Cost and Choice: An Inquiry in Economic Theory

James M. Buchanan.
Buchanan, James M.
(1919- )
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Indianapolis, IN: Liberty Fund, Inc.
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Foreword by Hartmut Kliemt.

1. James M. Buchanan and G. F. Thirlby, LSE Essays on Cost (London: Weidenfeld and Nicholson, 1973), 6; Cost and Choice: An Inquiry in Economic Theory (Chicago: Markham Publishing Co., 1969), volume 6 in the series.

2. In particular, as reprinted in Debt and Taxes, Externalities and Public Expenditure Theory, and Public Principles of Public Debt, respectively, volumes 14, 15, and 2 of the Collected Works.

3. See also some of the essays in Economic Analysis, volume 12 of the Collected Works.

Chapter 1

4. Adam Smith, The Wealth of Nations (New York: Random House, Modern Library Edition, 1937), p. 47.

5. Even in 1967 economists need to be warned of the fallacy. On this, see Royall Brandis, "The Myth of Absolute Advantage," American Economic Review, LVII (March 1967), 169-74.

6. Frank H. Knight, "A Suggestion for Simplifying the Statement of the General Theory of Price," Journal of Political Economy, XXXVI (June 1928), 359.

7. Ibid., 355.

8. Ibid., 363.

9. F. von Wieser, "The Theory of Value," Annals of The American Academy of Political and Social Science, II (March 1892), 618. See also F. von Wieser, Über den Ursprung und die Hauptgesetze des wirtschaftlichen Werthes (Wien, 1884), p. 100.

10. Frank H. Knight, "The Common Sense of Political Economy (Wicksteed Reprinted)," Journal of Political Economy, XLII (October 1934), 660-73, reprinted in Frank H. Knight, On the History and Method of Economics (Chicago: University of Chicago Press, Phoenix Books, 1963), pp. 104-18. This is a review article of the two-volume edition of Wicksteed. Frank H. Knight, "Notes on Utility and Cost" (Mimeographed, University of Chicago, 1935). Published as two articles in German in Zeitschrift für Nationalökonomie (Vienna), Band VI, Heft 1, 3 (1935).

11. Knight, "Notes on Utility and Cost," op. cit., p. 18.

12. Ibid., p. 19.

13. Knight, "The Common Sense of Political Economy (Wicksteed Reprinted)," op. cit., p. 116.

Chapter 2

14. Philip H. Wicksteed, The Common Sense of Political Economy (London: Macmillan, 1910), p. 380.

15. Ibid.

16. Ibid.

17. "These reflections will explain the great ambiguity of the term 'cost price.' ... [M]embers of the same trade ... will use the word in different senses. One will declare that he is 'making no profits at all,' but is 'selling at a loss,' and another will say that 'things are bad enough with him, but not quite so bad as that,' when they both mean to indicate exactly the same state of affairs. Men will declare in good faith that they are 'selling below cost price,' and yet will never think of suspending operations." Ibid., pp. 380-81.

18. Ibid., p. 385.

19. Herbert J. Davenport, Value and Distribution (Chicago: University of Chicago Press, 1908), p. 273.

20. See esp. ibid., p. 404.

21. For a summary of the history of cost theory in which Davenport's ideas are prominently featured, see Bob M. Keeney, "The Evolution of Cost Doctrine" (Mimeographed, Midwestern Economics Association, November 1967).

22. Frank H. Knight, "Fallacies in the Interpretation of Social Cost," Quarterly Journal of Economics, XXXVIII (August 1924), 592f., reprinted in F. H. Knight, The Ethics of Competition (London: Allen and Unwin, 1935), p. 225.

23. L. Robbins, "Certain Aspects of the Theory of Cost," Economic Journal, XLIV (March 1934), 1-18. Robbins' interest in the issues here was indicated in his earlier paper, "On a Certain Ambiguity in the Conception of Stationary Equilibrium," Economic Journal, XL (June 1930), esp. 209-11.

