Opportunity Costs, Capital, and Calculation

Steven Horwitz

I'm in Atlanta at the moment at FEE's "Introduction to Austrian Economics" seminar.  Last night, Paul Cwik gave a talk on "Menger and the Early Austrians" that included a discussion of Wieser's role in originating the idea of opportunity cost.  What struck me was that Paul used examples all from the producer's perspective.  That is, he framed opportunity cost in terms of the expected value of the output sacrificed by putting one unit of an input to its perceived highest valued use.  I don't have my Wieser with me for some strange reason, so I don't know if Wieser made the case from the producer side, but assuming so, it led me to an interesting "musing."  (I'm sure Richard Ebeling will give us the facts on this one!)

Most economics textbooks teach opportunity cost in terms of foregone utility from consumption choices (e.g. "beer vs. pretzels"), although Economic Way of Thinking is an exception.  And I think this is consistent with the post-Marshallian vision of most economists wherein subjectivism is about consumption and value but production decisions are based on more objective notions of cost as embodied in the cost curves.  Other than EWOT, how many intro books derive the supply curve using an approach that emphasizes the rising marginal opportunity cost of alternative uses of the inputs?

What struck me was how this more Austrian approach that recognizes the subjectivity of opportunity costs on both sides of the market links so nicely to the centrality of capital and economic calculation in the Austrian theory of the market process.  The fact that capital goods HAVE opportunity costs is the equivalent of saying that they have multiple but not infinite uses.  In a world of perfectly specific capital goods, they have no opportunity cost because each input has only one use.  In a world of perfectly homogeneous capital goods, they have no opportunity cost because each input can be used equally well for each output.  Seeing opportunity cost on the supply side implies a conception of capital that matches with how the Austrians see it.

And this, of course, is why economic calculation matters:  we need a way of determining whether capital goods are being put to their most highly desired use precisely because they DO have opportunity costs.  Should we use the steel for more bridges or more skyscrapers?  Should we use the potatoes for more french fries or more clam chowder?  Those questions only make sense in a world where capital goods have a limited number of uses, and thus have opportunity costs.  It is the price system, which enables calculation and budgeting, that at least gives us a shot at making some sort of comparison and determining the best decision.  Prices are, as Frederic Sautet said today, a "compass" that gives us a sense of what direction we should head. 

The multiple specificity of capital, economic calculation, and producer side opportunity costs are all an interconnected part of the Austrian vision.  One could add into this mix Wieser's work on imputation as well.  It also would seem to connect with Hayek's greater sympathy for Wieser's work, especially the stuff on imputation, than that of his contemporaries and modern Austrians.  Hayek's concerns too were with the intersections among capital and calculation and the issues raised by imputation, as he notes in his end shot at Schumpeter in "The Use of Knowledge in Society."

Indeed, more generally, this mix of concepts points to why Austrians reject, or at least strongly stress the limits of, general equilibrium analysis:  all of these problems are absent in such a world.

As I said, this is nothing more than a "musing" rather than a tighter argument so I'd be interested in comments, especially on the question of Wieser's explanation of opportunity costs.  It does seem to me that thinking of opportunity cost being first and foremost about the application of inputs to outputs puts the central problem of the market order (the allocation of capital via economic calculation) into its rightful central place in economic theory.

Comments

[Lode Cossaer]

I feel slightly proud, because I finished - just today - a chapter in a little intro book on the economics of a free market, in which I also explained oppurtunity cost in terms of productionalternatives (combined with the discussion on comparative advantage). Not that this matters in any way, but it's probably because I'm currently studying EWOT - I found a whole bunch of them for 6 euro on a market which sells overstock and stuff like that. (I'm totally bringing one of them to Advanced Austrian, for an autograph!)

Unfortunately; my take on Wieser is severly limited, but I go to great pains to explain (in the chapter) why it's important to have capital theory; the main argument - obviously - being that capitalequipment is heterogeneous, i.e. can have alternative uses.

Basically; I'm saying: I agree.

[Current]

> And I think this is consistent with the post-Marshallian
> vision of most economists wherein subjectivism is about
> consumption and value but production decisions are based
> on more objective notions of cost as embodied in the
> cost curves.

