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Fred S. McChesney

Armen Alchian: An Economist-Lion in Winter

Fred S. McChesney*

Editor's Note

The following was written before the announcement that the 2009 Nobel Prize in Economics Sciences would be awarded to Elinor Ostrom and Oliver E. Williamson, choices the author does not dispute. It was written only in the belief that Armen Alchian also should some day win that Prize.

 
"Perhaps no other economist of our time has given as much attention to costs as has Armen Alchian."
Being named as winner of the Nobel Prize in Economic Sciences says little about one's long-run stature among economists. Nor are Nobel laurels a necessary condition for recognition as a great economist. No better proof of that proposition is the standing among economists of Armen Alchian, an intellectual giant as a theorist and an educator.1 With Alchian now in his nineties, it is appropriate to review his many noteworthy contributions to economic science.

Foremost is his work in property rights. Before Alchian, economists took for granted the existence of private property. Adam Smith's famous principle of the invisible hand works only if individuals have property rights over their own bodies and over the fruits of their labor. The point is so obvious that it seemed to require no discussion—thus, economists did not discuss it.

But Alchian, in a series of pathbreaking articles, pointed out that property rights are defined differently in different institutional contexts and that the differences matter.2 For example, some fifty years ago, Alchian raised an question that was timely then but even more debated today: Why do university professors obtain tenure, effectively a right to work and be paid for life?3 Tenure is the norm even at private colleges and universities, but it does not exist in any other sector of the private economy. Alchian noted the standard argument that tenure was necessary to protect professors' ability to "search for truth," but countered that the true basis for tenure was the structure of property rights within the university:

[M]y conclusion is that the reason for the general acceptance of tenure is not that the search for truth has some special characteristics which distinguish it from other products, but that, instead, its acceptance springs from the special ownership arrangement and financial structures of our colleges. Economic analysis has driven me to this conclusion, that it arises from an absence of the ordinary kind of property rights that exist in profit-seeking businesses.

Alchian pointed out that in a private business, shareholders who own the firm pay attention to what directors and officers do for the firm and pay them accordingly. But in a university, although it may take in millions in donations ("endowment"), nobody owns the earnings from those funds. So, if the university president spends the money badly, no one really will complain. "Students and their parents are less able to punish him so severely for behavior not in conformity with their desires, since the profit incentive is attenuated, as it is not in a profit-seeking owned institution."

So how does this lead to a tenure system? Here, Alchian's second insight was essential. True, no one "owns" a university, as that term is understood in the private economy. But, he continued, the issue then becomes who actually controls the allocation of resources in universities, institutions that collect and control billions of dollars. Who has the effective property rights over those decisions, and so those dollars? Since the faculty members, who elect their deans, are the ones that spend the money, why not spend it on themselves, in the form of a lifetime appointment?

 

See "Property Rights," by Armen Alchian, in the Concise Encyclopedia of Economics for more applications.

The implications of all this were left for future researchers to elucidate. And so they did. Notably, one quantitative study found, the extent to which faculty manage a college or university has a negative impact on research output, controlling for other factors.4 Likewise, overall university quality, as measured by incoming students' SAT scores, is a negative function of the degree of faculty management, all else equal.

Alchian is the product of an era when economics was foremost an applied science, and when economists typically had real-world experience to accompany their work in the ivory tower. While in the Army Air Forces during World War II, he studied the production of airframes, with two pathbreaking implications. First, Alchian investigated statistically the learning curve associated with the manufacture of airframes.5 The idea that learning on the job will decrease production costs dates from Adam Smith, but it had never been rigorously investigated. It remains underexplored, both theoretically and empirically, today.

But there is a broader insight underlying the idea that costs will decline with experience, and Alchian was the first to recognize it: Time is an economic resource and should be treated like any other resource. On the supply side, Alchian pointed out, one cannot specify a cost-volume relationship without also specifying the rate of production. Over what period of time is a particular volume or quantity being produced? As a given quantity must be produced over a shorter duration, costs of production must rise.

