Sam Peltzman on Harold Demsetz

I have just learned of Harold Demsetz’s death.  I knew he had been in decline for some time, but the news still occasioned a great sadness.  Harold was a major influence on me and on the world at large.  It is this larger significance of his work that I want to emphasize here.  We have lost one of the giants of economics in the past century.

Many will rightly cite his 1972 AER paper with Armen Alchian on team production or the 1967 AER paper on property rights.  Either would have been sufficient for the Nobel Prize that he inexplicably didn’t get.   I want to highlight here a couple of other papers that also had an outsized influence.  Here the influence was as much outside the profession as within. Harold’s work had profound effects on public policy, or at least on the framework of how policy is analyzed and discussed.

His 1973 Journal of Law and Economics paper, “Industry Structure, Market Rivalry, and Public Policy” fundamentally altered our understanding of the relation between market structure and market performance, and it had a significant impact on how economists think about competition policy.  This paper represents a continuing challenge to the intellectual basis for that policy in the field of mergers. The prior orthodoxy about how market structure affected competition reigned from the time of Edward Mason’s work in the late 1930s until well into the 1970s. It was embedded in a “structure-conduct-performance” (SCP) paradigm whereby market performance was ultimately determined by a market structure that was treated as exogenous.  A large empirical literature developed that generally showed a positive correlation between price-cost margins and the concentration of output among sellers.  Since concentration was treated as given, the correlation was interpreted as demonstrating the price-enhancing effects of oligopolistic interaction.  If merger policy has any factual basis today it would be rooted in this empirical SCP literature.  The “Demsetz critique” of this literature in the 1973 JLE paper showed how the same profit-concentration correlation could arise from the cost and price reducing effects of competition in innovation. He also showed that much of the previous literature was more consistent with the competitive interpretation, whereby concentration was not a given but the result of innovative “winners” taking market share from other firms.  This work dramatically altered empirical research in industrial organization: the search for cross-sectional correlations between profit margins and concentration ratios basically ended, and few industrial organization economists today would draw the kind of causal inferences from such correlations as in the SCP literature.  Competition policy makers would also today be less likely to infer harm to competition solely from evidence that sellers’ profitability was above some norm. Merger policy has evolved away from a mechanical restriction on market concentration to a more “rule-of-reason” approach, whereby evidence of efficiencies from mergers can be weighed in the balance.   I think this quite profound change in how both economists and policy makers think about market concentration is Harold’s legacy.

The other paper I want to discuss also lives on in public policy.   His 1968 JLE paper “Why Regulate Utilities?” showed how “competition for a market” could marshal private information to achieve the public policy objective of price regulation more efficiently than direct price regulation.  Utilities are of course the canonical price regulated natural monopoly. Harold proposed to substitute a “Demsetz auction” for the government price regulation.  This was an auction whereby bidders competed for the right to be the monopoly supplier by specifying the lowest price they would accept for output.  Such an auction would mobilize private information on who was the low cost supplier.  The real innovation here is to clarify greatly the distinction between the objectives of public policies on market failure (in this case the objective would be the lowest price consistent with efficient supply) and the mechanisms that could implement these objectives most efficiently.  While the “Demsetz auction” has had limited applicability in the precise form he proposed, the essential logic appears in much of the subsequent wave of privatization, in the vertical restructuring of natural monopolies such as electricity, and in the provision of public services. To mention just one example, those London double decker buses used to be government run. They are now run by private operators who compete to bid the lowest acceptable subsidy (positive or negative) to run the buses on the terms specified by the government.  Very Demsetzian.  Perhaps such innovation would have occurred with or without Harold’s paper, but the fact is that such marshaling of competition for provision of public services was virtually unknown before.

Few of us who analyze and debate public policies leave a mark on the practical affairs of the world.  Harold’s work did so, and we are all the poorer for losing him.

Sam Peltzman

Booth School, University of Chicago (Emeritus)