Harold Demsetz

Harold Demsetz made major contributions to the economics of property rights and to the economics of industrial organization. He also coined the term “the Nirvana approach.” Economists have altered it slightly but use it widely. Demsetz was one of the few top economists of his era to communicate almost entirely in words and not math. Demsetz also defended both economic freedom and civil liberties.

Drawing on anthropological research, Demsetz noted that, although the native Canadians (Canadians often call them First Nations people) in Labrador had property rights in the early 18^th century, they did not have property rights in the mid-17^th century. What changed? Demsetz argued that the advent of the fur trade in the late 17^th century made it more valuable to establish property rights so that the beavers were not overtrapped. By contrast, native Americans on the southwestern plains of the United States did not establish property rights; Demsetz reasoned that it was because the animals they hunted wandered over wide tracts of land and, therefore, the cost of establishing property rights was prohibitive. One of Demsetz’s most important contributions was a 1967 article, “Toward a Theory of Property Rights.” In it, he argued that property rights tend to develop where the gains from defining and enforcing those rights exceed the costs. He found confirming evidence in the presence or absence of property rights among native Americans and native Canadians, and he dismissed the idea that they were primitive people who couldn’t understand or appreciate property rights. Instead, he argued, they developed property rights in areas of North America where the property was worth defending.

In the 1960s, the dominant view in the area of economics called industrial organization was that concentration in industries was bad because it led to monopoly. In the 1970s, Demsetz challenged that view. He argued that the kind of monopoly to worry about is caused by government regulation that prohibits firms from entering an industry. He pointed to the Civil Aeronautics Board’s restrictions on entry by new airlines and the Federal Communication Commission’s hobbling of cable TV as examples. He wrote, “The legal route of monopoly runs through Washington and the state capitals.” But, he argued, if a few firms achieved a large market share through economies of scale or through superior performance, we should not worry, and the antitrust officials should not go after such firms. As long as the government doesn’t restrict new competitors, firms with a large market share will face competition in the future.

In a 1969 article, “Information and Efficiency: Another Viewpoint,” Demsetz accused fellow economist Kenneth Arrow of taking the “Nirvana approach” and recommended instead a “comparative institutions approach.” He wrote, “[T]hose who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient.” Specifically, Arrow showed ways in which the free market might provide too little innovation, but then simply assumed that government intervention would get the economy closer to the optimum. Demsetz conceded that ideal government intervention might improve things, but he noted that Arrow, like many economists, had failed to show that actual government intervention would do so. Economists have slightly changed the label on Demsetz’s insight: they now refer to it as the “Nirvana fallacy.”

Another major Demsetz contribution was his thinking about natural monopoly, evidenced best in his 1968 article “Why Regulate Utilities?” In that article, Demsetz stated that the theory of natural monopoly “is deficient for it fails to reveal the logical steps that carry it from scale economies in production to monopoly price in the market place.” How so? Demsetz argued that competing providers could bid to be the single provider and that consumers, if well organized, could choose among competing providers. The competition among potential providers would prevent the winning provider from charging a monopoly price.

Economists often use negative externalities as a justification for government regulation. One standard example is pollution; in their actions, polluters do not take into account the damage imposed on others. Demsetz pointed out that governments also impose negative externalities. In the above-mentioned 1967 article on property rights, Demsetz wrote, “Perhaps one of the most significant cases of externalities is the extensive use of the military draft. The taxpayer benefits by not paying the full cost of staffing the armed services.” He added, “It has always seemed incredible to me that so many economists can recognize an externality when they see smoke but not when they see the draft.” Demsetz was a strong opponent of the draft.

One of Demsetz’s other contributions, co-authored with Armen A. Alchian, was his 1972 article “Production, Information Costs, and Economic Organization.” A 2011 article written by three Nobel Prize winners—Kenneth J. Arrow, Daniel L. McFadden, and Robert M. Solow—and three other economists—B. Douglas Bernheim, Martin S. Feldstein, and James M. Poterba, stated that this article was one of the top 20 articles publishes in the American Economic Review in the first 100 years of its existence. In it, Alchian and Demsetz proposed the idea that the reason to have firms is that team production is important and monitoring the productivity of team members is difficult. Therefore, they argued, firms, to be effective, must have people in the firm who monitor and who are residual claimants. These people, often, but not always, the owners, get some fraction of the profits of the firm and, therefore, have an incentive to monitor effectively. That helps solve the classic principal-agent problem.

