L.S.E. Essays on Cost
First published in Economica (May 1952).
The subject of this paper is the idea that the businessman fixes his output at that level at which the surplus of his total revenue over his total cost is maximized, and accordingly at which his marginal cost and marginal revenue have been brought nearly*1 to equality. It is (sometimes) admitted or asserted that this description is only a first approximation to a description of actual behaviour. I shall accordingly, and for brevity's sake, refer to it as 'the first approximation'. I propose to discuss its limitations, and what we have to do with it before we have something which really comes anywhere near to being a description of a businessman's and a business organization's behaviour.
At each step I shall first examine the shortcomings of the first approximation as a description of the behaviour of the businessman who has no human associates in the business, and then proceed to discuss their significance for the situation in which the business consists of more than one man, that is to say, where the business consists of an organization of human beings. Economists—I am speaking rather of economists operating in the realm of pure theory, and using this marginal cost-marginal revenue 'technique'—do sometimes speak of a 'firm', but rarely does the 'firm' become anything really different from the man combining factors. It is true that one of these factors is 'labour', but labour is thought of as if it were a substance of which the owner sells a quantity to the 'man' ('entrepreneur') or 'firm'. After this moment of sale the previous owner of the labour (the labourer) appears to be decisionless with respect to the use of the labour that he has sold: there is still only one man concerned with the 'firm's' planning operations which dispose of that labour.
Yet it is not always true that there is only one man taking part in the 'firm's' planning. Sometimes another person, just as much as the first, is a planner, making responsible decisions, based on uncertain estimates of future events, and taking his part in the determination of the organization's plan and executory operations. The neglect of this case in economic theory is due, I imagine, to some inhibition in economists against recognizing the existence of an organization of men. In oral discussion with colleagues I have noticed the tendency to dismiss the relationships between the contributory decision-maker and the other members of the organization as matters of internal politics. Whether the organizational relationships which develops a 'maximized' cost-revenue situation are politics, while the market relationships which develop a price are economics, does not seem to me to matter. What does matter, and is distressing, is that the organizational relationships should fall between two stools (economics and politics), and make it necessary to establish a new subject called administrative theory.
The first approximation is probably so-called partly because the costs and revenues are supposed to be money, while it is admitted that a businessman is not necessarily striving always and exclusively for a maximum surplus of money revenue over money cost. In other words the implicit statement of the man's value judgement, or policy-making judgement, is not quite correct. This value judgement and other subjective judgements we shall have to discuss. They become particularly significant when we come to study the organization. But it would be better to return to them after we have referred to the timeless equilibrium setting of the marginal cost-marginal revenue 'equation'.
II THE TIMELESS EQUILIBRIUM SETTING OF THE EQUATION. THE SUPPRESSION OF THE PLANNING OPERATION AND THE EVASION OF DOCTRINE. THE SUPPRESSION OF 'THE ORGANIZATION' AND THE CONCEPTS WHICH ITS TREATMENT REQUIRES. AUTHORITY AND AUTHORITARIANISM
To make the equation conform to anything like business reality, this timeless equilibrium setting has to be seriously altered. The businessman does not make a decision about a situation with which he is already 'in equilibrium': while out of equilibrium with the situation, he makes a decision to bring himself into equilibrium with it.*2 Neither are his results achieved simutaneously with the making of his decision nor in a state of timelessness: a period of time elapses between the making of the decision and the achievement of the results. To put this matter right it is necessary to substitute for the timeless situation a situation in which there is a planner who plans for a period ahead, proceeds to carry out that plan, and is in equilibrium while, and to the extent that, he continues to do so, that is to say, so long as, in the course of the period, nothing happens to render him unable to continue to carry out his plan, or to cause him to change his plan.*3 As I see it, this continuing, or period, equilibrium corresponds exactly with what we understand in business administration by production under standing orders. In execution of the standing orders, various conversions of money into factors, factors into products, and products into money may occur in equilibrium, that is, with no new decision following the decision which laid down the standing orders, or with no change of plan.
