Harold Demsetz speaking at GMU 2009
I received the sad news this morning that Harold Demsetz has passed away.
A lot of folks who think in terms of “fresh water” and “salt water” economists, or “free market economists” versus “interventionist” economists, get confused about the economics taught at places like UCLA (1950s, 1960s and 1970s), University of Washington (1970s), and UVa (1950s and 1960s), VPI (1970s) and George Mason University (1980s–). UCLA was not Chicago West Coast, as folks sometimes suggest, just as UVa, VPI and GMU were never Chicago East Coast. The UCLA and GMU type economics is influenced by an Older Chicago School of Knight no doubt, but also so many additional strands including LSE and Hayek. Listen carefully to Alchian’s interviews with Hayek as part of the UCLA oral history (or Leijonhufvud’s interviews with Hayek as well) — the influence goes back far in their personal educational history, and its not about people or ideology. It is all about the analytics of price theory, and in particular the role that relative prices play in guiding exchange and production decisions. It is wrong to insist the position articulated in economics so perceived is one that continually asserts that whatever is, is efficient (that is the tight prior of Stigler and Becker), as opposed to an insistence that individuals are not persistently stupid, that they will be creative and clever in seeking out the mutual gains from trade, and thus that there is always in operation an evolution towards a solution that must be appreciated and studied. The mantra, if there is one, is not “efficiency always”, but “where are the deals?; what bargains can be struck between actors?” Economics in the hands of these economists is about exchange and the institutions within which exchange takes place. Prices are never merely a sufficient statistic that is reflected in a unique vector in a deterministic system of competitive equilibrium. Prices are not a parameter in this work, prices are instead continually adjusting and communicating to economic actors critical information that guides them in making the appropriate adaptations required to realize productive specialization and peaceful social cooperation.
Harold Demsetz was a practitioner of UCLA price theory par excellence. He challenged the prevailing orthodoxy in microeconomic analysis and public policy that was emerging in the wake of the Samuelsonian revolution in economics. He developed a dynamic understanding of market competition, putting emphasis on conditions of entry and exit rather than on market structure. In addition, his work constantly drew attention to the creative adaptations and adjustments that economic actors engage in throughout a competitive economy, the multiple margins of adjustment that individuals, as buyers and sellers, engage in through the market, and how alternative institutional arrangements impact competitive behavior.
Demsetz was named the Distinguished Fellow of the American Economic Association in 2013. But I personally believe he should have been awarded the Nobel Prize in Economic Science, along with Alchian, many years before that.
Demsetz from the beginning of his career tackled issues associated with monopoly power, externalities, and a variety of deviations from the textbook ideal of perfect competition. His contribution did not consist of reasserting the perfect market ideal. Instead, Demsetz demonstrated that deviations from the textbook notion of the ideal perfect competition model did not necessarily prevent the price system from coordinating economic activity. He demonstrated how the market process coordinates the productive activity of some with the consumption patterns of others such that the invisible hand explanation of market theory follows from the pursuit of self-interest within a certain set of institutional conditions. Those institutional conditions are established by the rules of property and contract that are established and enforced.
Governance matters and context matters, both theoretically as well as empirically. This is particularly relevant at the present moment, when many within the economics profession and the public policy community are stressing the potential monopoly problems associated with the “platform economy”. Traditional definitions of industrial structure underestimated the role of competitive forces and entrepreneurial innovation by focusing on concentration and firm size rather than the conditions of entry and exit in any market. As the work of Demsetz illustrated, even giant firms currently in possession of a large market share will behave as if they were in a competitive market when a market is contestable.
Demsetz’s was not an abstract theorist, his contributions are more to be found in the application of economic theory and in persistently and consistently deriving the implications of viewing competition not as an end-state, but as an ongoing set of rivalrous activities that entails multiple margins on which creative economic actors can adjust and adapt. Starting with his work in the late 1950s, Demsetz began challenging the then prevailing orthodoxy concerning monopolistic power, natural monopoly, and industrial structure. In his 1968 paper “Why Regulate Utilities?”, for example, he made the critical point that: “we have no theory that allows us to deduce from the observable degree of concentration in a particular market whether or not price and output are competitive” (Demsetz 1968: 59-60). This paper would argue that we do not need to regulate utilities to curb monopoly power provided that there is vibrant competition for the field among potential providers of the service.
In his 1973 paper on “Industry Structure, Market Rivalry, and Public Policy”, he would develop this point in a more subtle way and show that even in the presence of short run monopoly power, the rivalrous behavior of individuals and firms in the market would erode this power. “There is no reason to suppose that competitive behavior never yields monopoly power, although in many cases such power may be exercised not by creating entry barriers, but through the natural frictions and ignorance that characterize any real economy. If rivals seek better ways to satisfy buyers or to produce a product, and if one or a few succeed in such endeavors, then the reward for their entrepreneurial efforts is likely to be some (short term) monopoly power and this may be associated with increased industrial concentration. To destroy such power when it arises may very well remove the incentive for progress” (Demsetz 1973: 3). And, in his most cited paper (co-authored with Armen Alchian), Demsetz argued that: “Conceiving competition as the revelation and exchange of knowledge or information about qualities, potential uses of different inputs in different potential applications indicates that the firm is a device for enhancing competition among sets of input resources as well as a device for more efficiently rewarding the inputs” (Alchian and Demsetz 1972: 795).
As already mentioned, the relevance of the work of Demsetz is as critical to understanding the dynamics of marketplace today as it was when he first approached the study of industry structure and competitive behavior. If you look at the emerging market structure of the past decade, one would certainly have to recognize the near-monopoly status of Amazon, Apple and Netflix, yet one would also have to recognize the great level of consumer satisfaction associated with these firms. Despite their dominant market share, these firms provide quality goods and services at low prices. And there is no expectation that these firms will have any ability to behave differently than continuing to strive to provide high quality products for the lowest price. This is because they compete in a contestable market. Consider the classic browser wars with Microsoft and competitors from a decade ago. How monopolistic can a firm behave if its product can be used to freely download its competitors product? The standard Structure-Conduct-Performance paradigm in industrial organization simply is incapable of providing a clean explanation for the competitive marketplace in the age of the internet. Market leaders will fall by the wayside unless they keep moving forward faster to further satisfy consumer preferences. Amazon and Netflix know they better keep innovating or Hulu, or some other streaming service, is right there to better satisfy the demand of consumers.
I hope you will spend some time today reading these papers I have mentioned, or sampling several other fundamental contributions to economics and political economy that Harold Demsetz made throughout his career — see The Organization of Economic Activity, Vol. 1 and 2, or just do a search for his name on EconLit, or the Liberty Fund produced Intellectual Portrait DVD of a conversation with him. There are great intellectual gains to be had for the modern student of economics spending time reading Demsetz. He was a clear writer and thinker. I had the privilege to meet him several times, and always had very pleasant conversations with him about economics and its practical application to understanding real world phenomena.
The economics profession has indeed lost one of its most insightful practitioners of the subtle and beautiful art of applied price theory.
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