Cost and Choice: An Inquiry in Economic Theory
By James M. Buchanan
You face a choice. You must now decide whether to read this Preface, to read something else, to think silent thoughts, or perhaps to write a bit for yourself. The value that you place on the most attractive of these several alternatives is the cost that you must pay if you choose to read this Preface now. This value is and must remain wholly speculative; it represents what you now think the other opportunity might offer. Once you have chosen to read this Preface, any chance of realizing the alternative and, hence, measuring its value, has vanished forever. Only at the moment or instant of choice is cost able to modify behavior…. [From the Preface]
First Pub. Date
Indianapolis, IN: Liberty Fund, Inc.
First published in 1969 by Markham Publishing Company, Chicago, Ill. Foreword by Hartmut Kliemt.
The text of this edition is copyright ©: 1999 Liberty Fund, Inc. Picture of James M. Buchanan: File photo detail, courtesy Liberty Fund, Inc. James M. Buchanan, 1963.
Cost Without Markets
If prices are established in a market process, the decisions of buyers and sellers will be based on cost-benefit comparisons. Before any choice is made, anticipated benefits must exceed opportunity cost. If continuous adjustment is possible, each participant moves toward behavioral equilibrium where anticipated marginal benefit equals marginal opportunity cost. In this purely individualistic context, questions about the precise meaning of cost or of benefit need not arise. The analysis offers a logic of rational individual decision, and cost is simply that which is foregone by positive choice, at the moment of choice itself.
As Hayek emphasized, equilibrium in a market interaction is categorically different from the behavioral equilibrium of an individual participant in that interaction. In the latter, there must be an absence of gains-from-trade
within the perceived choice range of the individual. In the former, there must be an absence of gains-from-trade, in total or at the margin, from action taken
among all individuals, each one of whom perceives the prospects of trade with others as a part of his own choice set. In order for market equilibrium to be established, every participant must be in his own behavioral equilibrium, but the contrary need not be true. That is, each individual can attain behavioral equilibrium at the moment of choice, but unless the decisions of separate persons are in a unique relationship with one another, market equilibrium need not
result. The failure of this equilibrium to emerge will set in motion changes in behavioral equilibria of individuals for subsequent choices.
Prices, Costs, and Market Equilibrium
What are the relationships between “prices” and “costs” in full market equilibrium? For each participant, expected marginal benefit will be equal to marginal opportunity cost, both measured in terms of the individual’s subjective valuation. All persons are observed to confront uniform relative prices for goods; this is a necessary condition for the elimination of gains-from-trade. Since each participant is in full behavioral equilibrium, it follows that each person must confront the same marginal cost. As a demander, the individual adjusts his purchases to ensure that anticipated marginal benefit equals price. Hence, the anticipated marginal benefits of a good, measured in the numeraire, are equal for all demanders. As a supplier, the individual adjusts his sales to ensure that anticipated opportunities foregone, marginal opportunity cost, equals price. Hence, marginal opportunity cost, measured in the numeraire, is equal for all suppliers.
Prices tend to equal marginal opportunity costs in full market equilibrium. But costs here are fully analogous to marginal benefits on the demand side.
Only prices have objective, empirical content; neither the marginal evaluations of the demanders nor the marginal costs of the suppliers (the marginal evaluations of foregone alternatives) can be employed as a basis for determining prices. The reason is that these are both brought into equality with prices by behavioral adjustments on both sides of the market. Prices are not brought into equality with some objectively determinable and empirically measurable phenomena, on either the demand or the supply side of the market.
In this elementary logic of the market process, we are back in the classical model for goods with fixed supply, the model that became the general one with the advent of the subjective-value theory. There is no “theory” of normal exchange value with positive content here. The analysis provides an “explanation” of results, a logic of interaction; it contains no predictive hypotheses.