I think that the modern mainstream view can help with this.

Because of information gathering and collating costs no business can really build precise "cost curves". So, such production decisions are also subjective. And that provides a link to entrepreneurship.

Incidentally, the same sort of mainstream "information cost" view also provides an alternative way to look at account falsification. We can say: the information costs associated with accurately deflating a set of accounts are too great to make it worthwhile.

[Jerry O'Driscoll]

Cost and Choice by James Buchanan is the most authoratative statement of the subjectivist view of opportunity cost. Schumpeter was excellent on the issue, especially with respect to Marshall's confusion on the two blades of the scissor. Schumpeter noted that both blades were composed of the same subjectivist material.

[Danny]

Something tangentially related that popped into my head while I was reading this post:

One of the ideas which Hayek harps on repeatedly is the fact that the price mechanism enables people to make effective economic decisions without actually being aware of the true social opportunity costs of utilizing the resources they do. All they know is that it costs them money to use resources. Hence, from the producer's point of view, production decisions would not involve a deliberate attempt to allocate resources to their highest-valued uses from the point of view of social opportunity cost.

I know you weren't suggesting otherwise, but it might be relevant in thinking about why some people have tended away from emphasizing opportunity cost when talking about these sorts of things. Given that opportunity costs can be conceived in different ways, things can get confusing pretty quickly. The last thing you want is for an undergrad to walk away thinking, "Man, producers should stop making pointless luxury items for the rich -- the opportunity cost of using those resources that way is way too high to justify producing them!"

[Mauricio Flores]

The true social cost is a rather confusing concept. cost is only a cost as long as it affects the behaviour of the person making the choice. because of that, "social" cost should not be very important for any type of normative "welfare" economic analysis. it certainly does not affect anyones behaviour, by that I mean it is not included into anyones assessement of the alternative use of resources. Unless they explicitly want to take into account some kind of subjective valuation of what "social" cost is. Prices only imperfectly reflect some kind of "social" evaluation. But they are certainly way better than any kind of information that could be obtained otherwise in a market order. Given the fact that there are alternative but limited uses to capital, it would make a lot of sense for some producers to specialize in producing stuff for the rich, even though at least some of the capital of that production process could be use to feed starving children. As long there is a market order the subjective cost approach is the analysis tool. I agree with Danny, in intro courses it is imperative to define the concept of alternative cost way clearer than it is done now, if at all.

could anyone recommend any book by Wieser that I should read?

[Greg Ransom]

Wieser's _Natural Value_ is here:

http://oll.libertyfund.org/index.php?option=com_staticxt&staticfile=show.php%3Ftitle=1685&Itemid=27

[Greg Ransom]

If you read closely, this stuff is at the heart of Hayek's case against Lange's "solution" to the problem of collectivist economic planning (I've got the specific passages flagged in my copy.)

Steve writes:

"The multiple specificity of capital, economic calculation, and producer side opportunity costs are all an interconnected part of the Austrian vision. One could add into this mix Wieser's work on imputation as well. It also would seem to connect with Hayek's greater sympathy for Wieser's work, especially the stuff on imputation, than that of his contemporaries and modern Austrians. Hayek's concerns too were with the intersections among capital and calculation and the issues raised by imputation, as he notes in his end shot at Schumpeter in "The Use of Knowledge in Society.""

[Daniel Kuehn]

I'm confused, Steve - how exactly are you thinking that everyone else derives those cost curves? At William and Mary, we learned it was the opportunity cost of capital. In I think every intro economics course you learn that there's a distinction between accounting profits and economic profits - and that distinction is precisely the opportunity cost of capital.

