Mr. North is a Ph.D. candidate in history at the University of California, Riverside.
One of the most frustrating experiences in the area of economic reasoning is to explain in detail why a particular government welfare project is economically unsound and therefore wasteful of scarce resources. After giving assent to point after point of the argument, the listener refuses to accept the logical conclusion that the project should be abandoned: "But we can’t stop now. We’ve already sunk too much into it. If we stop now, it would mean that we’ve lost everything!" On the face of it, this answer seems convincing. So, how does one deal with it?
Take, for example, the urban renewal program. It has been in operation for two decades, and apparently is a permanent and expanding part of the expenses of the Federal government. Its spectacular failure to accomplish its stated goals — to provide inexpensive housing for low-income groups — has been thoroughly explored in Professor Martin Anderson’s study, The Federal Bulldozer (M.I.T. Press, 1964). We can ignore here such aspects of the program as the destruction of community bonds which relieve the alienation of urban life, the inevitable result of tearing down old, familiar neighborhoods. We need only point to the conclusion of Professor Anderson: "Most of the new buildings constructed in urban renewal areas are high-rise apartment buildings for high income families; only 6 per cent of the construction is public housing." This fact is amply demonstrated: "The median monthly rent of the private apartments built in 1962, which mainly replaced low-rent housing, was $195." The program has aggravated the housing shortage for these low-income groups by evicting them from their present residences, forcing them to compete for the remaining available space in other neighborhoods. Since the new accommodations are those that were passed over by these people, voluntarily, before they were forced to move, the conclusion is obvious: these people have been coerced by the Federal government to accept living conditions that are less satisfactory to them than those which they previously had occupied.
Between 1950 and 1960, over 125,000 dwellings were destroyed under the auspices of the urban renewal program. Only one-fourth of these have been replaced, and most of these are high-rent units. Professor Mises’ warning that state interference into the operation of a free market is likely to produce exactly the reverse of what the planners originally expected is aptly demonstrated by the urban renewal program. It has involved a multibillion-dollar subsidy, as Anderson’s book shows, to "upper income people and a few elite groups." Who paid for the subsidy? Those of us whose taxes went to finance the projects, and those millions of urban poor who were forced to leave their homes by the administrators of the urban renewal program.
Anderson’s recommendation is that we phase out the whole program. Let the projects now under construction be completed, but no more. He is aware of the reality of today’s politics: the public would not tolerate the program’s demise before present projects are finished. Half-completed empty buildings are a standing testimony to failure; neither the public nor Federal planners are likely to accept the implications of that failure. Yet, from the point of view of economic reasoning, those buildings should not be completed at all. At best, they will only benefit special elite groups that can afford other housing; at worst, they will result in actual economic losses, when rents fail to repay the original investment. Why should the public be unwilling to grasp this basic economic fact? Why should the public prefer to waste even more resources on projects that have proved to be unwise in the past? Why not call a halt to the waste immediately? Would it not be wise to offer these projects, as is, to the free market, accepting in payment whatever competitive private bidders would pay? The state could at least retrieve some of its losses by doing so.
The Sunk Costs Doctrine
The policies of waste are increasingly pursued by those who are well aware of the waste. Political considerations often overshadow economic realities. But there can be no possibility of reform if people will not understand or act upon a basic economic principle: the doctrine of sunk costs. It is not a principle readily grasped through intuition. It involves a careful, systematic line of argumentation, and many people are unwilling to devote the effort to master it. Nevertheless, it is vital that we do so; failure to grasp the issue will cost us heavily.
Let us turn from urban renewal for a moment to the more familiar area of private industry. How does the private entrepreneur make his decisions? At any point in time, he must decide whether or not to continue the projects already underway and whether to begin new projects. He decides on the basis of expected profits. What his firm has invested in fixed capital is no longer a relevant economic consideration, amazing as it may seem. What is a consideration is the value of the fixed capital if it should be sold now or rented now, but not what was invested before.
Previous investments are a part of what is called "sunk costs"; that is, they are past costs which no longer enter into economic consideration. Professor Israel Kirzner, in his excellent economics textbook, Market Theory and the Price System (Van Nostrand, 1963), explains why and how entrepreneurs make their decisions:
In making these decisions, the entrepreneur must still consider the costs of production necessary for a continuation of production. He must, as in all entrepreneurial decision-making, balance expected revenue against expected costs. But in making this calculation, he pays no attention whatsoever to the expenses of production that he has already paid out (or that he has irrevocably committed himself to pay). What has been paid has been paid.