Resource-Service Prices as Final-Product Costs
Final goods are not available in fixed quantities, however, and with the introduction of resource services, the objectivity of cost tends to be reintroduced. Prices for productive services are established in a market process, and these, like the prices for final goods, are empirically observable. These resource-service prices are derived from the evaluations placed on final products, which are acknowledged to be based on subjective elements. But the whole market acts to establish observable prices, and these prices, in turn, seem to make the
costs of final products objectively real. The costs of production as faced by producing firms are also the prices of resource units as received by supplying agents. For final-product markets, therefore, supply-side adjustments seem to offer an escape from the logic into empirical reality. Suppliers act so as to bring costs into equality with prices; costs represent the marginal evaluations of foregone alternatives as expressed by the whole market and as expressed in money terms. For the prices of final products at least, we seem to be back in the quasi-classical world of one-way causality.
Even in full market equilibrium, however, the objectivity of opportunity cost is only apparent. As Frank Knight correctly indicated in his 1934 and 1935 papers, even in full equilibrium, resource-service prices reflect costs only if nonpecuniary advantages or disadvantages are absent from the choices of resource-supplying agents. If pecuniary returns provide the sole motivation for resource suppliers, the observed price for a resource unit does represent the choice-influencing opportunity cost of that unit, even if indirectly. If, on the other hand, nonpecuniary elements are present in the decisions of resource suppliers, the choice-influencing cost of the resource units is not observable in money prices paid for resources. The apparent linkage between final-product cost, in some objective sense, and observed prices paid for resource services disappears.
This does not, of course, affect the standard analysis of market interaction, and it does nothing to modify the welfare inferences that may be drawn from an understanding of competitive adjustment. So long as individuals on either side of the market are allowed to express their preferences by continuous adjustments in behavior, nonpecuniary elements will be fully embodied in the solution that emerges. Prices will tend to equal marginal opportunity costs. What is destroyed by the presence of nonpecuniary elements in choice is the spurious objectivity of costs, as measured by prices of resource services.
These prices may embody nonpecuniary elements, however, for only some resource suppliers, and not necessarily for all. If there exist a sufficient number of suppliers who are on the margin of indifference among all employments yielding equivalent pecuniary returns, resource-service prices accurately represent
marginal opportunity costs despite inframarginal suppliers who are known to choose on the basis of nonpecuniary as well as pecuniary rewards. Inframarginally, nonpecuniary elements in choice do not affect the relationship between observed resource-service prices and marginal costs of final products. This applies only to marginal costs, however; average costs will not be accurately measured by observed outlays on resource inputs. Even if nonpecuniary elements are not present in effective choices made at the margin of adjustment and, hence, are not included in marginal opportunity costs, the presence of nonpecuniary elements in choices made over inframarginal ranges of supply ensures that observed outlays will not measure total costs. This does not modify the allocative results of the market interaction process, but it does mean that the use of predicted or observed outlays to measure total costs—costs which are to be compared with expected benefits as a basis for making nonmarket allocative decisions—can lead to serious error.
Market Equilibrium, Costs, and Quasi-Rents
In the absence of nonpecuniary elements in resource suppliers’ choices, observed outlays on resource services would seem to provide an objective, even if indirect, measurement of the choice-influencing opportunity costs to these suppliers if the system is in full competitive equilibrium. The conditions for equilibrium that are required in this context are, however, much more severe than those that are necessary for other purposes.
All resource suppliers must be on a margin of indifference among alternative employments; quasi-rents cannot be present. If some resource units earn quasi-rents, observed outlays on resource services will not accurately reflect the choice-influencing costs of resource owners with regard to the interoccupational or interindustry choices.
Resource-service prices are set at the appropriate margins of employment, and competition among purchasers causes similar units to earn similar returns. Similarity in internal or intraindustry productivity does not, however, imply similarity in alternative employment or interindustry productivity. Resources may be differentially specialized to particular industries. When this happens, quasi-rents emerge. The existence of such quasi-rents does not, of course, violate the logic of market interaction. In equilibrium, prices will be equal to costs, but costs must be tied to the particular decisions that are made. In selling his services to a
single firm within a competitive industry, the resource owner foregoes a return that he might secure from any other firm in the same industry. Quasi-rents are not present in this situation since the resource owner is indifferent among employment by different firms. However, the choice of employment within the industry generally, as against other industries, may take place in the presence of quasi-rents. The foregone earnings outside the industry may fall short of those that may be secured from any single firm within the industry. Prices will, therefore, be equal to the costs that inform
within-industry choices. For all except the marginal supplier, however, the prices paid for resource services—the outlays—will exceed the marginal evaluation of prospective alternative returns foregone outside the industry, even in full market equilibrium.