In a famous 1933 book titled The Modern Corporation and Private Property, Adolf A. Berle and Gardiner C. Means had argued that diffusion of ownership in modern corporations gave managers of large corporations more control, shifting it from the owners. These managers, they argued, would use that control to benefit themselves. Demsetz and co-author Kenneth Lehn questioned that reasoning. They argued that owners would not give up control without getting something in return. If Berle and Means were correct, they wrote, then one should observe a lower rate of profit in firms with highly diffused ownership. But if Demsetz and Lehn were correct, one should see no such relationship because diffused ownership would happen where there were profitable reasons for it to happen. They wrote:

A decision by shareholders to alter the ownership structure of their firm from concentrated to diffuse should be a decision made in awareness of its consequences for loosening control over professional management. The higher cost and reduced profit that would be associated with this loosening in owner control should be offset by lower capital costs or other profit-enhancing aspects of diffuse ownership if shareholders choose to broaden ownership.

Demsetz and Lehn found “no significant relationship between ownership concentration and accounting profit rate,” just as they expected.

In a 2013 tribute to Demsetz’s co-author Alchian, economist Thomas Hubbard highlighted their 1972 article, writing:

This paper may be the most influential paper in the economics of organization, catalyzing the development of the field as we know it. It is the most-cited paper published in the AER [American Economic Review] in the past 40 years. (If one takes away finance and econometrics methods papers, it is the most-cited ‘economics’ paper, period.) It is truly a spectacular piece. It is a theory not only of firms’ boundaries, but also the firm’s hierarchical and financial structure.[1]

He was also an early defender of the rights of homosexuals. At the September 1978 Mont Pelerin Society meetings in Hong Kong, Demsetz criticized, on grounds of individual rights, the Briggs Initiative, on the November 1978 California ballot. This initiative would have banned homosexuals from teaching in public schools. The initiative was defeated, helped by the opposition of Demsetz’s fellow Californian Ronald Reagan.

For more on Demsetz’s life and work, see A Conversation with Harold Demsetz, an Intellectual Portrait at Econlib Videos.

Demsetz, a native of Chicago, earned his undergraduate degree in economics at the University of Illinois in 1953 and his Ph.D. in economics at Northwestern University in 1959. He taught at the University of Michigan from 1958 to 1960, at UCLA from 1960 to 1963, at the University of Chicago from 1963 to 1971, and then again at UCLA from 1971 until his retirement. In 2013, he was made a Distinguished Fellow of the American Economic Association.

In 1963, when Demsetz was on the UCLA faculty, a University of Chicago economist named Reuben Kessel asked him if he was happy there. Demsetz, sensing an offer in the works, answered, “Make me unhappy.” The University of Chicago did just that, and Demsetz moved to Chicago for eight productive years.

About the Author

David R. Henderson is the editor of The Concise Encyclopedia of Economics. He is also an emeritus professor of economics with the Naval Postgraduate School and a research fellow with the Hoover Institution at Stanford University. He earned his Ph.D. in economics at UCLA.

Selected Works

1965. “Minorities in the Marketplace.” North Carolina Law Review, Vol. 43, No. 2: 271-97.

1967. “Toward a Theory of Property Rights.” American Economic Review, Vol. 57, No. 2, (May, 1967): 347-59.

1968. “Why Regulate Utilities?” Journal of Law and Economics, Vol. 11, No. 1, (April, 1968): 55-65.

1972 (with Armen A. Alchian). “Production, Information Costs, and Economic Organization,” American Economic Review, Vol. 62, No. 5, (December 1972): 777-95.

1973. “Industry Structure, Market Rivalry, and Public Policy,” Journal of Law and Economics, Vol. 16, No. 1 (April, 1973): 1-9.

1974. ‘Two Systems of Belief about Monopoly,” in Industrial Concentration: The New Learning, edited by H. J. Goldschmid, H. M. Mann and J. F. Weston, Little, Brown.

1985 (with Kenneth Lehn). “The Structure of Corporate Ownership: Causes and Consequences,” Journal of Political Economy, Vol. 93, No. 6 (December, 1985): 1155-1177.

1989. Ownership, Control, and the Firm. Cambridge, MA: Basil Blackwell.

1990. Efficiency, Competition, and Policy. Cambridge, MA: Basil Blackwell.

Footnotes

[1] Thomas N. Hubbard, “A Legend in Economics Passes,” Digitopoly, February 20, 2013. At: https://digitopoly.org/2013/02/20/a-legend-in-economics-passes/

1930-2019

About the Author

Selected Works

Footnotes

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