In a quick google search I found references to the opportunity cost of capital in lecture notes for Montana University (http://www.montana.edu/econ/djyoung/301/ch7f09.pdf), Boyes and Melvin's textbook (http://college.cengage.com/economics/boyes/fundamentals/3e/students/outlines/ch05.html), Berkely teaches it (http://are.berkeley.edu/courses/ECON100A/2006/lecture_slides/lecture10.ppt#261,4,Business vs. economic costs), so does this worksheet from BVT Publishing, whoever that is (http://www.bvtpublishing.com/files/BV13Guide03.pdf), Santerre and Neun's Health Economics textbook teaches it for medical firms (http://tinyurl.com/2dr4eau), the Baumol text apparently teaches it - this is an online quiz for that textbook (http://www.swlearning.com/economics/baumol/baumol9e/quiz_perfect/perfect.html), it's taught at Drexel (http://faculty.lebow.drexel.edu/mccainr/top/prin/txt/Comp/PC.html), Lipsey and Harbury's textbook has it (http://tinyurl.com/27ew4sd), Oswego teaches it (http://www.oswego.edu/~spizman/eco101ch9a.htm), Williamette teaches it (http://www.willamette.edu/~fthompso/501/Ch20.ppt#372,1,Slide 1).

That's from the first two pages of my google search, but I think I'm making my point. I'm just curious how you think cost curves would be taught WITHOUT teaching about opportunity cost of capital. I can't even conceive of how you would derive one without that, so I'm not sure what you have in mind.

I think Austrians and really anyone who has models that are primarily driven by the structure of production place special emphasis on the opportunity cost of capital. I don't think it follows, however, that that is something that nobody else is teaching or understanding, or that opportunity costs only matter for people when it comes to consumption.

[Mario Rizzo]

I think that perfectly homogeneous capital can have an opportunity cost as long as it is scarce. However, its application will be more or less mechanical. Furthermore, we would get no phenomena like "investmentmenmt that raises the demand for capital" and so forth.

[Bob Layson]

Being set within the price-system allows the producer to economise on inputs and not to take a lesser opportunity when a greater is perceived to be available.

The surrounding price-system process itself may be said to economise on producers and to make manifest, through insolvency and the incorporation of their assets elsewhere, the opportunity cost of too many firms entering the same industry.

[Roger Koppl]

What Mario said.

[amv]

Steve,

Wieser indeed makes this point. I'm working on a paper showing that it carries over to Arrow-Debreu based production theory. Schumpeter in History of Economic Analysis attacks Marshall's synthesis from this perspective. Robbins speaks of producers' supply curves as inverted demand curves and argues for strictly increasing marginal costs due to the strength of excluded demand.

[The Cuttlefish of Cthulu]

Steve just got faced by Daniel Kuehn.

[Current]

Daniel Kuehn,

I think you're wrong about this.

The treatment of opportunity cost by Austrian Economists is very different to that by others. Take James Galbraith and William Darity's book "Macroeconomics" as an example. Opportunity cost is only mentioned in the chapter about Post-Keynesian economics. That section begins by saying that all other schools of economics treat capital as a homogeneous stock, except post-keynesians. It then gives Sraffa's own-rate-of-interest model.

[Richard Ebeling]

Steve asked about Friedrich von Wieser's conception and use of the opportunity cost idea.

(It should be remembered that while Wieser formulated the concept early on, it was David Green, in his article "Pain-Cost and Opportunity Cost" (1894) who gave it the name with which we are familiar . And it was Pantaleoni, who in his "Pure Economics," referred to it as "Wieser's Law" in 1889.)

In the context of Steve's question, the clearest statement, and most readily available in English, of Wieser's view can, perhaps, be found in his article, "The Theory of Value: a Reply to Professor Macvane" in "The Annals of the American Academy of Political and Social Science (March 1892) pp. 24-52.

There, Wieser challenges defenses of Ricardo's conception of cost as labor input or the "pain" of effort in producing products. Rather, cost is the "forgone" (marginal) utility of that which could have been produced or for which the resources might have been applied in another direction.

But how does the "cost" get reflected in the prices of the market. They are the expectational estimates of competing entrepreneurs or businessmen in judging the value of the finished products the factors of production could be employed in manufacturing, which then becomes objectified in their bids for purchasing and hiring those factors in the form of factor prices.

But it was Green in his 1894 article on opportunity cost who emphasized very directly that cost is a subjective estimate by the decision-maker about a "might-have-been," i.e., that which could have been done instead if the chooser had not decided on another course of action.