But my main object in insisting on the introduction of the time dimension is to stress the planning operations preceding the period of execution. A mental deliberation or planning operation, followed by a decision, precedes the business operations which are so planned. I think this should be more definitely stressed even where we are speaking of one-man businesses. To do so would keep in front of our minds the high degree of subjectivity in the maximization process, performed as it must be in advance of the market operations, and based as it must be on advance calculations, or forecasts, of the market conditions (factor and product prices) that will obtain when those market operations occur. It would prevent our attributing, as we are so prone to do, a false objectivity to the cost and revenue figures to which the businessman is supposed to respond. 'Uncertainty', so often completely forgotten, or regarded as a 'trimming', by economists, is something that it would be disastrous not to introduce into administrative theory at the outset. If money revenue is the businessman's sole aim, cost, as well as revenue, is always somebody's uncertain, fallible estimate or projection of future prices*4 and is a 'function' of that particular person's mind. If the first approximation allows us to forget this, it becomes a 'vicious abstraction'.*5
To fail to bring the planning stage to the surface perhaps does not matter so much—though I rather think it does—while we are still confining our attention to the one-man business. To continue to suppress it when we are supposed to be talking of an organization—whether this be an English joint-stock company, or whether it be Russia—is to neglect more than half of the problem. It is to do more than this. It is to fail to provide a discipline for a vast literature which concerns itself with business 'organization', 'efficiency', 'planning', 'costing' and so on, but which has often proceeded without benefit of the notion of maximization, or without adequate recognition of it. Moreover it allows, by default, the emergence of the view that the large organization operates under a single planning mind, and, by not looking into the nature of the organization's authority relationships, allows to persist, if it does not propagate, authoritarian views of a very naïve order. The persistent 'he will adjust his output...', he will do this and he will do that, coming from teachers and students alike, is extremely irritating and provoking to anybody who has made a disciplined inquiry into these matters.
The situation that we have to face, and introduce into our discussion, as a first step in the direction of describing organization behaviour, is one which fulfils the following conditions. The work of planning leading to the plan which is calculated to maximize the surplus of revenue over cost is shared by a number of people. Their tentative plans have to be coordinated with one another. A's (definite) plan will depend on what B's tentative planning is: B's (definite) plan will depend on what A's tentative planning is. For example, a sales schedule (A's) has to be coordinated with a purchases schedule (B's). This has to happen before the organization's maximized plan, and each member's sectional plan, becomes definite and settled by a composite decision or coordinated decision ex ante.*6 Each of these people has necessarily to make uncertain forecasts of what is going to happen, and be responsible for those forecasts. It is impossible that A should know all that B knows about the situation that B has to deal with (say the buying market), and it is impossible that B should know all that A knows about the situation that A has to deal with (say the selling market). Thus willy nilly, A has to trust B and his uncertain judgements, and B has to trust A and his uncertain judgements. That is to say, it is recognized that the total situation is beyond the capacity of either A or B to deal with. And of course it is implied that A and B feel that they are better off if they work together as an organization than they would be if they worked separately.
This is the situation that, as I see it, has to be brought into any satisfactory description of the business organization. It incidentally raises the authority issues. The crucial issues, or some of them, can be forced to the front by assuming that A and B are equal partners and the only members of the organization. If authority is a property of organization, there must be authority here, for this is an organization. The organization's maximized plan becomes the organization's standing orders. The composite decision which settles the plan operates as an order to carry out the plan: in this case an order by A and B as a committee issued to A and to B as subordinates to it. But, although the order issues from above (the committee), the authority, or authoritativeness, of the plan, and hence of the order, moves up from below, that is to say, from A and B as subordinate planners in 'the organization'. For it is implicit in the assumptions that in the planning and coordination process A cannot expect to override B's judgement within B's sphere, and B cannot expect to override A's judgement within A's sphere. Arbitrary attempts so to override one another on committee would interfere with the development of an order (the committee decision) which would be accepted by A and B without psychological resistance—the harmony condition of authority.
I have little doubt that at this point many people would wish to substitute for the committee a third person, X, whose job it is to 'manage' A and B. If we make this substitution, either we assume that X usurps the functions which we have given to A and B or we do not assume this. If we do, then the 'larger' the organization ('larger' referring to the degree to which the planning and uncertain judgements surpass the capacity of one man) the nearer we come to assuming the omniprescient head—unsustainable authoritarianism. If we do not assume that X usurps A and B, then we are driven to admit that X must get his purchases and sales figures from the minds of A and B—and trust those people. Authority still moves up from below.
Of course X might have a 'staff-man' to collect the figures for him. Then either the 'staff-man' usurps the functions of A and/or B, or he does not. If he does—this sometimes happens—the position is the same as before: the staff-man becomes A and/or B. If the 'staff-man' does not usurp A or B, then he must get the figures from their minds. Authority still moves up from below.
I shall not here attempt to explain how X and his 'staff-man' may make a show of 'managing' by short-circuiting the minds of A and B, and using records (some of them pseudo or 'conventional') instead. But I have no doubt that this procedure goes a long way to explain why some people receive the impression that firms adjust their market operations in a way which appears to defeat or ignore the marginal principle.
My illustration is highly abstract and inadequate, and leaves me open to attack at many points. But it does suggest some of the issues that the first approximation slurs over when it abstracts altogether from the planning operations of the organization.
