Book Review: Cost and Choice
Yun Zhang
Almost all economics textbooks and managerial accounting books begin with cost curves. The usual setting is that an owner-entrepreneur makes optimal input decisions in order to produce certain amount of outputs. She is faced with competitive factor market and product market. In such a setting, cost curves can be obtained by multiplying optimal input quantities by their competitive prices. Cost was such a simple definition to me that I seldom dwelled on its subtlety.
James Buchanan in his book Cost and Choice emphasizes an important however often overlooked point: cost has meaning only when coupled with choice. The word cost in the title means Opportunity Cost. It is what decision-taker sacrifices or gives up when he or she makes a choice. When a person is faced with several courses of actions to choose from, the cost of choosing one alternative is the benefits foregone with the most attractive alternatives among the rest. Opportunity cost is an ex ante or forward-looking concept: decision is made purely based on decision maker’s assessment of what will happen in the future. This definition of cost has following implications.
It is subjective because only the decision maker can tell which alternatives he or she has considered at the time of choice and how much he or she values these alternatives. It only exists in the mind of the decision maker. Consequently, cost is probably not possible for others to observe.
The author cautions us against the confusion that the word “cost” may have different meanings in different settings. There are two kinds of cost. One is choice-influencing cost, the other is choice-influenced cost. Opportunity cost, as defined above is choice-influencing cost as it directly influences one’s choice. However, choice has its consequences. For example, once a decision is made to construct a new plant. Land has to be purchased or leased. Construction contract has to be signed. And equipments are brought in. However, this ex post decision-influenced cost is not directly related ex ante choice as it happens after the decision is made.
What accountants usually record is decision-influenced cost. For example, how much labor costs are incurred in the fiscal year? All these records are about monetary outlays which result from a certain managerial decision. The word “monetary” is important, as decision sometimes may be dependent on concerns which can not be evaluated in monetary terms. For example, one may prefer to cleaner air so she chooses to buy a more expensive car with clean-fuel technology. Furthermore, although accounting records provide useful information, it is not the same as opportunity cost. This cautions us against relying too much on accounting records for decision management and control purposes.
In addition, opportunity cost is also different from budget, although budget is also an ex ante concept. Budget is an ex ante assessment of the choice influenced cost of a chosen alternative. In other words, budget is made after a decision is made to take an alternative.
One question comes to my mind is that under what conditions these two concepts (choice-influencing and choice-influenced) are of the same value. Suppose we are in a general equilibrium setting with complete markets. Factor markets and product markets are all in equilibrium. And individuals ruthlessly maximize their own utilities. In such a setting as described in almost all Econ textbooks, there would be no need to distinguish choice-influencing v. s. choice-influenced decision. This is because equilibrium forces make the two equal.
Buchanan’s emphasis on the subjectivity side of cost shows that he doesn’t treat individuals as economic automaton. Instead, he well recognized the fact that human decision sometimes is quite arbitrary and irrational. These two different views of human behavior, in my opinion, serve as the foundation of this book.
What if the current accounting practices are changed to emphasize describing opportunity cost instead of describing choice influenced cost?[1] Although opportunity cost is the right construct when making a decision, its role in managerial control is questionable. For control purposes, at least some degree of verifiability is needed. However, as discussed in the book, opportunity cost is fundamentally a subjective construct where no one other than decision-maker herself is able to observe. This may lead to strategic behavior by the decision-maker. For example, manager can justify her decisions using some alternatives which never realize. In contrast, choice influenced cost is somewhat objective and less susceptible to manager’s self-interested behavior: cash outlay and material usage are easy to calculate; labor hours are readily obtained. Choice influenced cost has advantage in evaluating and motivating employees. In contrast, choice-influencing cost is more useful for decision-making purposes.
Decision-making and decision control are two sides of the coin. Sometimes, tradeoff between these two goals has to be made. I think both methods have advantages. Whether one is better than another is situation specific and depends on this tradeoff.
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[1] This question was raised during our class discussion by Prof. Sunder.