The existence of such inframarginal quasi-rents does not modify allocative outcomes of the market process because these quasi-rents disappear at the margin. For both an interfirm and an interindustry decision, the marginal resource supplier is in full equilibrium. Observed outlay made to him by the firm accurately measures his evaluation of foregone alternatives. The receipt of quasi-rents by inframarginal suppliers was the subject of a major debate a half-century ago, and one of the contributions of Allyn Young was that of showing the irrelevance of these for allocative efficiency.
Problems do emerge, however, when any attempt is made to utilize the properties of the market process as guidelines or norms for the making of nonmarket decisions. In this extension, the relationship between inframarginal quasi-rents and “costs” must be kept in mind.
The Cost of Military Manpower: An Example
An example may illustrate some of the points put forth in this chapter. Let us suppose that the government calls upon an economist for expert advice. It asks him to estimate the “cost” of securing military manpower of specified quality and in specified quantity. The comparison of benefit estimates with this “cost” presumably will form the basis for making allocative decisions concerning the amount of military manpower to be employed. To simplify the problem, assume that a fixed number of common soldiers is needed. These are units that are homogeneous for the military purposes for which they are required.
In Figure 2, let us depict the actual supply curve for common soldiers as S, and let us say that X is the quantity needed. The supply curve, which we shall assume is accurately known to the consultant, represents a schedule of minimum prices (wages) that would be required to bring forth the several quantities indicated. Initially, let us also presume that all prospective soldiers are motivated solely by the prospect of pecuniary rewards. In this case, the curve S also represents the returns that these prospective military men forego in alternative lines of employment. The fact that the supply curve slopes upward indicates differential productivity in alternative employments despite the homogeneity of units in producing military services.
If the government is presumed to act as if it were a fully competitive industry in purchasing military manpower, its prospective outlay is measured by the rectangle 0XPY. This outlay overstates the “costs” that are involved in the prospective occupational choices, however, because of the inframarginal quasi-rents. The shaded area, RPY, is not a part of total costs in any choice-influencing sense. If the amount represented by this area is included in the cost side of a cost-benefit comparison, the result will be biased against resource commitment in this usage. Providing only that the government relies on contractual purchase agreements, this conclusion holds regardless of the means through which the government purchases its military force. If, for equity reasons, the government pays a uniform wage to all soldiers, despite the emergence of inframarginal quasi-rents, outlay will be greater than “costs,” but a part of outlay will now represent a by-product of the resource commitment. Unless this is recognized in the cost-benefit computation, too few resources will be allocated to all increasing supply-price public facilities or projects. The use of predicted outlay to measure “costs” in this situation would reflect the Pigovian error that Young effectively exposed.
If nonpecuniary elements are present in the occupational choices of resource suppliers, the supply curve no longer measures the earnings of prospective soldiers in other employments. Some such curve may be derived, say A in Figure 2, which does reflect alternative pecuniary earnings. As drawn, the curve of alternative returns in relation to the “true” supply curve suggests that nonpecuniary differentials shift from positive to negative over increasing quantity. This presents a more serious difficulty to the economist who must estimate costs than that which the presence of inframarginal quasi-rents presents. When nonpecuniary aspects of choice can be assumed away, the area under the actual supply curve does reflect “costs,” and this area can be roughly approximated from observed data on earnings in alternative employments. With nonpecuniary elements in the picture, however, no such indirect means of approximating choice-influencing costs exists. Whether or not some estimate of alternative earnings will over- or understate costs will depend on the quantity that is specified. As drawn in Figure 2, an overestimate would result for quantities toward the left of the quantity range, and an underestimate for quantities toward the right.