In the last section I referred to the businessman's decision to conduct a series of planned operations over the future. This planned course of action might be a course of action to produce, not necessarily only one product, but possibly a number of different products, and to produce them in different proportions on a number of different dates. And possibly it would include lending and borrowing operations as well. This particular plan is simply the one chosen from possibly many contemplated alternative particular arrangements or distributions of the same resources. It is necessary to define this entity 'the same resources'.
How are we to define the resources as they exist for the man's planning purposes, independently of, or prior to, the cost and revenue calculations which determined the chosen distribution? They must, I think, be deemed to include the following elements:
1 Such money and goods as the man has at the outset.
2 His 'knowledge' or 'prescience' (including uncertain judgements and mistaken beliefs) concerning the loans that he might be able to negotiate, and the factors and products into which he might be able to convert his original assets and these loans. The 'knowledge' will include his views about the (future) prices of the loans, factors and products. If the man knows John Smith, a dealer in linen thread, and feels fairly certain that John Smith would sell him a certain quantity of linen thread next week at a price which he feels fairly certain about too, he has this 'knowledge' as part of his resources. How much of such knowledge he possesses will depend very much upon his unique business experience and the scope of his unique relationships with other people in 'the market', and the qualities and limitations of himself as a unique person. Any such assumption as that all factors and products of every conceivable kind are 'priced', and that all these (future !) prices are known, or 'given', to anybody who chooses to read them off, must be rejected out of hand. We are dealing, not with a master-mind (or alternatively with an automatic response to a 'price system'), but with a fallible and unique individual who is trying to discern the future, and whose range of observation of even the past and present is limited.
3 The loans and factors themselves. That is to say, any loans and factors that the man thinks or believes would be in existence and available to him to acquire or buy if he wanted them for any production that he might plan. In the event some of them might prove not to be in existence or available. None the less his belief that they would be is a planning datum, and must be included for this purpose in 'the same resources'.
These loans and factors will, or may be, available only as a set of alternatives from which to choose. That is to say, if he plans to acquire some, he may not be able to plan to acquire others. This for the obvious reason that his original assets and (so far as the acquisition of factors is concerned) the loans that he contemplates might be inadequate to secure them all. It would not be surprising therefore if plan A contemplated the use of linen thread but no brass tacks, while an alternative plan B contemplated the use of brass tacks but no linen thread. The idea that the two plans are alternative distributions of the same resources is not destroyed by this possibility. Both the linen thread and the brass tacks (and the man's knowledge about them) are part of 'the same resources' that, in the man's opinion, are available for his planning activity.
Nor is the idea destroyed by the possibility that some of these resources (loans, at least) may be available for some purposes (e.g. work in which the man has special skill) but not for others. They are part of 'the same resources' that in the man's opinion are available for his planning activity.
Thus 'the same resources' are largely ideational in character, and would be irritatingly non-measurable to an external observer who felt that he ought to be able to measure them. They are very much in the way of being a 'function' of the man's mind. Their limits are much to do with the limits of the man's mind.
I have said, then, that the man adopts one particular distribution of 'the same resources' as his plan or accepted course of action, and that this plan will contemplate the use, for the purpose of earning revenue, of some or all of 'the same resources'. The 'revenue' that we think of in the first approximation is, or should be regarded as, the revenue that the man expects to accrue to him from the carrying out of this plan. This is the ideational, imaginary, planned or expected revenue whose surplus over cost he deems in the planning stage to be maximized. What then is the 'cost'?
It is often very difficult to understand what economists mean by cost when they are discussing the marginal cost-marginal revenue equation. But it is probable that at least sometimes what is meant is the sum of the prices of the 'factors' to be used in the chosen course of action. These prices may be buying or selling prices, according to whether the factors are to be bought or are already owned. It is extremely difficult to know sometimes whether all the resources that are to be used, including the man's own capacity, and money, are supposed to be included in the factors so priced. However, this meaning (factor prices) is not, I maintain, an appropriate meaning of cost for the purpose in hand. Or, at the best, these factor prices represent only one of the various alternative opportunities that might be confronting the man when he is about to make his decision. The appropriate meaning of cost is the revenue, from an alternative distribution of 'the same resources', that he would expect to achieve if, instead of his accepted course of action, he adopted that course which would yield the second highest revenue. It is the (greatest) estimated alternative productivity of 'the same resources', rather than their prices as factors, that we have to regard as cost. The two things might conceivably be one and the same: the best alternative to taking the accepted course of action might be to sell (or not buy) 'the same resources' or their services as such. But this is not necessarily so. The best alternative could be an alternative complex of activities to produce an alternative complex of the same products or different products or some of each. Consequently we need to adopt a meaning for cost which covers the cases where the best alternative is, not to sell (or not buy) 'the same resources', but to do something else with them. And we need to do this notwithstanding anything that may be said to the contrary in 'static', or other, equilibrium analysis. We are not assuming that the man is planning or operating in any kind of equilibrium, or other, conditions that require these two things to be the same.*7 We do not say how many different opportunities of making money he sees, or thinks he sees, in the rest of the 'system'. Consequently we define cost as his best alternative revenue rather than as the sum of the factor prices. If any adjustment is implied, I would make just this amount of adjustment to Professor Lionel C. Robbins's description of opportunity cost in his 'Certain Aspects of the Theory of Costs'.*8 Otherwise I would adopt his definition.
