L.S.E. Essays on Cost

11

Economists’ cost rules and equilibrium theory

by G. F. THIRLBY

This is an article about rules, devised and advocated by certain economists, for the control of business and other undertakings: rules, such as the one which says that marginal cost ought to be equal to price, which prescribe what are claimed to be correct relationships between an undertaking’s cost and revenue. I have attacked the rules before in a paper
*77 which has received some notice.
*78 The following observations on four crucial and interconnected issues succeed a re-scrutiny of some of the fundamental theoretical literature
*79 which must have guided me in the preparation of that article and one which immediately preceded it.
*80 While I am still following the same line of attack, seeking to expose the non-objectivity and non-implementability of the rules, I am this time offering a little more than a hint that the rules ought to fall away with the ground on which they were built, that is to say, with the notion of perfect competition or competitive equilibrium. This notion requires, I believe, to be replaced by a different notion of equilibrium which was, I feel, implicitly recognized in the earlier of my two articles to which I have just referred.

I CONFLICTING NOTIONS OF RATIONALITY

In economics the human being is supposed to pursue ends, valued
and chosen by himself, with the use of means of some kind.
*81 This behaviour, including the choice, is spoken of as rational behaviour. But the content of the conception of rationality varies. Sometimes it is adjusted to admit the behaviour of the ordinary, sane, human being who is limited in his knowledge,
*82 and can make mistakes in the processes whereby he selects and pursues his ends. Sometimes it is something less fallible than this, in that it includes knowledge that the behaving subject does not possess, or objective data of which the behaving subject may be unaware.
*83 At the extreme it is something which is omniscient and infallible: something which has, or is, perfect foresight.
*84 It was, I believe, because of an attitude which tacitly assumed that the behaving subject was possessed of a rationality which transcended his actual state
*85 that
it became possible to put forward the rules as implementable controls. The appropriate assumption is the other one: that the human being is limited and fallible.

II CONFUSION ON THE MEANING OF ‘COST’

In the consideration of the behaviour of isolated man in the non-market environment (Robinson Crusoe), it is admitted that the two values compared (the ‘cost’ and the other one) are values of alternative end products that might be achieved by the use of the same resources. The full application of the same doctrine to the entrepreneur in the exchange economy would require the cost to be regarded as the entrepreneur’s own valuation of the outcome of a course of action that he rejects. And because, as a first approximation, money revenue is regarded as the entrepreneur’s single aim, this outcome would be an alternative money revenue.
*86 But the doctrine is not always fully applied in this way. The rejected course of action with its outcome of money revenue tends to be ignored, and to be replaced (as the ‘cost’ element to be compared with the ‘revenue’ element) by the entrepreneur’s resources themselves (these being assumed to consist of money) or,
what amounts to the same thing, by the ‘prices’ of the factors to be bought and used in the accepted course of action.
*87 At this point, ‘cost’, defined as money resource input, or outlay, relinquishes its connection with the end value of the use of the entrepreneur’s resources in an alternative course of action, and consequently with the entrepreneur’s act of choice.

But this is not all. The subtle change in the meaning of cost, from the valuation of his
own displaced end product to the money input required for the selected course of action, is a change leading to still another conception, which carries with it the suspicion that it is to be regarded as a social cost. It resembles the first meaning of cost, in that it is supposed to be an alternative value displaced, but differs from it in that it is not the entrepreneur’s
own valuation of his
own displaced end product, but other people’s (consumers’) valuations of products which might have been produced by other entrepreneurs had they not been displaced. This further conception aries in this way. The money-resource input (or ‘factor prices’) of the first entrepreneur is now supposed to ‘reflect’ these other people’s valuations. It reflects these valuations because any one of the factor prices is supposed to be the limit (it should strictly be regarded as being
above the limit) that the excluded bidder (another entrepreneur) would be willing to pay for the factor in order to produce a product himself, and accordingly to reflect its contribution to the value of that product to consumers.
*88

III NEGLECT OF TIME AND UNCERTAINTY IN EQUILIBRIUM ANALYSIS

The presentation of the conditions of equilibrium
*89 proceeds in such manner as to suggest that the act of choice and the complete implementation of it occurred simultaneously. There is no apparent gap in time either between the selection of a course of action with its advance reckoning of cost and revenue, or between the beginning of the actual expenditure of resources and the termination of the achievement of the valued outcomes of the course of action taken. The rational choice which plans the achievement of a ‘revenue’, by the disposition of resources, at a ‘cost’ in some sense, virtually disappears from view, or becomes merged in the actual disposition of resources and the actual achievement
of the actual ‘revenue’. The termination of the achievement of the valued outcomes (‘revenue’), which in reality may occur only at the end of a long means-ends chain of events (purchases, conversions into outputs, sales and the like) occurring over a long period of time, appears to be simultaneous with a single-resource input. This procedure of telescoping time out of existence tends to obscure two things, which, brought into light, are devastating to any supposition that the rule under criticism could be implemented.