24. Ludwig von Mises, Human Action (New Haven: Yale University Press, 1949).

25. "Die Wirtschaftsrechnung im sozialistischen Gemeinwesen," Archiv für Sozialwissenschaften, XLVII (1920), reprinted as "Economic Calculation in the Socialist Commonwealth," in F. A. Hayek (ed.), Collectivist Economic Planning (London: Routledge, 1935).

26. Ludwig von Mises, Die Gemeinwirtschaft (Jena, Germany: Gustav Fischer, 1922). The second German edition appeared in 1932. Mises added an epilogue to this edition at the time of its translation as Socialism (New Haven: Yale University Press, 1951).

27. Lionel Robbins, The Great Depression (New York: Macmillan, 1934), esp. pp. 143-54.

28. F. A. Hayek (ed.), Collectivist Economic Planning, op. cit.

29. Ibid., p. 226.

30. A. P. Lerner, "Statistics and Dynamics in Socialist Economics," Economic Journal, XLVII (June 1937), 253-70.

31. F. A. Hayek, "Economics and Knowledge," Economica, IV (1937), 33-54, reprinted in Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1948), pp. 33-56.

32. Additional essays that appeared in 1940, 1941, 1942, and 1943 are included in the two volumes, Individualism and Economic Order, op. cit., and The Counter-Revolution of Science (Glencoe, Ill.: The Free Press, 1952).

33. Ludwig von Mises, Grundprobleme der Nationalökonomie (Jena, Germany: Gustav Fischer, 1933), translated by George Reisman as Epistemological Problems of Economics (New York: Van Nostrand, 1960).

34. See esp. his review of Henderson's Supply and Demand, reprinted in Edwin Cannan, An Economist's Protest (London: P. S. King, 1927), pp. 311-14.

35. R. H. Coase, "Business Organization and the Accountant," The Accountant (October-December 1938). These articles are reprinted in David Solomons (ed.), Studies in Costing (London: Sweet and Maxwell, 1952), pp. 105-58.

Along with Coase, other members of Plant's group of young business economists were R. S. Edwards, R. F. Fowler, and David Solomons. This group was interested in making economic theory of greater practical relevance for business operations and especially for accounting practice.

36. In his later, and more widely known, paper on marginal-cost pricing, Coase's argument for the multi-part tariff was informed throughout by the conception of opportunity cost developed in his earlier papers. His emphasis, as it has been interpreted by later writers, was, however, on the familiar conflict between marginal-cost and profitability criteria. His opportunity-cost defense of multi-part pricing has been largely overlooked. See R. H. Coase, "The Marginal Cost Controversy," Economica, XIII (August 1946), 169-82. In a comment on Coase's paper, G. F. Thirlby criticized the implied objectivity of cost. See G. F. Thirlby, "The Marginal Cost Controversy: A Note on Mr. Coase's Model," Economica, XIV (February 1947), 48-53.

37. G. F. Thirlby, "The Subjective Theory of Value and Accounting Cost," Economica, XIII (February 1946), 32-49.

38. Ibid., 33-34.

39. G. F. Thirlby, "The Ruler," South African Journal of Economics, XIV (December 1946), 253-76.

40. G. F. Thirlby, "The Economist's Description of Business Behavior," Economica, XIX (May 1952), 150.

41. G. F. Thirlby, "Economists' Cost Rules and Equilibrium Theory," Economica, XXVII (May 1960), 150.

42. Mises, op. cit.

43. See Murray Rothbard, Man, Economy, and the State (New York: Van Nostrand, 1962), esp. Vol. I, pp. 290-308.

44. See I. M. Kirzner, Market Theory and the Price System (New York: Van Nostrand, 1963), esp. Chapter 9.

45. Jack Wiseman, "Uncertainty, Costs and Collectivist Economic Planning," Economica, XX (May 1953), 118-28; and his "The Theory of Public Utility Price—An Empty Box," Oxford Economic Papers, IX (February 1957), 56-74.

46. The manuscript for this book was completed before I had access to the article on "Cost" by A. A. Alchian in International Encyclopedia of the Social Sciences, III (New York: Macmillan, 1969), pp. 404-15.