All of the measures of costs so far discussed, direct or indirect, assume meaning only if the government
purchases the resource units in a series of contractual market-like arrangements with the individuals who are to supply the services. The soldiers must voluntarily sell their services. If the actual recruitment of soldiers takes place in any other manner, the cost considerations discussed here must be re-examined. In the absence of nonpecuniary elements in choice for every one of the men conscripted, the opportunity costs of a conscripted military force would be measured by the earnings that members of this force could secure in nonmilitary employments.
*61 This would imply that each member of the force would be indifferent between military and nonmilitary employment if earnings in military employment were equivalent to those in nonmilitary pursuits. As noted earlier, this is a much more restrictive requirement than that which is needed to eliminate the significance of nonpecuniary elements for allocative decisions within a market-like process. In the latter, nonpecuniary elements need not modify the allocative results so long as a sufficient number of marginal adjusters remain indifferent to the nonpecuniary differences among the separate employments. If foregone earnings are to measure choice-influencing costs, however, this indifference must be manifested for every resource supplier, not just for those who are the marginal adjusters. The disappearance of nonpecuniary elements in choice at the freely adjusted margins of behavior, like the disappearance of quasi-rents at the margins, restores the allocative relevance of resource-service prices as proximate measures for
marginal opportunity costs. But this is helpful only if resource services are purchased through ordinary contractual arrangements.
The Cost of Crime: Another Example
Economists have only recently started to pay attention to crime and punishment, but this now bids fair to becoming a relatively important research area. Several studies have involved the extension of economic analysis to the decisions of criminals on the one hand and to those of law enforcement agencies on the other, both of which kinds of decisions are clearly outside a market equilibrium context. The implication of my discussion is that any costs which the economist may objectify need bear little relation to those costs which serve as actual obstacles to decisions. Recognition of this fact need not destroy the usefulness of the economic analysis. The costs that the economist quantifies may be directionally related to those costs that inhibit choice. In this case, changes in the level of objectified costs (for example, changes in the probabilities of conviction and in the severity of punishment) will produce effects on the number of offenses committed. Serious problems arise here only when the attempt is made to lay down more explicit norms for policy, as, for example, when the conditions for optimality or efficiency are discussed.
One part of Gary Becker’s recent, and excellent, paper may be used as an example.
*62 In a section in which he discusses optimality conditions, Becker argues that if the costs of apprehending and convicting offenders are zero, the marginal value of the fines imposed on criminals should be equated to the marginal value of the harm that offenses cause. This is an admittedly limited model, but, even here, Becker’s conclusion is valid only under a special assumption about the prospective criminal’s choice behavior. In contemplating an offense, the criminal must be assumed to leave out of account any and all considerations of the harm imposed on others. It must be assumed that this does not enter as an obstacle in his decision, that this is not a part of his choice-influencing cost. If, for any reason, this element enters as a genuine cost, Becker’s suggested norm would overshoot the mark. Some crimes that would be in the “social interest” would be prevented by the imposition of Becker’s conditions. (The analysis here is almost identical to that made in an earlier chapter with reference to the Pigovian analysis.) Perhaps more significantly, the optimal number of offenses would be secured when marginal fines remain considerably lower than the marginal damage to others. In other words, for the criminal who incorporates into his costs some consideration of the harm his crime will impose on others, the point at which “crime may not pay” him is reached well before the point at which the observing economist marks the disappearance of net profit.
Clarification of the cost concept may have certain interesting and relatively important policy implications for criminal activity, or even for noncriminal activity that is for any reason held to be suspect or immoral. To the extent that the consideration of prospective harm to others, or, in fact, any moral restraint upon the decision, varies with the location and incidence of the offense contemplated, the opportunity cost of the offense varies. Hence, we should expect that crimes committed within the local community of the perpetrator against persons with whom he has close contacts would normally involve a higher cost barrier due to the moral restraint upon the actor in such a situation. From this it follows that fines or penalties required to achieve any given level of deterrence can be somewhat lower for these cases than for others. That is, crimes committed locally should bear lower fines than those imposed for identical crimes committed outside the community and on “foreigners.” Other similar implications can be derived. Generally, punishments and fines for comparable crimes can be lower in small cities than in large. And, importantly, punishments for crimes against persons or property of the same racial or religious group can be lower than punishments for identical crimes against persons who are members of ethnic or religious groups differing from those to which the criminal belongs.