First it obscures the fact that any cost in the sense of a displaced alternative value or revenue (the imagined outcome of a course of action which is
not taken) will never have an actual, realized, counterpart, observed as achieved results, to compare with the imagined outcome. This absence of an actual counterpart is a necessary condition of the situation, whether we are referring to the entrepreneur’s
own cost, or whether we are referring to the ‘social’ cost
*90 (both of which I have explained in section II above), and is a condition which would obviously prevent the rule from being implemented in a manner which required
results to be looked at to see whether the rule had been observed.

The second thing that is obscured and has to be brought to light is something which stands in the way of implementation of the rule, not at time of the checking of results, but at the earlier time of the generation of the rational choice in the mind of the maker of it, that is to say, at the time when the controller would, presumably, want to know whether the planned course of action was in accordance with the rule. This is the uncertainty, or limited rationality,
*91 of the entrepreneur or anybody who tries to supersede or control him. When it is understood that a reckoning of cost, according to any one of the three concepts
*92 referred to in
section II, depends upon the forecasting of events and outcomes of the future, and when it is understood that any individual is uniquely situated in relation to past events on which such forecasts are based, it becomes clear that the result of the reckoning is dependent for what it is upon the unique knowledge and attitude (towards uncertainty or risk) of the unique and uniquely situated individual who calculates it, and that the validity, correctness or authoritativeness of an overriding calculation by somebody else would often be dubious in the extreme. The cost (as well as the revenue) calculation, or residual elements in it, is ultimately a matter of subjective opinion, and, where one person is trying to control the other, is likely to be a matter of differences of opinion. To the extent that this conflict arises and remains, the substitution of one opinion (the controller’s) for another (the controlled’s) as the authoritative one can be regarded as effecting also a transfer of the responsibility for the calculation. The prevailing opinion itself then escapes control, and it, instead of the other one, has to be taken on trust.

I have related these obscurities to the timelessness that appears in the statement of the conditions of equilibrium. This notion of equilibrium was attacked, and a different notion substituted, by F. A. Hayek in 1937.
*93 His attack was directed largely against the assumption of perfect knowledge (or what I have referred to as the omniscent type of rationality),
*94 and against the use of the
propositions of the pure logic of choice (which were supposed to relate to the choice of equilibrium of the single individual) for the purpose of describing an equilibrium (or social choice) of many people working competitively.
*95 Thus his attack supports my attitude in this section, and casts doubt on the validity of the use, as the cost concept, of the value to consumers of displaced products that might have been produced by entrepreneurs other than the one having to make the cost calculation—the third concept in section II. His restatement substituted time
*96 for timelessness, and recognized a distinction between the individual’s plan (or what I have called rational choice) and the subsequent execution of it. The individual’s actions, taken in execution of his plan, were to be regarded as being in equilibrium relationships with one another so long as his actual actions agreed with his planned actions—which
*97 means, approximately, so long as the emerging events of the external world, including the actions of other individuals in execution of their own plans, permitted this agreement, or, in other words, so long as the relevant forecasts expressed or implied in his plan proved adequately correct. Similarly for society, or individuals, at large, equilibrium and its continuance depended upon an adequate compatibility of one another’s plans
*98 and adequately correct forecasting of emerging objective data.
*99

IV NEGLECT OF DISCONTINUITY OF KNOWLEDGE WITHIN ‘THE FIRM’

I referred in section II to the apparent conversion of the individual cost/revenue relationship into a social cost/revenue relationship and in section III to (what amounts to much the same thing) the conversion of the individual choice or equilibrium into a competitive social equilibrium. An objection to the latter conversion, and hence to the former, is that in this competitive social situation there is discontinuity of knowledge, as between the different individuals who, each on the basis of his own particular knowledge, make the forecasts on which in turn their own individual actions are based. Hayek, in raising this objection with regard to the competitive situation in particular, was pointing
*100 to the lack of theories relating generally to the communication of knowledge. Regrettably, although many of his general observations were relevant, his interest did not lie specifically in the similar discontinuity of knowledge inside large business organizations. Consequently he was not led to criticize the practice, in the theory of the firm, of drawing no distinction between the one-man firm and the multi-man firm—a practice which ignores the possibility that in the business organization there might be any number of planning individuals ranging from two to as many as would be found in the competitive situation.

