more explicitly, by the Walrasian theory of general equilibrium. These several contributions represent a major conceptual advance over classical economic analysis by criteria of logic and coherence. But the logical symmetry achieved in explaining the workings of the economic process was secured at a cost which is reflected by drainage of empirical, objective content. The classical economists offered us a positive-predictive theory of relative prices; this theory was falsified. But the neo-classical model contained no comparable predictive hypotheses; there was no externally measurable standard which allowed the scientist to make predictions from observable data. This post-classical theory described an interaction process and allowed the identification of certain properties of equilibrium positions. But there was nothing upon which the economist could have based objective predictions about relative-price formation.

As I have suggested above, confusion emerged only when 1) theorists overlooked the absence of objective content in neoclassical and general-equilibrium analysis,
and 2) when they attempted to utilize the properties of market equilibrium as
norms for the optimizing solutions of problems posed in non-market institutional settings. The presence or absence of objective content assumed instrumental significance only when the planner was introduced, whether in the administration of state or public enterprises (piecemeal or
in toto) or in levy of corrective taxes and/or subsidies on production in markets. The control or correction of allocation requires that norms be invoked, and these norms must come from somewhere. The presumption of modern economic theory that such norms are readily identifiable must be attributed to the acceptance of the paradigm one-resource model sketched above.

Prices tend to equal marginal opportunity costs in market equilibrium. But costs here are fully analogous to marginal benefits. Only prices have objective, empirical content. Neither the marginal valuations of demanders nor the marginal costs of suppliers can be employed as a basis for determining or setting prices. The reason is that both are brought into equality with
prices by behavioural adjustments on both sides of the market. Prices are not brought into equality with some objectively measurable phenomena on either the demand or supply side.

Perhaps the most significant L.S.E. impact on modern economics has come through an indirect application of opportunity-cost theory rather than through an undermining of basic cost conceptions. ‘Marginal social cost’, enthroned by Pigou as a corner-stone of applied welfare economics, was successfully challenged by
R. H. Coase a quarter-century after his initial work on cost. His now-classic paper on social cost,
*4 which reflects essentially the same cost theory held earlier, succeeded where the more straightforward earlier attacks on the marginal-cost pricing norm—attacks by Coase himself, by Thirlby and by Wiseman—apparently failed. Nonetheless the still-provisional success of Coase’s modern challenge should be noted. As this is written, in mid-1972, the implications of Coase’s attack on the Pigovian concept of social cost for the elementary textbook discussions of opportunity cost have not yet been realized. Advanced textbooks, and notably those written in what may loosely be called the ‘Chicago-Virginia’ tradition, devote some space to the ‘Coase theorem’, but the standard chapters on cost in these same textbooks remain as if the more fundamental critique in the Coase paper had never been published.
*5

A primary purpose of this summary of doctrinal developments has been to emphasize the general importance of the theory of opportunity cost, and the London contributions to the development of a fundamentally correct theory which has not yet come to inform mainstream thinking in economics. The significance may, I fear, be hidden from those who glance only at the volume’s title,
L.S.E. Essays on Cost, and whose subjective image of ‘cost’ calls up carefully specified algebraic functions, sharply etched geometrical figures, or actual numbers carried to at least two decimal points in accountants’ worksheets. Such an image may unfortunately be reinforced by a superficial survey of titles of some of the independent essays included here. Coase, Edwards and Thirlby, in some of the papers reprinted here, were interested in practical problems faced by business decision-makers in business administration as such. They were attempting to use economic
theory in this severely practical setting, to apply opportunity-cost notions to the problems faced in everyday economic choices. In this effort the London economists did not themselves fully appreciate the uniqueness and originality of their approach. To an extent they looked on themselves as writing down, in the context of practical-problem situations, what ‘everyone knew’ about cost, at least everyone around L.S.E. during the period in question.

What is so ‘revolutionary’ in the theory of opportunity cost that threatens the very foundations of modern applied economics? This introductory essay is not designed to summarize the papers reprinted in the volume, and I do not propose to develop my own interpretation and application of the theory. I have done the latter in
Cost and Choice. But brief elaboration of the central argument may offer some support to my assertions about significance. The basic idea is at once extremely simple and profound.
Cost is inherently linked to
choice. This notion did not of course originate with the economists associated with the L.S.E. in the 1930s or before or since. As students of Frank Knight learnt,
elements of the correct theory of opportunity cost are found in Adam Smith’s deer-and-beaver model. Even before the subjective-value revolution, Francesco Ferrara in Italy was sharply critical of classical theory on opportunity-cost grounds.
*6 The opportunity-cost conception was explicitly developed by the Austrians, by the American, H. J. Davenport, and the principle could scarcely have occupied a more central place than it assumed in P. H. Wicksteed’s
Common Sense of Political Economy.*7 This book was independently influential at L.S.E., and it properly deserves mention here.

