Knowledge And Decisions

When people casually speak of “the” cost of producing something, they usually mean the average cost — that is, the total cost of running the enterprise divided by the number of units of output it produces. But for actual decision-making purposes at any given time, the incremental cost is more crucial. The total cost of running an airline obviously includes the cost of airplanes, but in deciding whether or not to make a particular flight, what matters at that point is whether the incremental cost of that flight will be covered by its incremental value to the passengers, as revealed by what they are willing to pay for it. This question has to be faced whether the airline is a private company in an unregulated economy, a government-owned enterprise in a socialist state, or any other combination of economic and political institutions. The mechanisms by which the decision is made will be different, and of course the actual decision may be influenced or even determined by the nature of the institutional mechanism, but the point here is that the problem itself is independent of institutions, and institutions can be assessed in terms of how well they resolve the problem.

An airplane which would otherwise remain idle on the ground during a particular time has a very low cost in the economic sense of cost as a foregone alternative. If a plane that would otherwise remain in a hangar overnight is instead brought out at midnight to fly a party of vacationers to a nearby resort, the cost of this short flight that does not interfere with its other schedule of flights is much less than the “average” cost of an airplane flight. In this case, the incremental cost of the flight is little more than the cost of fuel and a flight crew, since the plane itself is there for another purpose anyway. In a price-coordinated economy, the amount of payment by the passengers required to induce the airline to fly under these conditions will tend to be much lower than the amount required to induce the same airline to set aside planes to fly the same distance on a regular schedule. For the latter decision, the passengers would have to pay an amount sufficient to cover not only the fuel and flight crew but to cover also the cost of the plane itself and the airline’s various “overhead” expenses. In an economy coordinated by government decisions, the same economic resolution would be efficient, though it would have to be reached institutionally through a political or administrative process. Whether the same resolution would be reached in fact would depend upon the extent to which the particular institutional arrangements convey the same knowledge of consumer preferences (incremental trade-offs) and production costs (incremental trade-offs), and whether that knowledge was conveyed in a form that was “effective” in the sense of constituting a personal incentive to the decision maker.

It often costs much more to make a commitment in advance to produce a given good or service than it does to produce the same good or service with equipment already provided for other purposes. In some substitutions incremental costs are less than average costs — sometimes only a tiny fraction of average costs. By the same token, if the existing equipment is already being used at its normal capacity, the additional use may cost even more than the normal use, as in the case of additional demand for electricity at a time when the generators are already straining. The difference between average cost and incremental cost is crucial not only in economic institutions in various economic systems but it is also crucial in political, legal, and other systems as well. The incremental cost of a telephone’s ringing may be quite low to a resting and slightly bored housewife, but may be maddeningly high to a housewife who is already simultaneously coping with a crying baby, a pot boiling over on the stove, and a fight among her other children. The incremental cost of making certain precedent-setting judicial decisions is not simply the cost in that individual case but the cost of committing legal institutions to settling similar future cases on a similar basis. This cost may be hundreds or thousands of times as large as the individual decision in itself. Looked at another way, where certain decisions may be made in any of a number of different institutions within a given social system, the institutional location of that decision-making process may raise or lower the costs entailed by large multiples of what is involved in the individual decision as such.

DIMINISHING RETURNS