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L.S.E. Essays on Cost; Edited by: Buchanan, James M. and George F. Thirlby
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From Professor F. A. Hayek and from the Editorial Board of Economica for 'Economics and Knowledge', published in Economica, February 1937.

Buchanan, Introduction, L.S.E. cost theory in retrospect

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

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.


The implications of this basic, and in one sense, elementary fact for applying economic theory's tools to the making of control decisions for a wholly or partially socialized institutional structure have not been fully recognized, even by those who have partially escaped the dominance of the single-resource model. To an extent the blame for this lies in the failure of the London economists, and of the latter-day Austrians, to develop a full-blown 'subjectivist economics' that commands intellectual respect while seeming to retain explanatory relevance. Mises and his followers have been too prone to accept the splendid isolation of arrogant eccentrics to divorce their teaching too sharply from mainstream interests, and too eager to launch into polemic: epistemological, methodological, ideological. Certain members of the London group, although profoundly influenced by the Austrians via both Hayek and Robbins, had the merit of maintaining more practical interest in business decision problems. But unfortunately their interest was too pedestrian to allow them to attempt the 'grand design' that might have been produced from the cost-theory foundations which they developed.


As a result, we find Hayek (and Mises even more emphatically) talking largely to the disciples of the Austrian faith, and alongside we find Coase, Edwards, Thirlby and Wiseman taking up the cudgels against orthodoxy in detailed and particularistic applications. In their later papers both Thirlby and Wiseman seemed to recognize the grander implications but both men were perhaps discouraged by their failure to secure acceptance of their particularistic arguments, discouraged to the extent that neither made the attempt to draft the 'treatise' that seemed to be required, and which still seems to offer challenge.

Hayek, Economics and Knowledge


A presidential address to the London Economic Club, 10 November 1936. First published in Economica (February 1937).

Economics and knowledge

The ambiguity of the title of this paper is not accidental. Its main subject is of course the role which assumptions and propositions about the knowledge possessed by the different members of society play in economic analysis. But this is by no means unconnected with the other question which might be discussed under the same title, the question to what extent formal economic analysis conveys any knowledge about what happens in the real world. Indeed my main contention will be that the tautologies, of which formal equilibrium analysis in economics essentially consists, can be turned into propositions which tell us anything about causation in the real world only in so far as we are able to fill those formal propositions with definite statements about how knowledge is acquired and communicated. In short I shall contend that the empirical element in economic theory—the only part which is concerned, not merely with implications but with causes and effects, and which leads therefore to conclusions which, at any rate in principle, are capable of verification *31—consists of propositions about the acquisition of knowledge.

Thirlby, Subjective theory of value and accounting cost
Cf. 'Resources and needs exist for practical purposes only through somebody knowing about them and there will always be infinitely more known to all the people together than can be known to the most competent authority'. Hayek, 'Scientism and the Study of Society', Economica N. S., 11, No. 41 (February 1944), p. 37.
On the limitations of committee management, see Hayek 'Scientism and the Study of Society', p. 31, footnote 2.
Thirlby, The Ruler
For circumstances under which it will not have such a cost, see Hayek, The Pure Theory of Capital, (London 1941), and G. F. Thirlby, 'Permanent Resources', Economica, N. S., 10, No. 39 (August 1943).
Thirlby, The economists description of business behaviour
Cf. Hayek: 'Economics and Knowledge', reprinted here, pages 43-68.
Wiseman, Uncertainty, costs, and collectivist economic planning
Much of the early discussion has been brought together in two sets of reprints of relevant articles: Collectivist Economic Planning, ed. F. A. Hayek (which includes L. von Mises's pioneer article, 'Economic Calculus in the Socialist Commonwealth') and On the Economic Theory of Socialism, ed. Benjamin E. Lipincott (which includes reprints of articles by O. Lange and F. M. Taylor suggesting and elaborating the use of marginal criteria). A number of other papers on the subject were published in the Economic Journal and Review of Economic Studies during the 1930s, and a marginal 'rule' was elaborated by ( inter alia) A. P. Lerner in Economics of Control (1944).
Thirlby, Economists cost rules and equilibrium theory

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


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.

