L.S.E. Essays on Cost

I THE FIRST APPROXIMATION

8

The economist’s description of business behaviour

by G. F. THIRLBY

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.

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.

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.

III THE OBSCURITY ABOUT COST. A RESTATEMENT

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.

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.

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

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

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.

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