Defining Ideas

The Greatness Of Harold Demsetz

Monday, January 14, 2019
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This past week, Harold Demsetz, one of the great economists of the Chicago School, died in California at the age of 88. In one sense, Demsetz’s passing marks the end of an era now that the Chicago School of Economics, to which I generally subscribe, is subject to multiple sustained attacks. Behavioral economists, such as Daniel Kahneman, believe the secret to understanding human behavior lies in identifying, through experimental observation, anomalies in individual choices tending to undermine the axioms of rational choice theory. Meanwhile, other modern populists such as legal scholars Tim Wu and Lina Khan attack Chicago-style antitrust law for wrongly exalting economic efficiency over all other values, such as the protection of small businesses from competition or the ability of moral communities to flourish when operating in the large shadow of powerful economic firms.

Demsetz would have none of this. As if to rebut these novel approaches in advance, Demsetz constantly stressed the dangers of falling prey to the “nirvana fallacy,” or the view of public policy that “implicitly presents the relevant choice as between an ideal norm and an existing ‘imperfect’ institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.” As economist Peter Boettke has pointed out, Demsetz never quarreled with success in the marketplace. If firms like Amazon and Netflix can obtain and sustain a dominant position, it is because they have figured out a formula for success that they constantly adjust to ensure that some new upstart competitor in these “contestable” markets does not take their place. Demsetz was right to scorn the populist critique of popular firms that succeed because they offer low prices and excellent service.

Demsetz’s no-nonsense approach was built into his DNA. I first met Demsetz in the early 1970s when I was a young law professor at the University of Southern California. Demsetz, then one of the leading lights at Chicago, was visiting UCLA, whose economics department was often dubbed Chicago-West for its deregulatory slant and its emphasis on industrial organization. I had a front row seat as Demsetz debated whether to leave Chicago for UCLA. He fretted in the same way as lesser minds would. On several occasions, Demsetz went over the pros and cons of his choice with rare emotional intensity. Ultimately, he decided to venture somewhere new and stayed at UCLA for over forty-six years.

His all-too-human characteristics quickly receded, though, when the conversation turned to economic theory. Demsetz, who grew up as a poor, tough kid from the West Side of Chicago, was as relentless with others as he was with himself. Similar to his tart view on monopoly, Demsetz insisted that economic theory should never travel down the byways, but should focus on the powerful and centralizing tendencies of human social behavior in order to decide whether market institutions were resilient enough to adapt to the changes in technology and attitudes. Throughout his life, Demsetz was very much the disciple of his Chicago ally, the great Ronald Coase, whose work on transaction costs has shaped how we think about contracts and property.

First Coase and then Demsetz were preoccupied with this question: why do firms emerge when it was always possible for people to engage in one-off transactions to buy and sell goods and services? Coase’s great contribution on this topic, contained in his 1937 classic article, The Nature of the Firm, offered a simple but universal explanation that brought to the fore in economic theory the vital and ubiquitous role of transactions costs, which arise in any commercial or social setting. Using a market requires setting up price systems, which is always costly to do. The firm arises when the entrepreneur hires his employees under contracts that set a wage for their overall work but does not itemize each transaction separately. In equilibrium, the market does not yield a single dominant solution because sometimes spot transactions are cheaper to organize than firms and sometimes the opposite is true.

In 1971, Demsetz teamed up with the late Armen Alchian, another great UCLA economics professor to identify the factors that influence this choice between firms and spot contracts. In their famous article, Production, Information Costs, and Economic Organization, published in the flagship American Economics Review (AER), they posited that firms arose when the need to monitor and coordinate inputs to a given project required a single or a small set of owners, who, as “residual claimants,” had the best incentives to perform this task correctly.

