The ideas of Harold Demsetz, 1930-2019

Thomas N. Hubbard

Harold Demsetz, who passed away earlier this year, was an enormously influential figure in industrial organisation, the economics of organisation, and law and economics. This column, written by a friend and colleague, outlines some of his most influential ideas and characterises his thinking as rigorous, insightful and highly relevant to central problems in industrial organisation and business strategy today.

Harold Demsetz, who passed away in January 2019, was an enormously influential figure in industrial organisation, the economics of organisation, and law and economics.

He grew up in Chicago. As a kid, one of his part-time jobs was being a peanut vendor at Wrigley Field (for Bears games, who played there at the time). From there he studied as an undergraduate at the University of Illinois, and received a PhD in economics at Northwestern. He might be the most influential economist to have received a PhD from Northwestern; if not, he is one of a small handful at the top.

Demsetz was most closely associated with the University of Chicago and the University of California, Los Angeles (UCLA). He spent most of the 1960s at the University of Chicago, where he worked alongside George Stigler. He was then recruited to UCLA in the early 1970s by his friend and colleague Armen Alchian. Along with the intellectual environment, southern California offered more and less expensive space for his family. He remained there for the rest of his career.

Demsetz’s career was punctuated by several papers that are influential to this day; Nobel Prizes have been rewarded for less. His most cited paper, “Production, Information Costs, and Economic Organization”, with Armen Alchian, was published in the American Economic Review in 1972.

As I wrote when Alchian passed away nearly five years ago (Hubbard 2013):

“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 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.”

Like all great work, it was the foundation for other huge contributions – work by other great economists such as Oliver Hart, Bengt Holmstrom, Paul Milgrom and many others can easily be traced to this paper. The paper’s starting point – that coordination within firms is not accomplished ‘by fiat’ (Demsetz famously remarks “This is delusion”), and that one should instead examine how incentive structures within firms create efficiencies relative to other forms of organisation – became the starting point for nearly the entire field of the economics of organisation ever since.

Demsetz’s work in industrial organisation was equally influential. His critique of the ‘Structure-Conduct-Performance’ paradigm, which had pervaded industrial organisation for at least 20 years by the mid-1970s, has had lasting effects on how economists think about the relationship between market concentration and competition – this relationship reflects effects that work in both directions. Subsequent work by John Sutton (1991) and others owe an obvious intellectual debt to Demsetz’s insight, and antitrust policy treats concentration measures as a proxy for competition much less than it did before his work.

His 1968 paper “Why Regulate Utilities?” examined how ‘competition for the market’ could generate competitive outcomes. This work was an antecedent to subsequent work by Oliver Williamson (1975), who clarified the role of specific investments in answering the question that Demsetz posed, and by William Baumol et al. (1982), whose analysis of contestable markets was very closely related to the initial Demsetz analysis.

Demsetz’s insights regarding the various forms that competition can take (that is, ‘competition for the market’ versus ‘competition in the market’) are also the foundation of modern analyses (such as Whinston 2006) of the competitive effects of exclusive contracts, share-based contracts, and other arrangements where firms contract for large chunks of business rather than on a transaction-by-transaction basis.

Finally, his 1967 paper “Toward a Theory of Property Rights” is one of the most highly cited papers in the field of law and economics. In this paper, Demsetz points out that the definition of a property right is not a given – instead, it is an economic outcome. Individuals have incentives to define property rights in a way that serves their interests, and these incentives, combined with competitive forces, lead such rights to be defined in a way that creates efficiencies.

In particular, the definition of property rights will tend to create situations where individuals internalise the effects of their actions, and to minimise the extent to which individuals’ actions create externalities. An implication of this is that changes in the economic environment are likely to lead to changes in the definition of property rights; however, it is likely to take time for individuals to figure out exactly how the latter should change.

Echoes of this idea can be heard throughout analyses of the implications of incomplete contracting. For example, in explaining why its merger with Time Warner would create efficiencies through innovation, AT&T discussed this very problem in December 2016.

AT&T explained that new technologies for content development and distribution provided the potential for firms to create new products, but a roadblock in doing so via arm’s-length arrangements in this new environment is that parties have not yet figured out exactly how (intellectual) property rights should be defined in a way that would both facilitate value creation and prevent externalities. It argued that a merger would allow for such internalisation, and would create efficiencies relative to an environment where parties have not figured out how to define property rights in a way that would allow such efficiencies to be created by separate firms.