I would emphasize that this adjustment of the meaning of cost from factor prices to rejected alternative revenue does not in any way rule out the relevance of factor prices in planning or in the determination of cost.*9 Whether the man will include the use of John Smith's linen thread in one alternative plan or another will surely depend partly upon the level of the price that he contemplates having to pay for it. For the level of this price will be one determinant of the quantity of linen thread that he will be able to get with a given input of money. Hence it may be one determinant of the size of an output (of say, boots). Hence it may be a determinant of revenue from this output—on plan A. And, as the sacrifice of this revenue may be the cost of achieving a revenue on an alternative plan B (which incidentally may not contemplate the use of linen thread at all), the (expected) price of linen thread may be a determinant of cost.
I have not yet said what marginal cost is. A marginal cost is simply the revenue that the man expects to lose in one direction (to be set against the revenue that he expects to gain in another direction—the marginal revenue) by shifting his proposed application of some part of 'the same resources', for example, by shifting some from product A to product B, or from the money market to a product, or from personal consumption*10 to business investment, or from investment on day 1 to investment on day 2, or from 'idleness' to investment. Clearly one such shift occurs in moving from the 'second-best' plan to the 'best' plan. Clearly the marginal revenue involved is greater than the marginal cost involved: net revenue is positive. Or, reversing the process, the marginal revenue involved in moving from the 'best' to the 'second-best' plan is less than the marginal cost involved: net revenue is negative.
Up to this point I have spoken of the man's aim as being the maximization of the surplus of revenue over cost. It is now no longer necessary—indeed it is very nearly erroneous—to do this. It is enough to speak of maximizing revenue. To maximize revenue is to choose the best or greatest of all the alternative revenues that are in mind. There is a surplus of the best over the next best (cost), but to speak of maximizing this surplus is to contradict the assertion that the two revenues are the best and the next best.*11 Let us henceforward speak simply of maximizing revenue.
I come now to the substitution of 'the organization' for the 'man'. Cost, for the organization, would still refer to the revenue of the 'best' of the rejected alternative plans that were under consideration in the planning stage and rejected by the composite decision. But the constitution of this rejected plan, like the constitution of the accepted plan, would be the result of the planning activity and (interpersonal) coordination of a number of collaborating minds, instead of being merely the result of the coordination of the processes of a single mind. Hence 'discovery' of the cost, and how it was arrived at, would have to overcome corresponding complexities. Marginal cost would still refer to the revenue expected to be lost in one direction by shifting the proposed application of some part of 'the same resources'-possibly now by shifting it from one member's use to another member's use. 'The same resources' and their application would have to be thought of in the same way for the organization as for the man, except that 1) the limit to 'the same resources' would depend on the capacities and views of a number of collaborating people instead of one person, and 2) we should have to bear in mind that the amount of the organization member's personal resources that becomes organization resources (and consequently the amount of personal 'leisure' and so on that he sacrifices) is fixed by bargain and contract between that member as a person and the other organization members or the organization as such. So is the member's remuneration for what he so contributes, whether this remuneration is a definite sum, whether it is the residual revenue that is to be maximized, or whether it is a definite share in that residual revenue.
IV THE SUPPRESSED VALUE JUDGEMENTS. NON-MONETARY ENDS AND MARGINAL COSTS. INTRA AND ULTRA VIRES POLICY-MAKING AS AFFECTING THE OPERATION OF THE MARGINAL PRINCIPLE IN THE ORGANIZATION. IDENTIFICATION
We can now return to the value judgements which the first approximation obscures. I have already referred to the assumption that the man's single aim is to maximize money revenue, and to the admission that this assumption may not be quite correct. A man may relax this valued aim somewhat to allow, say, for his preference for producing the kind of product that he 'likes', or for his preference for 'leisure' or food (valued because he 'likes' them as ends, and not merely as indirect means to maximize his money revenue) or even for his preference for being benevolent towards other people. His 'net satisfactions' may be greater if he does so. In other words the man may have other ultimate ends, or rather other ends penultimate to 'value', besides the end of money revenue.