At the L.S.E. there was the beginning and the widening recognition of the implications of elementary opportunity-cost theory for applications of economics. Herein lies the contribution of the economists who are represented in this volume. Almost all professional economists, old and new, can provide a rough working definition of opportunity cost that is tolerably acceptable for pedagogic purposes. But very few economists, new or old, have been consistent. Almost none of them beyond the London-Austrian axis has recognized just what his own definition suggests for the application of his discipline.

Simply considered, cost is the obstacle or barrier to choice, that which must be got over before choice is made. Cost is the underside of the coin, so to speak, cost is the displaced alternative, the rejected opportunity. Cost is that which the decision-maker sacrifices or gives up when he selects one alternative rather than another. Cost consists therefore in his own evaluation of the enjoyment or utility that he anticipates having to forgo as a result of choice itself. There are specific implications to be drawn from this choice-bound definition of opportunity cost:

1. Cost must be borne exclusively by the person who makes decisions; it is not possible for this cost to be shifted to or imposed on others.

2. Cost is subjective; it exists only in the mind of the decision-maker or chooser.

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 that choice is made; the alternative which is rejected can never itself be enjoyed.

5. Cost cannot be measured by someone other than the chooser since there is no way that subjective mental experience can be directly observed.

6. Cost can be dated at the moment of final decision or choice.
*8

In any general theory of choice cost must be reckoned in a
utility rather than in a
commodity dimension. From this it follows that the opportunity cost involved in choice cannot be observed and objectified and, more importantly, it cannot be measured in such a way as to allow comparisons over wholly different choice settings. The cost faced by the utility-maximizing owner of a firm, the value that he anticipates having to forgo in choosing to produce an increment to current output, is not the cost faced by the utility-maximizing bureaucrat who manages a publicly owned firm, even if the physical aspects of the two firms are in all respects identical. As the London economists stressed, cost is that which might be avoided by not making choice. In our example the private owner could avoid the explicit incremental outlay
and the incremental profit opportunity should he fail to produce the output increment. The socialist manager, by our assumptions, could avoid the same objective consequences by taking the same course of action. These consequences could be measured in monetary terms. But the opportunity cost relevant to choice-making must be translated into a utility dimension through a subjective and personal evaluation. The private owner may evaluate the objectively measurable consequences of choice quite differently from the bureaucrat, although both are utility-maximizers.

I am not suggesting that the contributors to the London tradition in cost theory fully appreciated and understood all the implications of their own conception, nor that even now they
would endorse my interpretation of this conception. I suggest only that their several papers mark a beginning of such appreciation, that they reflect an early critical questioning of aspects of modern economic theory, a questioning that is more urgently needed in the 1970s than it was when they wrote.

While the contribution of the L.S.E. group of economists should be emphasized, the constructive content of their work should not be exaggerated. Taken as a whole, the London effort is largely negative in its impact. Properly interpreted, it demonstrates major flaws in the applications and extensions of economic theory. But there is little in this work which assists us in marrying ‘subjectivist’ and ‘objectivist’ economic theory. Few modern economists would be willing to go all the way with the latter-day Austrians and convert economics into a purely logical exercise. Most of us want to retain, and rightly so, positive and predictive content in the discipline, to hold fast to the genuine ‘science’ that seems possible. To accomplish this, however,
homo economicus must be returned to scientific respectability, and economists must learn to accept that hypotheses may be falsified. Finally, and more importantly, we must try to construct meaningful, if limited, norms for decision-making in non-market institutional structures. In competitive markets prices tend to equal marginal costs, but do we want to
make prices equal ‘marginal costs’ in non-market settings, when we fully realize that marginal costs can only be objectified by the arbitrary selection of some artificially homogenized measure? Do we really want to make one beaver exchange for only two deer when poisonous snakes abound near the beaver dams? Of course not! But how do we know that the snakes are there? Because the beaver hunters think they are?
*9