All Commentary
Friday, January 1, 1971

Cost-Plus Pricing


Every selller of a commodity or service wants to cover his costs of production and receive something over and above such costs if pos­sible. He spends long hours keep­ing records and, with rare excep­tion, believes that he actually sets the price of his goods and services by adding a margin above his expenditures.

The truth, however, is that all recorded costs of an item are washed out and rendered irrele­vant by the actual market price at which that item is traded—a price determined by the competitive forces of supply and demand. That price becomes the new “cost” of consideration to the next user, regardless of how much labor he or any prior owner expended on that particular item. And if he sells it in turn to another willing buyer, the latter’s demand will have as much to do with determining the price as do the supplier’s recorded expenses. Cost, of course, influences the supply side of the market and thus the price; but costs incurred do not determine price.

To believe or to say that any item of commerce is but the sum of the costs incurred in producing it—a package of somebody’s prior labor—is to introduce a confus­ing irrelevancy into the bargain­ing process that determines the price at which free trade takes place. The only relevant factors in a voluntary trade are that each party to the transaction, at the moment, values what he re­ceives more than he values what he gives. Each thinks that he gains from the trade, no matter what costs were incurred to pro­duce what he gives or gets in exchange.

That’s all there is to the subjective theory of value. It takes into account the demand as well as the cost of production. And this determination of prices in the open competitive market affords the current running record of costs and returns that a business­man needs in order to calculate profit or loss and judge whether or not to continue a particular business activity.

His record of yesterday’s costs and returns may afford him some clues as to the efficiency of his procedures. But today’s prices are the nearest indication available to him as to what tomorrow’s costs and returns may be. What are to­day’s prices for the buildings and machinery in use as compared with other production facilities now on the market or waiting to be in­vented? What are today’s prices for various raw materials as com­pared with available or potential substitutes? How do today’s prices for hired help compare with prices for labor-saving machinery? And how do today’s prices for his sale­able commodity or service com­pare with prices for competing items?

The Labor Theory

Despite this marvelous facility of market pricing and economic calculation, a man as producer finds it almost impossible to view his product or service other than as the result of labor or work. If he’s working for wages, he de­mands a wage rate high enough to keep pace with “the cost of living.” If he’s selling wheat or corn or beans, he wants prices high enough to cover his costs of production. If he’s providing a postal service under an exclusive government monopoly, he wants postage rates to cover costs.

In other words, the seller’s in­clination is to try to hedge against the forces of supply and demand so as to assure a price that would include a “fair” markup over costs. What he seeks, in effect, is a guaranteed customer. And the postal service monopoly is a good example of such a condition. If the customers do not cover the costs, other taxpayers are obliged to do so. Market prices, with com­petitive postal services, are for­bidden. There is no way of know­ing what might be the demand for or the supply of postal services if buyers and sellers were obliged to look to the market to tell them how much of which scarce resources to devote to such purposes. Resources are simply used in the postal monopoly, with no way to know whether the use represents con­servation or waste. The force of government sees to it that the full costs are covered by taxpayers, regardless of the inefficiency and waste.

Outside the Market

Government pricing and govern­ment contracts, including the pay­ment of subsidies of any kind, al­ways are on a “cost-plus” basis because in those cases the efficient market method of pricing has been prohibited. Supply and de­mand are ruled out of the determi­nation: the customer is led to be­lieve the resources involved are not very scarce—relatively free; the supplier is guaranteed that taxpayers will cover his costs, whatever they may be. Such social­istic pricing affords no effective method of economic calculation by which to measure success or fail­ure, profit or loss, conservation or waste. Thus, socialists are fore­doomed to stumbling in the dark with their outmoded labor theory of value—the sum of costs.

As long as men continue to view goods and services as a package of labor or the sum of the costs of production, they will continue to turn to government for subsidies, handouts, privileges, guaranteed incomes, protectionism, and the like. The more this is done, the less chance there is to trade for gain in the open market—the only system of pricing that conserves rather than wastes scarce re­sources.¹ Chief and foremost among those scarce resources is man, not for his capacity to con­sume as the socialists imply, but for his productive power to serve himself by serving others.

 

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Security May Betray Us

Whenever I hear that the government is helping someone, I feel sorry for that person. Or whenever I find that someone, by a monopoly grant of power, has a sure market or a sure job, I feel sorry for him too. Even helping a person to help himself may be a disservice to him; for you will probably—perhaps uncon­sciously—compel him to do it your way. Charity, if needlessly bestowed, probably will have a vicious effect. People who are promised support will hardly work. All grants, all subsidies, all rewards for services not rendered have a deleterious effect on character; and if character is not of foremost consideration, what is?

ARCHIBALD RUTLEDGE

Foot Notes

¹ It may be assumed that the most urgent purposes of consumers will be served in one way or another and that it is best to do it as efficiently as possible. A businessman’s profit or loss is the measure of his efficiency—his capacity to minimize the cost of serving consumers. Profit denotes the conservation, and loss the waste, of scarce resources.


  • Paul L. Poirot was a long-time member of the staff of the Foundation for Economic Education and editor of its journal, The Freeman, from 1956 to 1987.