The significance of the possible presence of these other ends is just this. In so far as the man has them, his pursuit of money-revenue maximization will be restricted by marginal costs which will be, not exclusively alternative marginal money revenue, but his valuation of the marginal achievement of these other ends—e.g. additional 'leisure' to be enjoyed as a valued end. Or revenues will be 'weighted' by the other valued ends that the man expects to achieve in the process of earning the revenues—e.g. when he 'likes' making one product more than another. In either case his resources will be partly devoted to the achievement of ends other than revenue maximization. This is the main point. But we should notice incidentally that if in these circumstances we desired a concise expression to describe the man's optimum distribution of his resources, and to indicate what we meant by cost, we should be driven to say that he adopts a course of action which maximizes his value,*12 and that the cost is the value.*13 from an alternative distribution of 'the same resources', that he would expect to achieve if, instead of his accepted course of action, he adopted that course which would yield the second highest value.*14 This is what happens to us when we remove the oversimplification in the assumption that the man's value judgement makes revenue maximization his single end. We get back to the old-fashioned description of rational behaviour.*15
I want now to suggest how the introduction of these other valued ends affects organization behaviour.
To make a value judgement as part of an effective decision is to make policy. Whether it can be distinguished in practice or not, this act of policy-making can be distinguished in thought from the acts of administration and execution which implement the policy. When the subject of our inquiry is the man working alone, this distinction may not be a matter of great significance. The man is assumed to approve what he decides to do and does. That is the end of the matter. There is no problem of whether his decisions and actions are in accord with his policy. If they were not, he would be presumed to be irrational or mad.*16
When the subject is the organization, however, we are in a different position. It is obviously possible for an organization member to make a decision which is inconsistent with the policy or approved aims of the organization, that is to say, to allow his personal value judgements to intrude, or to allow his misguided 'identification'*17 with a department, person or practice to intrude. For example, he might decide to make product A, rather than product B, because he personally 'liked' making product A, or because he was 'identified' with the product-A department, although he thought product B would yield more revenue, and although the organization policy was to maximize revenue regardless of product. Such a person is not necessarily irrational (mad), although in such circumstances 'the organization' may be.*18
But this deliberate intrusion of personal values, and this misplaced identification, are not the only aspects of the matter. It is often very difficult to see how administrative decision-making can be delegated without driving the administrator into making policy himself. Suppose, for example, that it was the organization's policy to make product A rather than other products, even at some loss of revenue, because it (or its policy-makers) had a special 'liking' for making product A. Then the problem of devising a policy-directive giving the weights to attach to the A marginal revenues so as to allow the administrator to measure them against the marginal revenues of other products would be difficult if not insuperable. Again suppose that it was the policy of the organization to provide some 'welfare' at the expense of some revenue, that is to say, because it 'liked' providing welfare and not merely because it regarded the provision of 'welfare' as a means of increasing revenue. Here again the problem of devising a policy-directive giving the descriptions of tangibles*19 that were supposed to yield 'welfare', and the weights to attach to them, so as to allow administrators to measure them against the marginal revenues of products, would be difficult if not insuperable. The only rational way out of the difficulty would seem to be to provide for discussion between administrators and policy-makers proper, and for tentative administrative plans to be submitted for confirmation to policy-makers proper. There is then a meeting of minds and a two-way flow of ideas. Policy-makers can eventually 'value' and select from the alternative plans which the administrators submit to them. Administrators thus have the means of making their plans definite without themselves making policy.
It might be thought that another way out of this difficulty would be to delegate policy-making itself to the administrator. The members of a company might be thought to delegate policy-making to its board of directors. But this situation is surely morally intolerable. To delegate policy-making is to permit somebody else to make one's ethical judgements for one. A person joining an organization accepts, not any aim that some other member chooses to adopt subsequently, but the aim which he and all other members at that time accept in common. He accepts ethical or moral responsibility for pursuing that aim. It would seem, then, that the making, or changing, of policy without common consent is necessarily a change ultra vires—that policy-making cannot be delegated.*20 If policy-making could be delegated, and if a company delegated policy-making to its board of directors, the board would be at liberty to devote all the resources of the company to charitable works, or whatever else it saw fit to regard as 'good'.*21
So far then I have suggested that what the organization's output is, and what are the marginal costs, or marginal values, that are determining it, may depend partly upon the presence of ultra vires policy-making within the body of the organization, either because of the intrusion of personal values or because of misguided identification or because administrators without appropriate policy-directives are driven to make policy. A serious inquiry into the determination of a business organization's 'output' would have to be prepared to 'discover' whether influences of this kind were at work. It should be noticed incidentally that if it did find these influences at work, it would not have disproved the marginal principle*22 though it would have discovered marginal costs and marginal values whose introduction rendered the organization behaviour irrational.
