Cost and Choice: Insights for Choosers

The upshot of sorting these confusions is that we might derive better connections between prices, costs, and values. Economists study these concepts in developing myriad scientific theories—the nature of cost is a key tool to derive predictions of human behavior. In a competitive market, for example, prices might converge to the marginal cost of production. Laymen make use of these concepts every day, often without knowing it. For example, people tend to sell their labor services in exchange for something they value at least as much as their foregone opportunity. As the nature of cost runs deep throughout economic science, Cost and Choice implies there are many branches of economics where greater scrutiny is warranted. Faulty notions of cost abound; economists and policymakers, unaware of such deficits, might then encourage perverse policies and stifle human flourishing.

Let’s get to it.

In Cost and Choice, Buchanan does not merely develop the notion of opportunity costs; Adam Smith recognized opportunity costs were important (but he failed to recognize their marginal and subjective nature). Children recognize these issues implicitly when asked to choose between going to an ice cream or a toy store. Part of Buchanan’s contribution is that our definitions and assumptions about opportunity costs have logical implications that shape economic science and our views of the world. Making such definitions and assumptions explicit, Buchanan argues, goes a long way in resolving any confusion.

Unfortunately, economists are more often than not sloppy in their definitions and assumptions about costs. Adam Smith, for example, implicitly assumes an objective kind of opportunity cost—one’s time spent on labor, which indicates cost is measurable and observable. The upshot, for Smith, is that this common denominator of value allowed him to connect production costs and relative prices, which served his purposes to explore the nature of value.

With Smith’s classical connection, anyone might then be able to count the number of lines of code written or the number of pages read per hour. With such data, we can derive objective opportunity costs. If we can write twenty lines of code in one hour or read forty pages in one hour, the objective opportunity cost of writing a single line of code is reading two pages. If these goods were marketable, more importantly, we would expect a convergence between objective opportunity costs and relative prices. That is, we would expect people to exchange their service of writing code for nothing less than the service of reading two pages. Just as I would be more willing to sell my line(s) of code to people willing to pay me more than two pages (or more), I would be less willing to sell as people offer less than two pages.

Yet, prices might not converge towards objective opportunity costs. As demand for lines of code rises, for example, people are willing to pay more for that code regardless of the objective opportunity cost, i.e., the time one could have spent reading. That is, the exchange value of a line of code can remain above its objective opportunity cost as long as demand remains elevated. With such a divergence in what the building blocks of economics predict, perhaps there can be no predictive science of economics. Or, perhaps, there are inefficiencies within the nature of individual trading partners or in markets themselves, e.g., monopolies, that explain when costs and prices diverge.

Rather than bemoan this finding, critique the unscientific nature of economics, and advance notions of inefficiencies, Buchanan reviewed centuries of discourse on value and cost—from Adam Smith and David Ricardo to Carl Menger, Phillip Wicksteed, and Alfred Marshall and from Frank Knight to scholars in the “London Tradition”, such as Lionel Robbins, F.A. Hayek, Ronald Coase, and George Thirlby (and Ludwig von Mises). With this review, Buchanan sets the stage for his big reveal. He argues that our confusion over costs rests in the selection—consciously made by individual economists—of particular objective measures of opportunity costs at the expense of the more genuine nature of value and opportunity cost, namely that it is subjective.

Following the London Tradition, Buchanan argues costs are subjective. This approach is profound because it generates a more genuine science of choice grounded in choosing individuals, and it maintains the logical notions of cause and effect that facilitates prediction. Just as people have myriad goals, they have myriad subjective evaluations of foregone opportunities. With such goals in mind, we can now better understand—and predict—how people might behave in response to changing (subjective) opportunity costs. The overall problem for Buchanan is that in their attempts to make more tractable models about values, costs, and prices, economists ignored individuals, their values, choices, and the real costs individuals perceive.

Buchanan’s resolution is a framework of subjective opportunity costs, which are primarily choice-influencing costs. Such costs imply the following (p. 41): costs are only borne by an individual; they are subjective in that they exist in the mind of an individual; costs are based on expected future states of the world; costs necessarily follow choice; costs can only be measured by an individual; and costs are dated at the moment of choice.

These points are more biting when Buchanan returns to a brief discussion on the nature of market equilibrium. With reference to the “subjectivist economics” of Hayek, he states, “[Equilibrium] is attained when the plans of participants in the economic interaction process are mutually satisfied. Although prices continue in this equilibrium to bear some relationship to costs, such costs carry no objective meaning and cannot, therefore, be employed as criteria for determining prices in some welfare or efficiency sense” (48). Thus, Buchanan urges economists to consistently apply the notion of subjective opportunity costs, which implies that notions of market equilibrium—among other concepts—depend on the subjective experiences and values of choosing individuals.

With this primary confusion resolved, Buchanan then tackles subsidiary confusions that rely on faulty notions of cost. Overall, Cost and Choice is about the inappropriate application of models of cost economists use—mistakenly—in their attempts to describe real-world behavior. For example, the logic of choice-influencing costs implies that public expenditures do in fact have opportunity costs, even when resources are underemployed. Commentators might claim that public projects are relatively inexpensive given workers are underemployed or that they have a relatively low opportunity cost, perhaps as during the Great Depression. According to Buchanan, however, such claims are based on a narrow version of opportunity costs, namely an objective measure of market wages. Yet, the choice-influencing costs of makework projects—like building post offices—refer to the value of projects that could have been advanced. Policymakers might not greenlight such projects if they considered the relevant choice-influencing costs.