The discontinuity of knowledge inside the organization is significant, in the context of economic and administrative theory, for at least two reasons. First it raises the question whether the
conversion of the idea of an individual cost/revenue relationship into the idea of an overall, or organizational, cost/revenue relationship is worthy of the same scepticism as is the conversion of the idea of an individual cost/revenue relationship into the idea of a social cost/revenue relationship. Secondly it relates to the question whether an internal rule relating to the cost/revenue relationship is non-implementable in the same way as is an externally imposed rule. On this second question, I do not propose to say much more than that what applies to a rule supposed to be imposed by an external controller upon the entrepreneur applies in much the same way to a rule supposed to be imposed by a superior (coordinating) administrator upon a subordinate administrator in the organization. I want to deal briefly with the first question, because I do not wish to leave the impression that if the social relationship goes, the organizational relationship goes with it. Before I do that, it will be well to look at what is left of the cost/revenue relationship after my treatment of it in sections I to III.

It will be seen that, after rejecting the other notions of cost, I am left with the view that cost is the entrepreneur’s own second-best outcome-value (second-best ‘revenue’) reckoned by him according to his own uncertain, highly subjective, calculations, and rejected by him in favour of his own, similarly calculated, best-outcome value (best ‘revenue’) from the use of the same resources. I am left, too, with the view that, with the multi-product and output-variation ideas introduced, this best outcome-value differs from the second-best outcome value only by a
net marginal variation. I say ‘
net‘ because the marginal variation in the planned course of action, upon which the change in value is dependent, can be conceived of as having a minus (‘marginal cost’) effect and a plus (‘marginal revenue’) effect upon the value—e.g. when the variation in the course of action consists in ideationally reducing the output of one product (and so its revenue) a little, and increasing the output of another product (and so its revenue) a little.
*101

This view can now be reduced to the simple statement that the entrepreneur’s total cost is approximately equal to his total revenue,
*102 and his marginal cost is approximately equal to his marginal revenue,
*103 but it is a view which allows
the planned revenue, related to the planned resource input (money or mixed) of the selected course of action, to be of any magnitude.*104 And, to reiterate, it is a view which sees the costs and revenues as subjective data—unrealized planning data belonging to the decisional process preceding action.
*105

Now it appears to me that a rule, based on this theoretical statement of the final situation in the entrepreneur’s decisional process, would be not only non-implementable, but also about as instructive and guiding as—and possibly much less intelligible than—an injunction of the order of ‘seize your best opportunities!’ The statement is not intended to be the basis of a rule to instruct or control the behaving subject: it is rather a theoretical, hypothetical, statement offered as a description of the behaviour of the behaving subject.

I shall now assume that this statement, understood as I have explained it, is as applicable to the organization as to the individual, and that the multi-person organization replaces the one-man entrepreneur as the behaving subject.
*106 And I turn to the question whether this conversion is as worthy of criticism as is the conversion of the individual cost/revenue relationship into
the competitive social cost/revenue relationship. On this issue, and in support of the idea of the organization cost/revenue relationship, I can do little more here than point to two significant differences between the competitive situation and the organization:

1. In the organization, the individuals are assumed to be common-goal-oriented.
*107 Hence the organization itself, although it has no mind, has to be viewed anthropomorphically,
*108 that is to say,
as if it were behaving rationally, like a man, and has consequently to be assumed, in determining its course of action, to develop an overall, or organizational, cost/revenue relationship. In the competitive situation, on the other hand, the individuals are not assumed to be common-goal-oriented in this way. Consequently the overall (social) cost/revenue relationship is not implied in this way.

2. In the organization the individual decision-makers—the sectional planning administrators—are assumed to declare their plans, for the purpose of interpersonal coordination, before their plans are executed. This behaviour is an essential condition for the acceptance of the view that there is an overall, or organizational, cost/revenue relationship: the relationship is a reflection of this declaration and coordination.
*109 In the competitive situation, on the other hand, this
ex ante declaration and coordination does not occur.

There is now little more that can be done in the space available than to stress that this assumption that the individual declares his plan for the purpose of coordination does not imply that the coordinator perceives and comprehends it with the same exhaustiveness as does the individual who submits it, or that the
individual perceives and comprehends the other plans, with which his own have to be coordinated, with the same exhaustiveness as do the other individuals who have to prepare them. In the organization there is discontinuity of knowledge between people of limited rationality, gaps that are filled by reciprocal-(mutual) authority relationships which replace some of the single-minded coordinations which occur when the individual operates alone in a narrower sphere. The individual’s plan, though it clearly must disclose the elements which are required to be known for the purpose of coordination,
*110 is, as communicated, an authoritative statement whose acceptance is of necessity one which is to a greater or less extent accepted on trust as a communication possessing the potentiality of reasoned elaboration.
*111 To say this is not to say either that the reasoned elaboration is never requested, or that the plan can never be ‘faked’-any more than that these same assertions would be made of authoritative communications in other spheres. But acceptance on trust has to enter. And within what is so accepted will often be much revealed and unrevealed cost-and-revenue calculation.