47. G. L. S. Shackle, Decision, Order and Time in Human Affairs (Cambridge: Cambridge University Press, 1961), pp. ix, x.

Chapter 3

48. F. H. Knight, "A Suggestion for Simplifying the Statement of the General Theory of Price," Journal of Political Economy, XXXVI (June 1928), 355.

49. See my "Public Debt, Cost Theory, and the Fiscal Illusion," in Public Debt and Future Generations, James M. Ferguson (ed.) (Chapel Hill: University of North Carolina Press, 1964), pp. 150-62.

Chapter 4

50. For a critical discussion of the measurement of national product which is grounded on analysis that is related to, although quite different from, the analysis developed here, see S. H. Frankel, The Economic Impact on Under-Developed Societies (Cambridge: Harvard University Press, 1953), esp. Chapter III.

51. I am not concerned here with various modern qualifications on this proposition, all of which derive from some version of second-best limitations. My criticism holds even if all of the welfare conditions are fully satisfied elsewhere in the system.

52. In an earlier work, I have tried to relate the effects of different fiscal instruments on the individual's behavior in fiscal process. See my Public Finance in Democratic Process (Chapel Hill: University of North Carolina Press, 1967). See also Charles Goetz, "Tax Preferences in a Collective Decision-Making Context" (Unpublished Ph.D. dissertation, Alderman Library, University of Virginia, 1964).

53. It is interesting to note that sophisticated cost-benefit analysts recognize the relevance of the distribution of tax shares (or benefit shares), while at the same time they fail to recognize the relevance of the distribution of decision-making power. The oversight of this second distributional effect stems, of course, from the paradigm in which "costs" exist as objectively quantifiable magnitudes, unrelated to the choice process. Among the applied welfare economists who have examined the methodology of cost-benefit analysis, only Roland N. McKean seems to be aware that a problem so much as exists here. See his paper, "The Use of Shadow Prices," in Samuel B. Chase, Jr. (ed.), Problems in Public Expenditure Analysis (Washington, D.C.: Brookings Institution, 1968), pp. 33-65. For a specific discussion of the importance of the distribution of tax or benefit shares, see the paper by Burton A. Weisbrod, "Income Redistribution Effects and Benefit-Cost Analysis," pp. 177-208 in the same volume.

54. In my early book, my ideas on cost were confused. See my Public Principles of Public Debt (Homewood, Ill.: Richard D. Irwin, 1958). Somewhat later, in response to critics, I traced the differences in debt theory to cost-theory confusions. My contribution, along with other papers, is contained in James M. Ferguson (ed.), Public Debt and Future Generations (Chapel Hill: University of North Carolina Press, 1964).

55. See their contributions in Ferguson, op. cit. A similar error is made by Feldstein and endorsed by Prest and Turvey in their review of cost-benefit analysis. In Feldstein's view, the cost of a project depends, in part, on whether or not the funds are withdrawn from current consumption or from investment. However, to the extent that cost-benefit measurements are helpful at all, the persons from whom funds are secured, presumably in this case through taxes, must be assumed to be in equilibrium between consumption and investment outlays. In this case, the utilities per dollar's worth have been equalized at the margin. As suggested earlier, unless such full equilibrium is assumed, the whole approach, which is limited at best, becomes worthless. See M. S. Feldstein, "Opportunity Cost Calculations in Cost-Benefit Analysis," Public Finance, XIX (1964), 126, as cited in A. R. Prest and R. Turvey, "Cost-Benefit Analysis: A Survey," Economic Journal, LXXV (December 1965), 686-87.

Interestingly enough, Davenport seems to have indirectly warned against this error a half-century ago. He stressed that the cost to a borrower (that which he must give up in order to secure funds) has no direct relationship to the cost to the lender (that which he must give up when he makes a consumption-saving decision). Two distinct choices are involved and hence two costs. See H. J. Davenport, Value and Distribution (Chicago: University of Chicago Press, 1908), p. 260.