Such an inquiry would not be easy. Even in the one-man business, it would be difficult enough to discover from the man's mind how far he was forecasting achievements of other ends than revenue, and setting the forecasts against, or adding them to, his forecasted achievements of revenue. Indeed he might himself be only partly conscious of what he was doing. In an organization a serious inquiry would be much more complex. It would have to probe the minds of more than one person. It would have to study the effects of meetings of minds. These meetings, whether for the purpose of securing the administrative composite decision,*23 or for the purpose of reconciling administration and policy, would not necessarily proceed through formal committee meetings: as likely as not the link-up would occur in informal discussions.
The investigation would have to be wary of misplaced identification. This I have mentioned before, but it needs further stress. n an organization people are necessarily in some sense specialized: to say this is to say no more than that the organizations activities are divided amongst the people in it. A man, or a 'department' of men, might be specialized to the production of a 'product' or to plant maintenance or to 'welfare' activities or to 'accounting'. Either because they personally like the activity, or because they get their living at it, or for some other reason, people so specialized sometimes 'identify' themselves with the departmental end rather than the organization's end, and, when they are before the coordinating body, 'push' their departmental end, and press for resources to achieve it. Incidentally they are likely to develop standards or practices relating to their specialism, and push these, even sometimes where they are inappropriate. Sometimes these standards or practices are those of a profession to which the people belong and with which they are 'identified', recognizing the profession as a group or organization superordinate to the business organization in which they are working. It is notorious that accountants are 'identified' with the practice of 'attaching' and 'expiring': I have written about that elsewhere.*24 At least some of them develop a pseudo-objective 'cost' calculation, which includes these arbitrary attachments, and which an unwary and uninitiated investigator might be led into substituting for the estimates of alternative revenues (and alternative 'values') that I have been discussing. Misleading inferences about how output was determined might follow. I have no hesitation in adding that it is to such 'cost' calculations that I was referring, in section II, when I spoke of the behaviour (which I should now describe as organizationally irrational) of the 'manager' and his 'staff-man'.
V OTHER SUPPRESSED SUBJECTIVE JUDGEMENTS. TIME PREFERENCE. POLICY-MAKING AND ADMINISTRATIVE JUDGEMENTS AFFECTING MARGINAL COST
In the last section I supposed the value judgement to be relaxed so as to allow the man to be pursuing another end besides money revenue. Sometimes it is admitted that, even though money revenue is deemed to be the single end, another value judgement intrudes as soon as we think of maximization of revenue over time. This appears in the determination of what is known as the rate at which future revenues are discounted. Money may be planned to come in (or go out) at different times and in different quantities over the future. These planned times and quantities may be varied. The man may prefer a pound at one date to a pound at another date, and plan to get it at one date rather than the other. This relative preference affects the meaning of maximization, even given that money is otherwise the single aim.
But to understand how much of this preference is of the value judgement nature—how much of it is 'policy'—we have to analyse it a little. Let us momentarily abstract from all elements of uncertainty about the possibility of accrual of the pound at either of the two alternative dates. Then the preference for the pound at one date rather than the other can be due to one of two things.
First, the man may prefer the pound at one date rather than the other because he 'likes' or 'values' it more at that date, possibly because he wants to withdraw money for personal consumption at that date rather than at the other—for personal consumption over and above what he requires to enable him to maximize revenue. This preferred date may be the date of the planned termination of the operating period (or infinity!) or the planned date of some interim drawing. My suggestion is that the decision settling the date of the termination of the period (the termination of the business operations) and the decision settling the date of interim drawings (which can be regarded as partial terminations of the business) are of the nature of value judgements (policy decisions) which are necessary adjuncts to the simple statement which says that the aim is to maximize revenue, but which says nothing about the length of the operating period. It would follow that if in an organization (e.g. a company) the policy-making body (e.g. a body including shareholders) was distinguishable from the administrative final coordinating centre (e.g. the board of directors), these decisions should be made by the policy-making body, and that the administrators should administer in accordance with the decisions so made.*25 This would require either a policy-directive laying down the time preference for revenue withdrawals, or the kind of discussion between administrators and policy-makers, and joint settlement of plans, to which I referred before. Otherwise administrators would be driven into policy-making. It should hardly be necessary for me to add that the introduction of this time preference affects marginal costs: a pound earnable at one date is no longer necessarily equivalent to a pound earnable at another date.