But in comparing anticipated costs to anticipated revenues, the entrepreneur pays no heed to those amounts that do not depend on his present decisions. These past amounts may have been wisely or unwisely incurred, but there is nothing that can be done to alter the past. The aim must be to exploit now the favorable position the entrepreneur may find himself in (as a result of the past decisions that now appear to have been wise ones); or to make the best of a poor situation he may find himself in (as a result of past decisions that now appear to have been unwise ones).
The doctrine of sunk costs reminds us of the old truism: there is no use crying over spilt milk. What each planner must do, whether in private business or in government, is to make the best of the alternatives available to him now. If losses are sure to be incurred by continuing in some line of economic endeavor, then the planner should abandon it. For every minute that the project is allowed to function it is taking money out of the business. In other words, it is using up scarce resources when those resources might better be employed to satisfy some other consumer demand (or be used by a more efficient firm to satisfy a given demand more effectively).
The Balloon Analogy
A rather far-fetched analogy might be used here to clarify the meaning of the sunk costs concept. Imagine a man who is suspended from a large helium balloon by a rope. How he got there is irrelevant for our example. It seemed like a good idea at the time. He is now some fourteen feet above the ground. Naturally, he does not want to let go at this point. But the balloon carries him higher, say, to twenty feet. He is now in a worse position than before. The issue which confronts him is simple: shall he let go of the rope now or later? His decision will be prompted by what he thinks the situation will be in the future: if the balloon is likely to climb higher, he should let go; if it will soon be slowly descending, he should hang on. This much, however, is certain: he failed to drop when he was only fourteen feet off the ground. Perhaps he should have let go then; possibly he now wishes that he had done so. But the fact remains that he did not let go then, and his decision cannot now be based upon any consideration of a fourteen-foot-drop five-minutes-ago universe. It is the future as compared with the present, not the past, which must determine any rational decision. The past is gone, for better or worse.
Along these same lines, we are frequently confronted with the familiar socialist argument that capitalism creates unemployment and permits idle resources. "Look at the deserted steel mills. Under socialism, the government sees to it that all the capacity of the economy is fully utilized." The answer to this line of reasoning involves the concept of sunk costs.
Take the steel mill example. Many mills were built years ago. They were built under an earlier system of technology: the plants may have cost more to construct than today (not in dollars, of course, but in comparison to the cost of living at that time); the plants were designed for processes of steel production now outdated. They were built under a certain set of assumptions about the state of the economy: the demand for steel, the nature of the competition, the alternative metals that could be substituted for steel, the costs of raw materials and labor, and so on. Some or all of those assumptions have proven erroneous with the passing of time. The plants began to produce losses because the entrepreneurs, being human, were not omniscient at the time when they drew up their plans. They made inaccurate forecasts. Their competitors, who made more accurate forecasts, will have prospered accordingly. Those who made the errors were informed of the mistakes through the operation of the price mechanism on the free market. Instead of compounding their errors by continuing to waste scarce resources in inefficient production processes, they "let go of the rope." That is, they shut down the inefficient mills. Thus, they released raw materials and laborers for the more efficient producers to use. Capitalism, in short, eliminated economic waste; it did so through the profit and loss mechanism of the market.
The socialist wants us to believe that capitalism is wasteful because it permits plants to be shut down by owners. "Look at all the investment that is wasted; capitalists sank so much capital into those projects, and now it is all lost." The argument rests on a half-truth. Yes, that investment is lost. It is lost under any system of economics; in fact, it was lost the day the plant was built. The entrepreneurs knew full well that it was lost; the point is that they expected this loss to produce profits in the future. That is the heart of all investment, whether under socialism or capitalism. Scarce resources used for one thing cannot simultaneously be used for another. It is the rational calculation of the free market which tells us whether or not the use of the scarce resources was a wise one, but it is not capitalism as such which destroys the investment.