This argument can be traced to Demsetz (1967): the definition of property rights is dynamic and difficult, and the pace of innovation will depend not only on innovative activities that are manifested in the innovation itself, but also innovations in property rights that efficiently structure parties’ incentives.

Demsetz was extremely prolific, although most of his papers are not nearly as well-known as those I discuss above. One of my favourites among his lesser-known pieces is his review of Oliver Hart’s 1995 monograph Firms, Contracts, and Financial Structure, which appeared in the Journal of Political Economy in 1998.

Demsetz liked Hart’s work very much, but spent most of his time on a critique. His main point – one that I and others who have applied Hart’s work should keep closely in mind – is that residual rights of control (the rights on which Hart focuses) are not the only control rights of interest, and might not even be the most important rights to focus on. Demsetz reminds us that the allocation of the rights that are not residual – those that are defined within contractual arrangements – is often at least as important. This point is important, and his discussion of Hart more broadly is worth reading.

I was lucky enough to know Harold Demsetz well. I met him for the first time in a job market interview at the AEA Meetings in Washington in 1995. There were many people in the room, but after his first question – which was the best question about my job market paper that anyone asked me in any of my interviews – he seemed to be the only person there. I had never met an economist who approached problems in the way that he did.

Demsetz strongly encouraged UCLA to hire me, and took me under his wing once I was there. Most of the time, this was in pointing out that I had not thought hard enough about one or more dimensions of a problem, and in suggesting what I should think more about (“Young man, …”). These discussions were often either in his office – always an open door – or to and from lunch. Walks to and from lunch were long because he preferred the more distant cafeteria at the hospital to closer options because its prices were somewhat lower.

These interactions were irreplaceable, not only because Demsetz was so smart, but also because he approached problems from unique angles. When I left UCLA for Chicago, this is something that I lost, though my interactions with Kevin Murphy and Bob Topel (who were influenced by Demsetz when they were UCLA students) offset this loss in part.

I am sure that some of you reading this met Harold Demsetz at some point in your career. Most of you likely did not, and therefore will have to know him through his work. This is well worth doing. Although it was not his style to make his arguments through formal models, his thinking was nevertheless rigorous, insightful, and highly relevant to central problems in industrial organisation and business strategy today.

Regrettably, what you will not see through his work is that – although he had a reputation of being gruff and critical – he was warm, generous, and witty man. I will miss him.

References

Alchian, A, and H Demsetz (1972), ‘Production, Information Costs, and Economic Organization’, American Economic Review 62(5): 777-95.

Baumol, W J, J C Panzar and R D Willig (1982), Contestable Markets and the Theory of Industry Structure, Harcourt Brace Jovanovich.

Demsetz, H (1967) ‘Toward a Theory of Property Rights’, American Economic Review 57(2): 347-59.

Demsetz, H (1968), ‘Why Regulate Utilities?’, Journal of Law and Economics 11(1): 55-65.

Demsetz, H (1973), ‘Industry Structure, Market Rivalry, and Public Policy’, Journal of Law and Economics 16(1): 1-9.

Demsetz, H (1974), ‘Two Systems of Belief about Monopoly’, in Industrial Concentration: The New Learning, The 1974 Conference on Industrial Concentration edited by H J Goldschmid, H M Mann and J F Weston, Little, Brown; reprinted in 1989 in Efficiency, Competition, and Policy: The Organization of Economic Activity Vol. 2 by H Demsetz, Basil Blackwell.

Demsetz, H (1986), ‘Corporate Control, Insider Trading, and Rates of Return’, American Economic Review 76: 313-16.

Demsetz, H (1997), The Economics of the Business Firm: Seven Critical Commentaries, Cambridge University Press.

Demsetz, H (1998) ‘Review of Firms, Contracts, and Financial Structure: Clarendon Lectures in Economics by Oliver Hart', Journal of Political Economy 106(2): 446-52.

Demsetz, H, and K Lehn (1985), ‘The Structure of Corporate Ownership: Causes and Consequences’, Journal of Political Economy 93: 1155-77.

Hart, O (1995), Firms, Contracts, and Financial Structure: Clarendon Lectures in Economics, Clarendon Press.

Hubbard, T (2013), “A Legend in Economics Passes”, Digitopoly, 20 February.

Sutton, J (1991), Sunk Costs and Market Structure: Price Competition, Advertising, and the Evolution of Concentration, MIT Press.

Whinston, MD (2006), Lectures on Antitrust Economics, MIT Press.

Williamson, O (1975), Markets and Hierarchies, Free Press.