Secondly, the man may prefer the accrual of the pound at one date rather than the other on the ground that he expects its accrual at that date to lead, through better opportunities for its reinvestment, to greater revenue in the end, or according to his scale of preference with regard to dates of withdrawal. In this case there appears to be no (additional) value judgement involved: the case is covered by the decision, and the value judgement involved in it, to maximize revenue in the end, or according to the scale of preference for withdrawals. This would mean that in the organization no additional policy-directive to administrators would be required, and that they could make this type of decision without reference back to the policy-makers. That is to say, given the policy-makers' scale of preference with regard to dates of withdrawal, the administrators would make the disinvestment and reinvestment decisions. Once again marginal cost is affected, this time by an administrative judgement which appraises the revenue to be sacrificed by an earlier or later disinvestment and reinvestment.
I would emphasize that neither of these preferences for a pound at one date rather than the other has anything to do with relative uncertainty of accrual. I have abstracted from this matter, not because it is of small importance, but because these relative uncertainties about accruals at alternative times can be regarded—from the point of view of whether the decision about them involves another value judgement—in the same way as relative uncertainties about alternative accruals at the same time. It is to this problem that I now turn.
Let us suppose that our businessman is concerned with a choice between two alternative courses of action which he believes would yield revenue. He states that if he took the first course he would be surprised if its revenue fell outside the limits of ten and twenty; if he took the second course he would be surprised if its revenue fell outside the limits of five and thirty.
I take the view that the question of which of these prospective revenues is the greater is not capable of being answered objectively, and consequently that the simple statement of the aim to maximize revenue has to be modified or elaborated to allow for the subjective judgement about which is the better risk to take or uncertainty to face. In this case, in which the lower and higher limits of the one revenue fall respectively below and above those of the other revenue, the man's decision seems to depend upon how much he 'likes' risk-taking, and accordingly involves a new value judgement, affecting what is meant by maximization of revenue and by marginal cost. It would seem to follow that in an organization a decision of this type would require the expression of the preference of policy-makers. I do not profess to know how a policy-directive could be framed for the purpose!
Now let us alter the example. Let it be otherwise the same, but let the revenue limits be ten and twenty for one course of action and twenty-five and thirty-five for the other. It seems to be clear that in this case the man in pursuit of revenue maximization could firmly choose the twenty-five to thirty-five alternative without making any new value judgement.
There is of course a subjective judgement involved. Uncertainty is involved. As far as we know, it is only he who is relatively certain that the limits are twenty-five and thirty-five: only he who would be surprised if the revenue fell outside those limits. If other people instead of this man were in his decision position at the time he was, their opinions might be different from his. And he (or they) might be wrong in the event. Similarly for the administrator in the organization. It would seem that decisions of this type, which do not depend on the decision-maker's special taste for risks, could be delegated by the organization's policy-makers to administrators, and that the subjective judgement involved is the element of judgement which is always involved in administration, but which is perhaps distinguishable from the value judgement involved in policy-making.*26
This section might be summarized thus. What the man working alone would mean by maximation or revenue and hence by marginal cost, would depend, not only upon his (administrative) views about when he should disinvest in order to reinvest, but also upon his policy defining the time or times at which he wished to withdraw revenue; not only upon his uncertain administrative judgement about revenues he could achieve in the future, but also upon his policy towards risk-taking. The meaning of maximization of revenue by an organization would depend upon the same administrative and policy-making judgements, with added complexities. These judgements are not all made by one person. The difficulties of disentangling administration and policy-making, and of devising appropriate policy-directives would probably lead to ultra vires policy-making. The alternative to the policy-directive, as a provision against ultra vires policy-making, is constant contact between policy-makers and administrators. I might add that this would limit the size of the organization in terms of numbers of members.*27
Notes for this chapter
I say 'nearly' because we say that 'marginal cost equals marginal revenue' only when we forget 1) that the position of equality is a position of indifference and 2) the minimum sensible. In administrative theory both these things are important.
On this, see Mises, Human Action (1949).
Cf. Hayek: 'Economics and Knowledge', reprinted here, pages 43-68.
This does not contradict my assertion, below, that costs are not necessarily actor prices.
A term I have taken from Bradley.
Professor H. A. Simon uses the expression 'composite decision'. This is equivalent to the expression 'coordinated decision ex ante' which I have used elsewhere. (See H. A. Simon, Administrative Behavior (1947), and my 'The Subjective Theory of Value and Accounting "Cost"', reprinted here, pages 135-61.