And it is really in Herbert Davenport's 1913 treatise on "The Economics of Enterprise" that cost is most distinctly insisted to be only known and born by the individual decision-maker weighing and selecting among alternatives.

In the market, consumer demand, of course, ultimately drives the market, but factor prices emerge out of the judgments of the entrepreneurial "intermediaries" who stand between and link together the demands of consumers with the use and appraisal of the factors of production.

The entrepreneur stands “as the intermediary in the case, representing in his hiring and buying of productive factors, the demand of the purchasing public, and representing in his cost computations, the degree of scarcity of the production factors relative to the demand for their products.”

It is "the competition of the entrepreneurs of each industry with the other entrepreneurs of the same industry, and of the competition of the entrepreneurs of each industry with those of other industries” that brings about the prices of the factors of production."

Since it is through the prism of the entrepreneur’s expectations that decisions are made, then the costs of production – in the form of the money prices that are offered and paid for the hire and use of factors of production – are reflections of the mental judgments of those who undertake the responsibility of “captaining” the society’s enterprises. All costs, therefore, are entrepreneurial costs within the firm.

And it is their estimates that determine what land, labor, and capital are worth in alternative uses. Their estimates are based on what they think consumers may want and the prices they might be willing to pay. But, nonetheless, they are the subjective appraisements about a future that might be, and which is not yet realized.

As Davenport expressed it, the entrepreneur’s “costs” of production are reducible to his individual judgments, estimates, and expectations of what he sees as the opportunities and their relative future market worth. “The cost computation must stand as a purely personal and individual computation . . . it must express and report his [the entrepreneur’s] method, process, and decision . . . .The bearing of cost . . . is significant only for such person’s as undertake the cost.”

The concept is first formulated by Wieser, but in those early years before the First World War, it is in the hands of David Green and Herbert Davenport that is individualistic and subjective qualities were most clearly brought out.

Green highlighted this, also, in his 1895 review of the English translation of Wieser's "Natural Value," in which he distinguished the Austrian approach to value and cost compared to William Stanley Jevons. For Jevons, "value" are expressions of the ratios of exchange at which goods are traded in the market place, while for the Austrians it is always linked to subjective valuation.

Said Green: "The difference must not be overlooked. On one side value is regarded as a ratio between commodities, on the other as importance for human well-being. One conception is objective, the other subjective. . . It seems to be largely through the Austrian influence, however, that recent contributions to economic theory have generally accepted the subjective concept as the primary meaning of value . . . The Austrians, as Menger’s definition indicates, consider value as primarily as an individual matter.”

I hope this helps in some small way, Steve.

Richard Ebeling

[Rafael Guthmann]

"And I think this is consistent with the post-Marshallian vision of most economists wherein subjectivism is about consumption and value but production decisions are based on more objective notions of cost as embodied in the cost curves. Other than EWOT, how many intro books derive the supply curve using an approach that emphasizes the rising marginal opportunity cost of alternative uses of the inputs?"

Well, in traditional economics the prices of the factors of production are taken as given by the producer. For example, marginal cost would be constant with constant returns of scale. If would only increase due to some decreasing returns to scale or because one factor is fixed.

The opportunity cost of employing the factor of production for the producer is fixed in the sense that his demand for the factors of production is insignificant compared to total demand, variations of his demand will not produce a change in price.

If you assume that his demand for the factor change it's subjective opportunity cost, you have a case of monopsony.

[Dave Prychitko]

Besides EWOT... Alchian & Allen.

[Denys Picard]

Maybe you should take a distance from the Austrians and classical and neo classical frameworks, and measure in the real world whom determines price and what price information carries with it.
Prices are determined strategically by market makers (the corporations)and the signal they carry is no direction of optimal ressource allocation.
Firms price to shape and dominate their market.
Not as a way to increase welfare. The word optimization in this case does not carry its true meaning, there is no economy wide benefit in firms pricing, no true optimization of ressources.
Opportunity costs are not a derterminant of efficiency under these rules...
I tell you, take a step away from the misconception and fallacies of neo-classisism...