Adam Smith on Cost and Utility

utility economic concepts history of economic thought cost

De-Xing Guan for AdamSmithWorks

"That Smith had emphasized cost is a consensus among economists, but that Smith emphasized utility might be a misunderstanding. In fact, Smith had put utility away in both his books for different reasons."
Probably the word utility was first used by David Hume in his Treatise of Human Nature, [1] though the idea had been proposed by Daniel Bernoulli in 1738, [2] just one year before the publication of the Treatise. But it was Jeremy Bentham who decided to popularize the idea of utility when he was reading the Treatise in 1776, as he recalled that 
That the foundations of all virtue are laid in utility, is there demonstrated…For my own part, I well remember, no sooner had I read that part of the work which touches on this subject, than I felt as if scales had fallen from my eyes, I then, for the first time, learnt to call the cause of the people the cause of Virtue. [3]
The idea of utility was later popularized by Bentham’s most important pupil James Mill, along with Mill’s eldest son John Stuart. The son was not like father in the sense that John Stuart Mill was only a mild admirer of Bentham, and tried to incorporate the quality, not just the quantity, of pain and pleasure into utilitarianism. Nevertheless, the emergence of utilitarianism was unfortunate because it laid foundations of economics on utility instead of cost, the cornerstone of the economics of Adam Smith and David Ricardo.
That Smith had emphasized cost is a consensus among economists, but that Smith emphasized utility might be a misunderstanding. In fact, Smith had put utility away in both his books for different reasons. The first time he refused utility was in the Theory of Moral Sentiments. Unlike Hume, Smith did not consider utility as a good basis of moral sentiments. As he said in the discussion of the sentiments of approbation: 
But still I affirm, that it is not the view of this utility or hurtfulness which is either the first or principal source of our approbation and disapprobation. These sentiments are no doubt enhanced and enlivened by the perception of the beauty or deformity which results from this utility or hurtfulness. But still, I say, they are originally and essentially different from this perception.” [4] 
Though Smith disagreed with Hume’s idea of utility, he accepted Hume’s idea of sympathy. But there is an additional difference between them: Hume used judicious spectator, [5] while Smith used impartial spectator. The former means in the common (or average) point of view, and the latter indicates that conscience, families, or close friends have more weights: 
Every man…is first and principally recommended to his own care…After himself, the members of his own family…are naturally the objects of his warmest affections…and the affection gradually diminishes as the relation grows more and more remote. [6] 
Hume’s judicious spectator is similar to Bernoulli’s emolumentum medium or mean utility. [7] But in Smith’s world with different social distances, common point of view or mean utility cannot be the basis of moral sentiments. As Smith had said that 
There is another system which attempts to account for the origin of our moral sentiments from sympathy, distinct from that which I have been endeavouring to establish. It is that which places virtue in utility, and accounts for the pleasure with which the spectator surveys the utility of any quality from sympathy with the happiness of those who are affected by it. This sympathy is different both from that by which we enter into the motives of the agent, and from that by which we go along with the gratitude of the persons who are benefited by his actions. It is the same principle with that by which we approve of a well-contrived machine. But no machine can be the object of either of those two last mentioned sympathies. [8] 
As to the reason why Smith ignored utility in An Inquiry Into the Nature and Causes of the Wealth of Nations, we must first understand that the basis of his economics is the idea of cost, or opportunity cost in a more modern sense. Smith reminded his reader of the distinction between value in use (i.e. utility) and value in exchange (i.e. price). [9] The nominal price of commodities is measured by money, and the real price by labor (i.e. labor theory of value). The price is composed of wage, profit, and rent. The price is equal to cost, not to (marginal) utility. 
Led by William Stanley Jevons, Carl Menger, and Léon Walras, marginal revolution is still orthodox economic theory. But in Smith’s world price is an exchangeable, and therefore measurable value. Though both cost and utility are subjective concepts, it is cost, not utility, which could be objectively measured when commodities are exchanged. Utility is a psychological phenomenon, which cannot be measured by either money or labor. If price were not measurable, then no transactions would happen. This means that price should be equal to cost rather than (marginal) utility. Ricardo was absolutely right about Smith’s distinction between cost and utility.  
Utility then is not the measure of exchangeable value, although it is absolutely essential to it…Possessing utility, commodities derive their exchangeable value from two sources: from their scarcity, and from the quantity of labor required to obtain them. [10] 
Another misunderstanding about Smith is that he proposed laissez-faire or perfect competition. It is untrue, if we could rightly quote Smith’s own words: 
When the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market…The commodity is then sold precisely for what it is worth, or for what it really costs the person who brings it to market. [11] 
What Smith said was that price should be equal to (total) cost, which is the sum of prime cost (the cost of raising and preparing) and the cost of bringing it to market. Smith had mentioned that this last cost is mainly concerned with the costs of retail and wholesale transactions. In terms of Ronald Coase, [12] they are transaction costs. Obviously Smith’s focus was on cost rather than utility.

Want to read more?
Philip D. Bunn's Seeing Beauty in Utility with Adam Smith
Jason Meadows and Jeremy Lott's comic Adam Smith Comics: Trinkets of Frivolous Utility
Read Theory of Moral Sentiments, Part IV, Ch 1, "Of the Beauty which the Appearance of Utility bestows upon all the Productions of Art, and of the extensive Influence of this Species of Beauty"

1. David Hume, A Treatise of Hume Nature, 1739-1740; Penguin, 1985, p. 350.
2. Daniel Bernoulli, “Exposition of a New Theory on the Measurement of Risk,”
Econometrica, 1954, 23-36. What Bernoulli used was the Latin emolumentum,
which was translated into English as utility.
3. Jeremy Bentham, A Fragment on Government, 1776; Cambridge University Press,
1988, p. 51.
4. Adam Smith, The Theory of Moral Sentiments, 6th edition, 1790; Liberty Fund,
1982, p. 188.
5. Hume (1985), p. 632.
6. Smith (1982), p. 219.
7. Bernoulli (1954), p. 24.
8. Smith (1982), p. 327.
9. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 5th
edition, 1789; Modern Library, 1994, p. 31.
10. David Ricardo, Principles of Political Economy and Taxation, 3rd edition, John
Murray, 1821, Ch. I.
11. Smith (1994), p. 62.
12. Ronald H. Coase, The Firm, the Market, and the Law, University of Chicago
Press, 1988.