Harold Demsetz: Preferring Reality to Nirvana.

Author:Liebowitz, Stan

Economist Harold Demsetz died on January 2019 at the age of eighty-eight. Demsetz grew up on the west side of Chicago, earned a B.A. in economics from the University of Illinois in 1953 and an MBA in 1954 and Ph.D. in 1959 from Northwestern University. Although Demsetz spent almost a decade at the University of Chicago in the late 1960s, the great majority of his professional career, before and after Chicago, was at the University of California at Los Angeles. At UCLA, he was the leading intellectual force among a strong group of economists who became known for their free-market brand of economics, which was closely aligned, though different from, the "Chicago School," particularly because of the UCLA emphasis on information and property rights.

Demsetz wrote on a range of topics, almost always taking a position that was contrary to mainstream thought at the time. He had a great gift to be able to see other interpretations of data or other explanations of economic behavior that had eluded the entire profession until he provided his interpretation or explanation. He was a pioneering thinker and great writer.

Our summary of his most important research is far from complete, and we leave out several important papers. Nevertheless, we hope we have provided a glimpse of the insights, power, erudition, and influence of his work.

The Firm as a Solution to Shirking and Metering

Demsetz's most famous paper, "Production, Information Costs, and Economic Organization" (1972), written with another UCLA giant, Armen Alchian, is one of the most consequential papers in economics--chosen as one of the top-twenty papers in the first hundred years of the American Economic Review, the premier journal in the field (Arrow et al. 2011). Alchian and Demsetz examine the ubiquity, variety, and importance of team production and how the firm as an organization arose to solve the problems inherent in team production, such as metering the performance of workers to make sure that they do not shirk.

Alchian and Demsetz take on the challenge to "to explain the conditions that determine whether the gains from specialization and cooperative production can be better obtained within an organization or across markets, and to explain the structure of the organization" (1972, 777). This is a variation on the theme that Ronald Coase discussed in his seminal essay "The Nature of the Firm" (1937), which considers when it would make sense to shortcut market transactions and produce products within the firm. Prior to these analyses, the firm was taken to be a black box into which inputs were fed and out of which efficiently produced products emerged.

Alchian and Demsetz emphasize that the relationship between the worker and the firm is not particularly different from the relationship between a seller and a purchaser. The relationship persists so long as it is in both parties' interests. That said, relationships typically are not ephemeral. We do not find, for example, plumbing contractors arriving each day at a labor hall, calling out for the set of the skilled workers they require for the day's production. Instead, workers and firms enter into arrangements, whether formal or not, that involve significant continuity. Among the good reasons for this process is team production.

Some production involves close active cooperation among a group of workers. The challenging case is where the marginal contributions of individuals cannot be easily determined. These conditions can dictate the sizes of firms, the sizes of...

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