Harold Demsetz

Harold Demsetz is one of the most creative and deep microeconomists of the 20th century.  Several of his contributions anticipated subsequent research by years or even decades, and have offered unusually insightful analyses of fundamental problems of economic theory.

Demsetz’s most famous paper “Production, Information Costs, and Economic Organization” (with Armen Alchian, American Economic Review 1972) is one of the most cited papers in all of economics. It analyzes the fundamental question first raised by Coase, “What is a firm?” and tries to understand the difference between contracts occurring inside the firm (for example, with employees) and those occurring in the market (for example, with customers).  Alchian and Demsetz argue that some contracts are efficiently brought inside the firm because doing so reduces the costs of monitoring of performance, especially when production occurs in teams.  Alchian and Demsetz’s approach has been challenged by more recent developments, such as Grossman and Hart (1986), but remains a classic in the theory of the firm. 

In 1968, Demsetz asked the question, “Why regulate utilities?” and argued that it is more efficient to get potential suppliers to compete in prices and terms by offering customers contracts than to control prices. Demsetz’s framing of the problem has become the dominant approach to the modern theory of regulation, see for example, Laffont and Tirole (1993).

In the same year, Demsetz published “The Cost of Transacting” in the Quarterly Journal of Economics, which raised fundamental questions about the determinants of transaction costs, and empirically documented the negative relationship between transaction costs and trading volume on different stocks on the New York Stock Exchange. The enormous subfield of finance now known as market microstructure begins with this hugely original article.

In 1967, Demsetz published a short but tremendously insightful article in the American Economic Review, called “Toward a Theory of Property Rights,” in which he analyzed the amount of property rights protection from the efficiency perspective.  The article argued that property rights are expensive to enforce, and that institutions enforcing them arise efficiently when the benefit of secure property rights outweigh the costs of these institutions. Today, the economic study of institutions is a massive field, and Demsetz’s article can be justly seen as a founding contribution.

In 1985, together with Kenneth Lehn, Demsetz published an empirical article in the Journal of Political Economy, called “The Structure of Corporate Ownership: Causes and Consequences.”  In that article, the authors document high ownership concentration of US firms in some sectors, such as newspapers and sports teams, and argue that the amenity potential of running these businesses (now known as “private benefits of control”) explains ownership concentration. In modern corporate finance, concentrated corporate ownership is seen as a norm rather than an exception, and private benefits of control as central determinants of ownership structures. Here again, Demsetz’s work came early, and accurately grasped both the empirical reality and the fundamental theoretical issues.

The number of areas in which Harold Demsetz’s contributions have stood the test of time is remarkable.  His work is highly original, independent of prevailing intellectual currents, and enduring.

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