Chapter 5

56. The companion criterion, equality between marginal private product and marginal social product, reduces to the cost criterion when the latter is stated in opportunity-cost terms. The failure to take action that exerts external benefits can be treated as analytically equivalent to the taking of action that exerts external costs. In his own formulation, Pigou used the product terminology almost exclusively, although he referred to both types of divergence. See A. C. Pigou, The Economics of Welfare (4th ed.; London: Macmillan, 1932), esp. pp. 131-35.

57. Notably, R. H. Coase, "The Problem of Social Costs," Journal of Law and Economics, III (October 1960), 1-44; Otto A. Davis and Andrew Whinston, "Externality, Welfare, and the Theory of Games," Journal of Political Economy, LXX (June 1962), 241-62.

58. It seems likely that this helps to explain the source of the confusion. Marshall and Pigou developed the externality notion within the context of interfirm models, implicitly assuming competitive structures. As we shall see, the relevance of objectively measurable costs is limited even in this model, but the errors are of a different order of magnitude from those that arise when the externalities refer to an interpersonal interaction or to an interfirm interaction where utility functions are employed. The possibility of objectively measuring external costs does not, of course, ensure that the policy of levying a corrective tax is desirable. Under competition, this policy can be plausibly defended within certain limits. In noncompetitive structures, by contrast, the attempt to levy corrective taxes on an externality-generating firm may do more harm than good. On this elementary point, see my "External Diseconomies, Corrective Taxes, and Market Structure," American Economic Review, LIX (March 1969), 174-77.

59. F. Knight, "Notes on Utility and Cost" (Mimeographed, University of Chicago, 1935). Published as two German articles in Zeitschrift für Nationalökonomie (Vienna), Band VI, Heft 1, 3 (1935).

60. It is perhaps worth noting here the interesting difference in emphasis between political scientists and economists, both of whom discuss essentially the same behavioral interactions. In politics, primary emphasis has traditionally been placed on political obligation, on the duty of the individual to act in the "public interest." This represents an attempt to improve results through modifying the individual's utility function in the direction of causing him to place a higher valuation on the utilities of others. Relatively little attention has been given until quite recently to the prospects of making institutional changes that will channel private choice in the direction of producing more desirable social results.

In economics, by contrast, institutional or policy changes have been the center of attention, and relatively little discussion has been devoted to norms for individual behavior. As our analysis shows, economists have implicitly assumed that individuals act in accordance with quite narrowly defined self-interest, and they have developed policy norms which may prove inapplicable if this underlying behavioral postulate is not descriptive of reality.

For an earlier discussion of this difference between the two disciplines, see my "Marginal Notes on Reading Political Philosophy" included as Appendix I in James M. Buchanan and Gordon Tullock, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962; Paperback Edition, 1965).

Chapter 6

61. This definition of the opportunity costs of conscription is advanced by George Stigler in his highly respected textbook in microeconomic theory. Stigler says, "The cost of a soldier for an economy, however, is his foregone product as a civilian, and this is not directly affected by his rate of pay." See George Stigler, The Theory of Price (3rd ed.; New York: Macmillan, 1966), p. 106.

62. Gary Becker, "Crime and Punishment: An Economic Approach," Journal of Political Economy, 76 (March-April 1968), 169-217.

63. See Gordon Tullock, The Politics of Bureaucracy (Washington, D.C.: Public Affairs Press, 1965).

64. These estimates are necessarily ex ante: only one outcome can be actually observed after choice.

65. E. D. Domar and R. A. Musgrave, "Proportional Income Taxation and Risk-Taking," Quarterly Journal of Economics, LVIII (May 1944), 388-422, reprinted in American Economic Association, Readings in the Economics of Taxation (Homewood, Ill.: Richard D. Irwin, 1959), pp. 493-524.

66. Devletoglou has argued persuasively that all human behavior must be analyzed in terms of a threshold-sensitive model. See Nicos Devletoglou and P. A. Demetriou, "Choice and Threshold: A Further Experiment in Spatial Duopoly," Economica, XXXIV (November 1967), 351-71.

End of Notes

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