Particularly Lionel Robbins, The Nature and Significance of Economic Science, 2nd ed (1935); Lionel Robbins, 'Remarks upon Certain Aspects of the Theory of Costs' reprinted here, pages 19-41; F. A. Hayek, 'Economics and Knowledge' reprinted here, pages 43-68 F. A. Hayek, 'Scientism and the Study of Society', Economica (August 1942, February 1943 and February 1944).
And possibly, confused the rationality of the behaving subject with the rationality of an observing economist, who was assumed to be omniscient. See Hayek's discussion of the confusion about the data, or facts, of the demand schedules, where he raises 'the question whether the facts referred to are supposed to be given to the observing economist, or to the persons whose actions he wants to explain, and if the latter, whether it is assumed that the same facts are known to all the different persons in the system, or whether the "data" for the different persons may be different' (F. A. Hayek, 'Economics and Knowledge', p. 52).
My account of the transition from 1) the isolated producer's end-product value, regarded as cost, to 2) the entrepreneur's money input or factor prices, regarded as cost, and regarded also as something which reflects the value of excluded products, is offered as a fair statement of what occurs in Robbins's 'Remarks upon Certain Aspects of the Theory of Costs', section 1, pp. 22-7. I cannot accuse him of actually calling the value of the excluded products a social cost, but the suggestion seems to be there, particularly, perhaps, in his insistence that the excluded products themselves, as distinct from their values, are not to be regarded as cost. For doubt cast upon the validity of the method of transition from the individual situation to the social situation, see Hayek's discussion in which he stated he had 'long felt that the concept of equilibrium itself and the methods which we employ in pure analysis have a clear meaning only when confined to the analysis of the action of a single person, and that we are really passing into a different sphere and silently introducing a new element of altogether different character when we apply it to the explanation of the interaction of a number of different individuals', and in which he stated that 'the data which formed the starting point for the tautological transformations of the Pure Logic of Choice...meant...only the facts...which were present in the mind of the acting person...But in the transition from the analysis of the action of an individual to the analysis of the situation in a society the concept [of "datum"] has undergone an insidious change of meaning' (Hayek, 'Economics and Knowledge', pages 47 and 51 respectively.)
It should be clear that this obstacle to implementation would remain if the meaning of cost were money (or other) resource input. However short the period of time between the cost calculation and the occurrence of the events which were the subject of it, the cost calculation would be uncertain and a matter of subjective opinion. While, in pure equilibrium analysis, 'it is simply assumed that the subjective data coincide with the objective facts' (Hayek, 'Economics and Knowledge' page 56.
It is significant that in his criticism of the pure equilibrium analysis, Hayek remarks: 'It seems that that skeleton in our cupboard, the "economic man", whom we have exorcised with prayer and fasting, has returned through the back door in the form of a quasi-omniscient individual' (Hayek, 'Economics and Knowledge', page, 58). In his restatement he said: 'It is important to remember that the so-called "data" from which we set out in this sort of analysis are (apart from his tastes) all facts given to the person in question, the things as they are known to (or believed by) him to exist, and not in any sense objective facts' (page 48). The 'data', distinguished from 'the objective real facts' as supposed to be known by the omniscient economist (page 52), are to be conceived of 'in the subjective sense, as things known to the persons whose behaviours we try to explain' (page 52). 'Subjective data' and 'individual plans' can be used interchangeably (note 11. page 56.)
Hayek, condemning 'an illegitimate use of anthropomorphic concepts', adds in a footnote, 'What is said in the text does of course not preclude the possibility that our study of the way in which individual minds interact may reveal to us a structure which operates in some respects similarly to the individual mind' (Hayek, 'Scientism and the Study of Society' part II, p. 45 and footnote).