If there is any profound reason why this implies that the man will not be able to carry out his plan, I should like to point out that I have not anywhere stated that be will be able to carry out his plan.
Reprinted here, pages 21-41.
Neither is it intended to belittle the significance of estimating future factor prices and calculating variations in prices and their sums which would be expected to accompany variations in planned production processes and outputs (production functions). Quite the contrary. But it is intended to take care of the situation in which the business man's cost calculation with respect to a particular product is not completed until he has looked at his alternative product demand curves as well as his factor supply curves, and calculated all the revenue he expects to lose by devoting resources (total or marginal) to this product instead of doing something else with them. It incidentally takes care of all interdependencies, including interdependencies of demand curves.
It should be noticed that, because the maximization of the surplus of money revenue over money cost is the man's single end, he will, apparently, reserve to himself 'leisure' and resources for food and other personal consumption only in so far as he thinks that to do so will indirectly increase the size of his ultimate money surplus.
I should have no objection to allowing cost to mean the 'worst' (or some other) revenue, instead of the 'next best' revenue, and so making sense of the expression 'maximize the surplus of revenue over cost'. (And if one of the alternative behaviours were holding idle, the expected outcome being money so held idle, I should of course be willing to include this outcome in the list of alternative revenues, and should have no objection to regarding it as cost.) I should have no objection to this provided that everybody agreed that 'cost' did still mean revenue (or the idle money outcome) and not the resources that the man has at the outset, as such.
It would be possible to go further and allow cost to mean these resources as such. I should have no objection to this either, provided that everybody agreed that cost did mean this, and that nobody then tried to subtract cost from revenue to give profit or net revenue or income. The resources never are homogeneous: the man has at least himself as well as any money he may have. To begin to 'price' the resources in order to make them summable, is to begin to convert them into the money yield (revenue) that the man thinks he could get for them. It is either this or much-practised pseudo-objective nonsense!
Or values or satisfaction or utility or ophelimity or something like that.
Or values or satisfaction or utility or ophelimity or something like that.
Or values or satisfaction or utility or ophelimity or something like that.
See Mises, Human Action.
See Mises, Human Action.
For a fuller discussion of 'identification' see H. A. Simon Administrative Behavior.
Fortunately for us it has not been possible to put organizations into lunatic asylums.
This cannot be avoided by a directive which simply allows so much money to be allotted to undefined 'welfare'. Under such a directive the administrator could define 'welfare' as putting the money into his own pocket.
This is not to say that there cannot be a considerable degree of common understanding of what policy is, even though no explicit policy statements or directives are issued: no doubt a man joining a business firm assumes that it is there largely to make money. The point is rather this. When the number of members is large, it becomes difficult to get and maintain common consent to a common policy which binds members to pursue a common end. But if the many try to leave policy determination to the few, the moral issue arises. When I say that policy-making (as distinct from administration) cannot be delegated, I mean that A who directs B to pursue A's ends for him cannot be presumed not to have defined or determined those ends, and valued, approved of or accepted moral responsibility for those ends as fit to be pursued. (If A were a group, perhaps including B, I should say this of each person in the group. This personal responsibility cannot, I suggest, be eliminated simply because the persons have formed an organization.)
To assume that the board is the policy-maker (and consequently that the shareholders are infants without moral responsibility) does not dispose of the issue in question, but only shifts its locus to the relationship between the board and the subordinates to whom the board delegates administration.
If economists want to study organization pathology, they should go about it in the right way, and not be too ready to scrap principles of their own which some of them have ceased to understand.
Economists, who appreciate the abstraction of a 'market price', should have no difficulty in grasping the idea of a composite decision as a similar abstraction.
'The Subjective Theory of Value and Accounting "Cost" ', reprinted here, pages, 135-61.
Whether or not this view is correct, it should be clear that administrative behaviour should be coordinated to secure that all administrators are working to the same range of preference regarding the dates at which revenue is to accrue or be maximized: otherwise an administrator of one section of the total plan might be working to maximize at the day after tomorrow, while another was working to maximize ten years later.
The influence of G. L. S. Shackle in these last few paragraphs will be apparent. Professor Shackle, who kindly read this paper in draft, suggested that the illustration of the distinction between administrative decisions and policy-making decisions might be compared with the distinction, in his Expectation in Economics, (1949), between deciding on the shape of a 'potential surprise curve', and choosing between two points on a 'gambler-indifference map'.
For helpful comment on the draft of this paper, I should like to thank particularly Mr Jack Wiseman and Professors G. L. S. Shackle, H. A. Simon and H. M. Robertson.
Essay 9, Uncertainty, costs, and collectivist economic planning
End of Notes
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