The fact that under capitalism plants lie empty should be seen as a blessing. Capitalism has permitted us to count the cost of continuing any given process of production. It encourages us to abandon the wasteful processes. The market is a constant reminder to us that there are such things as errors of investment. It reminds us that once a plant is built, we must make the best use of it that we can, and sometimes this means doing nothing with it, if doing something with it ties up additional scarce economic resources and wastes them. The market forces us to examine the probable future results of our decisions, while it encourages us to accept the reality and inescapable finality of those decisions that we have made in the past. Capitalism demands that we make the best of a poor decision in the past; socialism, by keeping plants in operation which are wasting scarce resources, permits men to make the worst of a poor decision in the past. The "unused capacity" argument is utterly fallacious.
The Stock Market Crash
An economically irrational refusal to acknowledge the validity of the doctrine of sunk costs has led many people to personal financial disaster. Consider the stock market decline of 1929-33. Many investors saw their paper profits collapse after October of 1929 when the inflationary policies of 1922-29 were reversed by officials of the Federal Reserve System. People saw that the general level of prices in the nation was declining, especially stock prices, but they refused to acknowledge the reality of the situation. Instead of considering the possibility that prices might fall even more, they concerned themselves with the amount of money they had put into their investments. This in turn led them to hold on; the result was financial disaster, as prices continued to skid. The man who refuses to let go of the rope at fourteen feet had better be fairly sure that the balloon is not going to carry him even higher.
The Illusion of Equity
One of the most common of all fallacies involved in the refusal to accept the sunk cost doctrine is that of "equity" in a home. During a depression, or any recession, some owners who want to sell their homes or land refuse to sell at the prevailing prices. They argue, "I have $5,000 equity in this piece of property; if I sell now, I’ll lose it." The fact is that there is nothing tangible or marketable about "equity." Once a mortgage payment is made, it is gone. It entitles one to remain the owner of the property until the next payment falls due. It entitles one to make decisions now as to the sale or retention or rental of the property. But there is nothing known as equity in economic reasoning: you may sell a house for more than you put into it, or less, or the same amount; but the market price is not determined by the amount of money sunk into the property. One cannot have something "in" the home, as if it were a refrigerator stocked with food.
We only have a title to the home which permits us to sell it for whatever we can obtain on the open market. "Equity" is a misleading concept which is stored in people’s minds, not something which is in some mysterious way stored in a piece of property.
The Labor Theory of Value
The labor theory of value is a concept analogous to "equity." It assumes that an economic good is worth a given amount of money on the market because a certain quantity of human labor has been invested in producing it. This idea was basic to all economic thought until the advent of the "marginalist-subjective" economics of modern times (1870′s). Karl Marx was the last major economist to hold to the position; only Marxists, among serious economists, hold it today. The concept is wrong. A buggy-whip, even if it were made by a painstaking master craftsman, is only worth in 1969 what the market will pay; the quantity of labor involved (which itself is a misapplied concept from mechanics, since there is no way to measure labor) is absolutely irrelevant. The buggy-whip does not have value because of the labor; the labor has value only because of the value the buggy-whip may have on the market. An hour’s labor by a brain surgeon commands a higher price than an hour’s services of a ditch-digger (in most economic situations, anyway).
So it is with a factory. The amount of labor invested in its construction is irrelevant, once it is built; the amount of raw materials invested is irrelevant, too. Once it is built, the factory (like the buggy-whip) must be valued in terms of what it can produce on the market or by what it could be sold for, either now or in the future. Profit and loss will determine what is to be done with the factory, not the money already invested in its construction. The doctrine of sunk costs was the inevitable replacement for the labor theory of value. Today, it is only the Marxist entrepreneur or planner who ignores the doctrine of sunk costs; the inefficiency of Soviet planning is, in part, traceable to just this ignorance.
Thus, we should look at any government project with an eye to the present and the future. The past, because it is past, is economically irrelevant. Unfortunately, the past is not politically irrelevant: politicians and bureaucrats may have made specific promises concerning some project. But that is another issue as far as the economist is concerned. If it is a question of economic waste versus economic benefit, the past must be discarded as part of our thinking. Our concern is in getting the greatest possible benefit from the resources that are available now. For economics, the words of Omar Khayyam are most relevant:
The Moving Finger writes; and, having writ,
Moves on: nor all your Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all your Tears wash out a Word of it.