Economists’ cost confusion

Published 10:36 pm Wednesday, August 27, 2014

Last week I discussed how college football illustrated how costs are less tangible than people suppose. Many decisions affect the cost of operating a football program, and it is impossible to say how much it “should” cost to field a team independent of these decisions. Economists have sometimes ignored the intangible nature of costs, and this confusion lies behind many wasteful government policies.

The ability to express costs in dollar amounts contributes to the illusion that costs are measurable and exact. You can fairly easily “price out” the ingredients for your favorite peach cobbler recipe, and we might think of this as the cobbler’s cost. Yet one can always use better (or inferior) ingredients, and the ingredient cost does not include the use of your oven and cooking utensils, energy to heat the oven, or the time and effort involved.

A business’s costs are even less clear. A commercial bakery could substitute machines for labor or change the recipe if an ingredient gets too expensive. The costs of ingredients, labor, energy, and rent constantly change. Last month’s cost of peach cobblers is already history and may not reflect costs this month or next.

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Our economy functions best when prices are kept in line with costs, so that the price of peach cobbler reflects the cost. A market economy relies on profit and competition for this. A business owner cannot check the difficult cost decisions she must make against an answer key. Canned peaches might cost less than fresh peaches, yet the decline in taste may reduce sales. Owners must also ensure that their employees work hard and make sound decisions. Profit rewards the effort of owners who successfully control costs.We also rely on competition. A bakery which charges too much – relative to the usual cost of production – can lose business to a price cutting rival. And a company unable to make the right decisions will be driven out of business.

People sometimes ask me why certain products cost so much. I usually do not have the slightest clue, and only someone engaged in a business is likely in a position to answer. But I am confident that competition between profit-seeking businesses is the best way to keep long run costs as low as possible.

Economists who believe that costs are easily measured often believe that cost control is possible without profit and competition. Many schemes for government management of markets proceed from this confusion. Progressive era economists proposed the regulation of electric, phone, natural gas and other public utilities to provide us with the benefits while dispensing with actual competition. Having multiple sets of power, phone and gas lines is admittedly costly, and economists thought we could avoid such “wasteful” competition.

Yet the unresponsiveness of the regulated telephone industry made football-shaped phones a radical innovation. Today most Americans use cell phones offered by companies competing vigorously and many no longer even have a home phone line. Electricity regulation allowed overinvestment in generating plants and rarely scrutinized the bulk of expenses. A modified version of this thinking produced local cable television monopolies. Economists thought costs could be managed without competition, leaving millions of Americans waiting in vain for the cable guy.

Economists’ confused belief that costs can be controlled makes government-run businesses not trying to profit at consumers’ expense look like a good deal. Yet the Postal Service, Amtrak, and public transit systems demonstrate the futility of trying to provide the benefits of markets without an actual market.

Los Angeles made news in 2010 with a $580 million school built to serve 4,200 students. Such “Taj Mahal” schools costing over $100 million are increasingly common in the U.S., while, the Pentagon famously overpays for items like toilet seats and hammers. Again the underlying problem is the fuzziness of costs. Numerous upgrades could potentially enhance a school’s learning environment. The lack of a bottom line and competition allows evasion of hard choices about whether the upgrades actually improve educational outcomes and justify the cost.

Many issues economists study seem quite removed from everyday life. A discourse on the nature of costs might seem suited only for a university colloquium. But it is just one more instance where muddled economic thinking has enormous practical consequences.


Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision.

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About Dan Sutter

I am the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University.

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