Knowledge And Decisions

The government is not behaving irrationally from a political standpoint. Neither are businesses behaving irrationally from an economic standpoint when they seem to be selling “below cost.” The costs of an industry are difficult — if not impossible — for third parties to determine. As we saw in Chapter 3, costs are foregone options — and options are always prospective. The past is irrevocably fixed, so all options are present or future. The objective data available to third parties refer to past actions taken in response to the prospective options subjectively foreseen as of that time. Those subjective forecasts themselves exist neither in the objective data of the past actions nor in the objective record of subsequent events, which may or may not have conformed to the forecasts. Apparently the foreseen costs were less than the foreseen benefits when Napoleon invaded Russia, or when the the Ford Motor Company produced the Edsel.

Government regulation can never be based on these fleeting and subjective appraisals of alternatives which actually guide business decision makers. Even if businessmen could remember everything exactly and describe it precisely, the government would have no way of verifying it. Government regulations and their estimates of “cost” are based on objective statistical data on actual outlays. Therefore businesses which determine their prices on the basis of options facing them at a given time often price below objective cost as defined by past expenditures on production.

If the hypothetical Zingo Manufacturing Company is launched with the idea that the world will be eager to buy zingoes, it may spend great sums producing that product, only to discover after the fact that consumers are so disinterested that zingoes can be sold only at prices which cover half of the past costs incurred in producing them. The options at that point are to (1) sell the existing zingoes at this price or (2) to incur additional costs by holding zingoes in inventory, in hopes of being able to drum up more consumer demand through advertising or other devices, or (3) declare bankruptcy and let it all become the creditor’s problem. Depending upon the capital reserves of the firm, selling “below cost” may allow them to minimize their losses on this product and survive as a firm producing some other product(s) in the future. But, regardless of which future option may be preferred, past “cost” data are irrelevant. As economists say, “sunk costs are sunk.” They are history but they are not economics.

The general principle applies much more widely than in economic transactions. Once Napoleon realized that he was losing in Russia, it mattered not how many lives had been sacrificed for the goal of conquering the country, or in capturing the Russian territory currently held; if future prospects were not good, he had to pull the army out of Russia, and write off the whole operation as a loss. In retreating, Napoleon may well have been returning territory to the Russian armies “below cost” in terms of the lives originally sacrificed to capture it. In military terms, as in economic terms, a given physical thing does not represent a given value without regard to time or circumstances. Land which was prospectively valuable as a strategic area from which to attack the rest of the country may turn out in retrospect to be just so much impediment on a retreating army’s escape route.

Businesses sell “below cost” not only when they have mistakenly forecast the future, but also when their costs for a given decision under specific conditions are less than the usual costs under the usual conditions. As seen in Chapter 3, the use of otherwise idle equipment may involve far lower incremental costs than acquiring equipment to serve the same specific purpose. Pricing according to these incremental costs (“marginal cost pricing” in the jargon of the economists) may be rational for the seller and beneficial to the buyer but is often attacked, penalized, or forbidden by the government. Regulatory agencies have consistently opposed low prices based on low incremental costs, and have insisted that the regulated firms base their prices on average costs, including overhead. The extent to which regulatory agencies — the Interstate Commerce Commission, Federal Communications Commission, Civil Aeronautics Board, etc. — keep prices above the level preferred by individual firms remains largely unknown to the general public, to whom such agencies are depicted as “protecting” the public from high prices or “exploitation” by “powerful” businesses. However, the government agencies are not being irrational, nor are the businesses altruistic. High volume at low prices has been the source of more than one fortune. Each side is responding to the respective incentives faced.