The most serious problem in extending the basic allocative meaning of choice-influencing opportunity cost to decisions that must be made outside the market process has been ignored to this point. The preceding discussion was limited to an examination of the meaning of cost in a nonmarket context and to some difficulties in estimation. The problem of choice-making itself was not raised here, although it was treated briefly in Chapter 4.
In the military manpower illustration presented earlier, we presumed, without critical scrutiny, that if costs could somehow be estimated, the choices that were finally to be made would be based upon these. This tends to remove all behavioral content from choosing behavior, however, and it is essential that the distinction between “true costs” and “costs that influence nonmarket choice” be clarified. The basic point to be emphasized is a simple one: costs that are relevant for the making of decisions must be those that relate to the decisions made. The very nature of nonmarket choice ensures that “costs” cannot be those that are confronted in market choice.
The employment of resource services in any manner involves a cost to the resource owners; this cost consists in their own evaluation of foregone alternatives, an evaluation made at the moment of commitment. This is the “true” opportunity cost that comes to be embodied in the market process, and it is this cost, at least at the margins of adjustment, which is brought into line with prices of final products. Allocative efficiency is the result. In this interaction, however, all choices are made by demanders and suppliers, each of whom is responsible for the results of his behavior. The resource owner who decides to commit his services to occupation A rather than to occupation B lives with this decision. To the extent that his own utility influences his behavior, he is under pressure to make “correct” decisions, since his utility will be the magnitude affected by the making of “incorrect” decisions. If a market decision-maker fails to take advantage of prospective opportunities, opportunities which later are revealed as highly desirable, he suffers the sensation of opportunity losses. Those experiences that “might have been” will be recognized as his own losses.
This decision structure cannot be present with nonmarket choice. If the “true costs” of employing resources could be measured (let us say by an omniscient observer who can read all preference functions) along with the “true benefits,” allocative efficiency in nonmarket resource usage could be ensured only if the effective decision-maker acted in accordance with
artificial criteria for choice. That is to say, allocative efficiency will emerge only if the effective choice-maker acts, not as a behaving person, but as a rule-following automaton. The distinction here has been widely recognized, and it is as old as the Aristotelian defense of private property. It has not, however, effectively and critically informed the core of economic analysis, largely, I submit, because of the confusion in elementary cost theory. Only recently in the efforts of those scholars (such as Alchian, Coase, Demsetz, McKean, and Tullock) who have begun to develop the rudiments of an economic theory of property do we find explicit examination of the relationship between the predicted outcomes and the decision structure within which the choices are made.
Socialist Calculation and Socialist Choice
The Austrians and pseudo-Austrians—Mises, Hayek, and Robbins—who were involved in disputing the possibility of socialist calculation in the great interwar debate were all contributors to the evolution of opportunity-cost theory and implicitly acknowledged the basic distinction emphasized here. This particular aspect of their argument tended to be obscured, however, by their relative overemphasis on the difficulties in
calculation that prospective socialist decision-makers would face. These difficulties are, of course, extremely important, and the information problems that centralized economic planning confronts are indeed enormous, as experience has surely proved. Relatively speaking, however, the more significant criticism of socialist economic organization lies in the difficulties of choice-making. Even if the socialist state should somehow discover an oracle that would allow all calculations to be made perfectly, even if all preference functions are revealed, and even if all production functions are known with certainty, efficiency in allocation will emerge only if the effective decision-makers are converted into economic eunuchs. Only if such men can be motivated to behave, to make decisions in accordance with cost criteria that are different from
their own, can this decision-structure become workable. This amounts to saying that even if the problems of calculation are totally disregarded, the socialist system will generate efficiency in results only if men can be trained to make choices that do not embody the opportunity costs that they, individually and personally, confront.