At one level the point looks to be a truism; but the American Economic Association rated the pair’s article as one of the top twenty most important ones published in the AER during the twentieth century. Why? Because this idea was so fertile, insofar as it immediately provides the guide posts to understanding corporate structures across complex capital and labor contracts where it is not so obvious who should be the residual claimant. For lawyers, their simple insights have powered inquiry in fields as diverse as corporate finance, bankruptcy, and employment law. Indeed, the subtlety of this work was critical to undermining the reflexive proregulatory bias that had dominated academic and public discourse since the progressive era.

Within the legal academy, Demsetz’s most influential article—and one well worthy of inclusion on the AER’s top twenty list—was entitled Toward a Theory of Property Rights. Written in 1967, it complements his work on the firm. Demsetz had no formal training as a lawyer but had a terrific eye for legal problems. This short masterpiece was perhaps the first to systematically link together changes in property rights regimes with changes in the intensity of use of a scarce resource. The simplest property rights regime—the rule of first possession—achieves its dominance for the most obvious of reasons: there’s no need to put an artificial wedge between someone taking possession of land or animals and his legal ownership of said property. Transactions costs are kept low if the first possessor keeps the property against the rest of the world. Making the first possessor the residual claimant gives him strong incentives to preserve, consume, or sell his asset on an economically sound basis.

One implicit assumption behind this conclusion is that the first possession rule will not exhaust the stock from which resources were made. Demsetz illustrated this weak underside of the first possession rule by referring to the anthropologist Eleanor Leacock's memoir, “The Montagnais ‘Hunting Territory’ and the Fur Trade,” which observed the formation of hunting territories for furs that the Montagnais, a Native American tribe, instituted when the arrival of the French traders dramatically increased their value. In essence, the traditional system, which allowed each hunter to catch animals at will for private consumption, only worked because aggregate consumption did not exhaust the stock. But the arrival of the French created an external market for furs. To stop overhunting, the tribe instituted a system of territories, each assigned to a given hunting group. Creating territories stopped, for example, the overhunting of beavers who themselves were territorial and thus allowed for an increase in overall yield. In Demsetz’s famous phrase, the institution of territories “internalized the externality” of excessive hunting.

Demsetz’s simple explanation paved the way for a more systematic study of the transformation of property rights for other resources as a function of new changes in technology. Think air rights and the advent of aviation, broadband in telecommunications, and water rights with increases in the intensity of use. Interestingly enough, Demsetz was led astray on one point by his basic insistence that distributional issues will generally take care of themselves. The creation of fur territories may have left some former hunters with neither property rights nor compensation for the loss of their traditional hunting privileges. So radical transformation looks like a recipe for massive civil strife. But that never occurred, and later research has explained why. The transformation of rights was not total, for all hunters were entitled to their pre-territorial allotments—so that the territories created gave exclusive rights only for the surplus extraction created by the property right regime.

Overall, the genius of Harold Demsetz did not lie in his finding the definitive answer. It lay in his ability to ask the right questions and to spin a powerful theory for others to expand and criticize. This short essay cannot delve into his entire body of work, but I would be remiss not to mention Demsetz’s short 1968 masterpiece, Why Regulate Utilities?, which questioned the conventional case for regulating the rates charged by public utilities. Demsetz’s powerful point was that this costly administrative effort to control monopoly profits in the short run could compromise long-term innovation in dynamic markets. Similarly, his short 1983 essay, The Structure of Ownership and the Theory of the Firm, mounted a powerful attack on the hypothesis of the lawyer Adolph Berle and the economist Gardiner Means in their 1932 classic book “The Modern Corporation and Private Property,” namely, that the separation of ownership and control in the modern corporation raised insuperable conflicts of interest between shareholders and management. In opposition, Demsetz argued that any decision by insiders to increase their own consumption out of firm assets would reduce the amount that they could command for the firm’s goods and services in product or labor markets.

It is a fair measure of his success that the major articles he wrote a half century ago remain essential reading today. Demsetz was one of the world’s most original economic thinkers, and he richly deserved the Nobel Prize that somehow eluded him.