The logic of choice-influencing costs also has implications for cost-benefit analyses. Buchanan cautions against the use of cost-benefit analyses—especially in public, governmental settings—that are typically used to favor some projects over others. Such analyses, Buchanan argues, are either unconnected from the values individual choosers have, or they are motivated by the normative values of different economist-observers. If either is true, it becomes more difficult to claim these analyses genuinely reflect the options people and groups face, let alone how to choose. Buchanan states, “The cost-benefit expert cannot have it both ways. He cannot claim ‘scientific’ precision for his estimates unless he restricts himself rigidly to objectively observable magnitudes. But if he does this, he cannot claim that his estimates reflect reasonable norms upon which ‘social’ choices should be based.”

And there are implications for standard Pigovian welfare analysis, the kind of economics typically used to justify government tax/subsidy policies to address externalities. If a tax, for example, is meant to correct behaviors that lead to externalities, what are policymakers to do if they cannot adequately measure costs—as only individuals bear costs at the moment of choice—or if individuals are more responsive to alternative kinds of opportunity costs—costs which only individual choosers are aware of? Buchanan states the problem succinctly: “Observed money outlays need not reflect choice-influencing costs, the genuine opportunity costs that the decision-maker considers” (71). Later on, Buchanan also notes that the Pigovian logic fails once people develop other-regarding norms—typical in civil society—which likely alters the divergence between private and social costs.

Buchanan sets his sights on the notion of market equilibrium too—a cornerstone of modern neoclassical economics. Supply and demand analysis, the bane of many economics 101 students, is a kind of equilibrium analysis. While individual rational choosers behave according to expected costs and benefits, this implies they are at an equilibrium as they choose. Yet, this does not imply the larger group of market participants are at equilibrium, given costs are impediments to choices related to the higgling of a market. Rather, it implies markets are more likely characterized by disequilibrium, whereby participants act and interact with others, which constantly changes market conditions.

Buchanan also explores several other topics where choice-influencing costs alter standard conclusions. He argues, for example, that the foregone opportunities of military service vary, which makes it difficult impossible for military planners to measure the genuine costs of staffing a military. He argues the costs of criminal activity—and thus any punishments we might want to impose as a deterrence—depend on choice-influencing costs criminals perceive, e.g., their norms about harming victims. He also revisits the socialist calculation debate to suggest that while generally correct, Mises, Hayek, and Robbins underemphasized the choices individuals faced, which would have strengthened their arguments. Socialist economic planning can only work, according to Buchanan, if individuals are transformed to ignore their subjective opportunity costs in favor of the values of planners. Buchanan then notes, again, that the heart of the matter is a confusion in the nature 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. (89)

All in all, Cost and Choice takes stock of the widening gap in modern economics because of the failure to recognize the nature of choice-influencing costs. For economists, policymakers, and laymen interested in advancing cost-benefit analyses, estimating the net benefits of public projects—whether it is infrastructure spending or staffing a military—extolling the virtues of government intervention, developing equilibrium-based models of market activity, assigning efficient punishments—for criminals or on externalities—Cost and Choice is a thorn in their side. Buchanan argues their assumptions about costs are flawed and any conclusions should be taken with big grains of salt because they poorly represent the choices real people face, as well as their subjective evaluations of foregone opportunities.

To be more biting for modern readers, Buchanan would cease all cost-benefit analyses unless they were advanced by individual choosers; no more reports from consulting, advocacy, or governmental groups advancing a new project. Such reports are often afforded a scientific status or authority, which are used to justify behavior whereas they are often entirely unconnected to individual decision making. Buchanan would be the first to yell that the emperor wielding such studies has no clothes, no logical basis to justify future expenditures.

Public expenditures, which seem increasingly frequent, also come under indictment. Cost and Choice suggests that governments often understate the costs of such expenditures. Annual expenditures on Social Security, healthcare, defense, infrastructure, education, and so on—major components of government expenditures—necessarily fail to account for the fuller costs when choice-influencing costs are ignored. Such costs refer to the value—defined by individual choosers—of foregone activities. Recognizing such higher costs, it is likely citizens would encourage their elected representatives to care more about such matters. Such considerations would likely limit the size and scope of government.

Cost and Choice: An Inquiry in Economic Theory is one of Buchanan’s epic critiques of economic science and his attempt to redress the wrongs implied by faulty notions of opportunity costs. In doing so, the book remains a classic work in economics, but it also provides a key to better understand myriad individual behaviors: opportunity costs to individual choosers depend on the choices they face. Any other notion of opportunity cost is devoid of meaning and provides negligible predictive content when divorced from choice.

Footnotes

[1] James M. Buchanan, Cost and Choice: An Inquiry in Economic Theory. Foreword by Hartmut Kliemt. Liberty Fund, Inc. First published 1969. Free online at Cost and Choice: An Inquiry in Economic Theory.