The contrast between the implicit behavioral assumptions made by those who have proposed the Pigovian corrective taxes and subsidies in the face of external diseconomies and economies and the implicit behavioral assumptions made by those who argued that socialist organization can produce efficient results is striking. As noted in Chapter 5, for the Pigovian policy proposals to accomplish their own stated purposes, individuals who generate externalities must behave so as to maximize their own narrowly conceived economic interests. The effects of their own behavior on the predicted utility levels of others than themselves cannot be assumed to influence their behavior. By comparison, the idealized manager of the socialist enterprise must be assumed to act solely on the basis of nonindividualistic criteria. His own utility cannot be allowed to influence the decisions that he makes; he must choose in accordance with the costs and benefits predicted for the whole community; and his own position in the community must be treated as if it were the same as that of any other member. Whereas the Pigovian man must be strictly
Homo economicus in the narrowest sense, the socialist bureaucrat must be
non-Homo economicus in the purest sense. Both men can be only caricatures of actual persons, but both have been present in much serious discussion of real-world policy.
The contrast in the behavioral assumptions implicit in these two related bodies of literature is striking in itself, but even more interesting for our purposes is the common source of the confusion. In their contrasting ways, both the Pigovian policy correctives and the idealized socialist economy are intellectual products of cost-theory confusion. Both find their roots in classical economics, with its objectification of costs. Only if costs can be objectified can they be divorced from choice, and only if they are divorced from choice can the institutional-organizational setting that the chooser inhabits have no influence on costs. In the socialist scheme of things, costs are derived from physical relations among inputs and outputs. These may be externally measured, and these measurements can provide the basis for the rules that are laid down for managers of enterprises. Valuation enters the calculus only as the consuming public, through their behavior, establish demand prices, which become objective realities once established. The subjective valuation that must inform every choice is neglected.
Costs in Bureaucratic Choice
Bureaucratic decision-makers are human beings. This simple fact is only now beginning to be acknowledged in the theories of bureaucracy.
*63 The individual who is confronted with a choice among alternatives must choose, and the cost that inhibits decision is his own evaluation of the alternative that must be foregone. Rules can be laid down which direct him to adopt criteria that reflect the underlying economic realities. In a world of complete certainty, there is no decision problem. A computer can make all “choices,” if indeed “choices” exist. One of the central confusions leading to the false objectification of costs has been the extension of the perfect knowledge assumption of competitive equilibrium theory to the analysis of nonequilibrium choices, whether made in a market or a nonmarket process. Genuine choice is confronted only in a world of uncertainty, and, of course, all economic choices are made in this context. Any analysis of bureaucratic choice must be based on a recognition of this simple fact.
It will be helpful to construct the simplest possible model. Assume that a civil servant must decide between only two courses of action,
b. These may be anything, including the production of
1 units of output. Either of two possible external events may accompany this action, event
y. Again these may take almost any form, including the state of consumer demand at the margin. Further, let us assume that the total payoff to the community under each of the four possible outcomes is accurately estimated and that these are indicated by the large numbers in the four cells of Figure 3.
The choice between
b will depend, of course, on the subjective probabilities assigned to
y. Let us assume that the choosing agent assigns each event an equal probability. From the arithmetic, it is then clear that the expected value to the whole community will be higher from
a than from
b. However, with a change in the probability coefficients, from (.5, .5) to (.4, .6), the expected value to the community becomes higher from
b than from
a. In genuine uncertainty, the decision-maker must assign such subjective probabilities; there is no objectively determinable set of coefficients. When this is recognized, it is clear that there is simply no means of evaluating the choosing agent’s performance externally and after choice. Each of two separate persons may choose differently when confronted with identical sets of alternatives. There is no “correct” choice independent of the subjective probabilities that are assigned. In our example, one chooser may reject
b because its cost exceeds expected returns; the other may reject
a for the same reason. There is no way that an external observer or auditor can,
ex post, decide which of the two persons followed “the rules” more closely.