Perhaps no other economist of our time has given as much attention to costs as has Armen Alchian. He discovered, while working at the RAND Corporation after the war, that military engineers and economists disagreed over the efficient ways to produce armaments because their concepts of cost were quite different.6 Engineers registered cost as a function of total output, and so saw costs as generally declining. But to economists, the costs associated with different levels of output depend on the rate at which they are produced: Producing the same volume but in a shorter period of time would be more expensive, ceteris paribus. Moreover, once one recognized the importance of time for reckoning cost, one had also to take into account the present value of the outlays required to produce, outlays that would vary depending on the timing of production. All of this Alchian explained in one of his most important articles.7

 

See "Elasticity and Its Expansion," by Morgan Rose for more on the elasticity of demand.

If time is important on the supply side, what of the demand side? Here, too, Alchian's work has been pathbreaking. In particular, he (with co-author William Allen) pioneered recognition of the Second Law of Demand. Under the First Law of Demand, quantities demanded decline (rise) with price increases (decreases), which yields the familiar downward-sloping demand curve. But, Alchian and Allen note, the extent to which prices and quantities vary inversely—the elasticity of demand—is a function of time. If prices rise, quantities purchased fall relatively slightly at first, but fall more over time.

Elasticity of demand is greater in the longer run than in the shorter run. Why? In the first place, more people will learn about the price change. Second, the cost of revising consumption patterns or activities is less if done with less haste and with more economical side adjustments. . . . "Demand," then, really refers to a host of demands, each applicable to a different lapse of time subsequent to any price change.8

The rate-volume effect, that is, applies just as much on the demand as on the supply side. And, as with his pathbreaking work in property rights, Alchian's identification of the importance of time has paved the way for further important contributions, notably by Nobelist Gary Becker.9

These are just a few of the fundamental contributions Alchian has made in his long career. Why, then, have they failed to secure for him recognition from the Royal Swedish Academy of Sciences? One hears several explanations for the oversight. It is said that Alchian has not written as much as some other Nobelists, many of whom (e.g., James Buchanan) are indeed prolific. But as David Henderson has written, "Alchian has published only a few articles, but very few unimportant ones."10 As with Ronald Coase, who won the Nobel Prize in 1991, Alchian's impact stems from the remarkable quality, not the quantity, of his work. Particularly as the Swedish Academy typically relies on just one or two principal contributions made by its honorees, it is hard to believe that the Academy has overlooked Armen Alchian simply because of the sheer number of his writings.

Two other reasons for the Nobel oversight suggest themselves. First, shining a light on oneself is acknowledged as important in the Nobel process, but Armen Alchian has assiduously avoided self-promotion. A remarkable example of his modesty is his pioneering use of the stock-market "event study." Today, examining the effects of regulation and other phenomena affecting business firms by studying their effect on firms' share prices is commonplace. The value and validity of event studies are usually traced to contributions made by economists in the late 1970s and the early 1980s.11 But Alchian had understood and already employed the event-study technique a generation earlier. Only at my insistence in 1996 did he publish what had, for national-security reasons, gone unreported for so long:

The year before the H-bomb was successfully created [in the 1950s], we in the economics division at RAND were curious as to what the essential metal was—lithium, beryllium, thorium, or some other. The engineers and physicists wouldn't tell us economists, quite properly, given the security restrictions. So I told them I would find out. I read the U.S. Department of Commerce Year Book to see which firms made which of the possible ingredients. For the last six months of the year prior to the successful test of the bomb, I traced the stock prices of those firms. I used no inside information. Lo and behold! One firm's stock prices rose, as best I can recall, from about $2 or $3 per share in August to about $13 per share in December. It was the Lithium Corp. of America. In January, I wrote and circulated within RAND a memorandum titled "The Stock Market Speaks." Two days later I was told to withdraw it. The bomb was tested successfully in February, and thereafter the stock price stabilized.12

Until pressed to recount this episode, Alchian had made nothing of it. Such modesty does not increase the odds of winning a Nobel prize.