This difficulty in evaluating the efficiency of nonmarket decision-making suggests that the institutional pattern of rewards and punishments may be modified to ensure that, regardless of the choices that are made, the chooser will have some personal incentive to perform in accordance with “social” maximization criteria. This will substitute
ex ante motivation for individual behavior in the “public interest” for the misguided and hopeless efforts at judging or auditing the results
ex post. The necessity for some coordination between the cost-benefit structure as confronted by the decision-maker and the “true” cost-benefit structure of the whole community has, by this time, come to be widely recognized both in theory and in practice.
This institutional device is necessarily limited, however, and for several reasons it cannot fully resolve the dilemma of nonmarket economic choice. Nonmarket choice cannot, by its very nature, be made to duplicate market choice until and unless the ownership-responsibility pattern in the former fully matches that in the latter, an achievement that would, of course, eliminate all institutional differences between the two.
Suppose, as an initial example, that an individual cost-benefit structure is introduced as shown by the single-bracketed terms in Figure 3. Ordinally, at least, the relative payoffs to the decision-maker coincide with those for the community. However, if he assigns equal subjective probabilities to
x and to
y, his own cost-benefit calculation will lead him to select
a. The numerical array is, of course, deliberately designed to indicate this result, but it should be evident that ordinal equivalence between the payoff structure of the decision-maker and that of the whole community is not sufficient to ensure consistency in choices.
Proportionality is suggested. If the personal payoffs to the decision-maker, negative or positive, are made strictly proportional to those of the whole community, then choices made in accordance with expected-value criteria will produce the required coordination. At this point, the relevance of expected-value maximization as a rule for individual choice behavior must be called into question. It is well established that an individual will maximize present value only if he derives no utility or disutility from risk-taking and if the marginal utility of income to him is constant over the relevant outcome range. If the marginal utility of income declines over this range and if the chooser is neither a risk averter nor a risk preferrer, he will tend to have some preference for the safer of the two alternatives, some “nonpecuniary” differential in favor of alternative
b in the numerical illustration of Figure 3. The question that then emerges is whether or not this nonpecuniary differential faced by the decision-maker whose payoffs are proportional to those for the whole community need be the same as that which “should” inform the decision made from the community’s point of view. As Domar and Musgrave pointed out in another connection,
*65 the individual whose payoff structure is only some proportionate share of that which he might confront under full ownership will tend to take
more risks. The reason is obvious. Since the nonpecuniary differential arises only because of the declining marginal utility of income, the fact that the outcome range is lower under proportionate share payoffs than under full responsibility and ownership ensures some lessening of this differential.
An additional and important element tends to work in the opposing direction. Given a structure of individual payoffs that are only proportional to total community payoffs, the absolute differences between the expected value of alternatives are lower for the decision-maker than for the community; and the differences in the opportunity costs of two separate alternatives are lower. Considering this, it seems evident that behavior will tend to be less responsive to changes in the underlying conditions under bureaucratic choice than under market choice. The decision-maker in the latter situation cannot perceive changes in signals with the same sensitivity as he could in the former for the simple reason that the signals are stronger in the first case. If we also recognize and allow for threshold-sensitive response in behavior generally, this differential in behavior becomes even more pronounced.
These separate elements emphasize the fact that proportionality between the decision-maker’s cost-benefit matrix and that of the community will not ensure an approximation to market-choice results in a regime of bureaucratic choice. Costs as confronted by the choosing agents must remain inherently different in the two decision structures, and it is these differences that constitute the basic problem of securing efficiency in nonmarket choice-making.
The Theory of Price (3rd ed.; New York: Macmillan, 1966), p. 106.
Journal of Political Economy, 76 (March-April 1968), 169-217.
The Politics of Bureaucracy (Washington, D.C.: Public Affairs Press, 1965).
ex ante: only one outcome can be actually observed after choice.
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.
Economica, XXXIV (November 1967), 351-71.