A more likely reason for the oversight is the sort of economics that Armen Alchian practices. Basic ideas of property rights, the nature of costs, the theory of the firm13 and so forth are so economically fundamental that they undeservedly escape the attention of modern economists more concerned with mathematical bells and experimental whistles. Automobile buyers devote most of their shopping attention to things like a car's lines, color and interior appointments. But none of these would matter if the car lacked an engine, drive shaft and wheels.

Alchian has always been more concerned about economics' scientific fundamentals. His monumental contributions in economics have elucidated the basic principles, of what makes an economy—like an automobile engine—run. Though in his nineties, he may yet receive the Nobel laurels he deserves. But, regardless, he has achieved what few of us ever will: the plaudits of his peers as one of the greats. And—to him, most important of all—the satisfaction of knowing that generations of economists have seen the world more clearly through his eyes.


See also

Alchian, Armen. The Collected Works of Armen A. Alchian. In two volumes. 2006. Liberty Fund, Inc.

A Conversation with Armen A. Alchian. The Intellectual Portrait Series. Audio available in several formats. 2000. Online Library of Liberty.


Footnotes
1.

This essay focuses on Armen Alchian as an economic theorist, but his role as an educator should also be noted. Like Nobelist James Buchanan at the University of Virginia, Alchian has viewed as paramount the training of graduate students who would then pass on to the next generation the essence of economic thinking. So successful were both men that what had been called simply the "Chicago School" of economic thinking has been increasingly referred to as the "Chicago-UCLA-Virginia School."

2.

See, for example, Alchian, "Some Economics of Property Rights," 30 Il Politico 816 (1965); "Corporate Management and Property Rights," in Economic Policy and the Regulation of Corporate Securities (H. Manne, ed., 1969).

3.

Armen A. Alchian, "Private Property and the Relative Cost of Tenure," in The Public Stake in Union Power (Philip D. Bradley, ed. 1958.

4.

Robert E. McCormick & Roger E. Meiners, "University Governance: A Property Rights Perspective," 31 Journal of Law and Economics 423 (1988).

5.

Alchian, "Reliability of Progress Curves in Airframe Production," 31 Econometrica 679 (1963). The article was written shortly after World War II, but could not be published at that time because it used classified data.

6.

Alchian recounts the episode in his "Principles of Professional Advancement," 34 Economic Inquiry 520 (1996). Reading and re-reading this article should be required of every budding economist.

7.

Alchian, "Costs and Outputs," in The Allocation of Economic Resources (M. Abramovitz et al. eds., 1959).

8.

A. Alchian and W. Allen, University Economics: Elements of Inquiry (3d ed. 1972), p. 63.

9.

Gary S. Becker, "A Theory of the Allocation of Time," Economic Journal 75 (299), pp. 493-517.

10.

David R. Henderson, "Armen Alchian," in The Fortune Encyclopedia of Economics (1993). Reprinted as "Armen Alchian," in the Concise Encyclopedia of Economics.

11.

G. William Schwert, "Using Financial Data to Measure Effects of Regulation," 24 Journal of Law and Economics 121 (1981). For an early use of the event-study technique, see Maloney & McCormick, "A Positive Theory of Environmental Quality Regulation," 25 Journal of Law and Economics 99 (1982).

12.

"Principles of Professional Advancement," supra note 6, p. 523.

13.

On the theory of the firm, see Alchian & Demsetz, "Production, Information Costs and Economic Organization," 62 American Economic Review 777 (1972).


*Northwestern University: Class of 1967 / James B. Haddad Professor of Law; Professor, Kellogg School of Management. I thank the Seder Corporation Research Fund for its support.

For more articles by Fred S. McChesney, see the Archive.
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