All Commentary
Wednesday, September 23, 2009

From Economic Man to Economic System: Essays on Human Behavior and the Institutions of Capitalism

Harold Demsetz is among the ten most frequently cited economists in the world. What makes him worth reading is that he has made his mark not through virtuosity with empty formalism but rather by careful reasoning about fundamental questions and evidence. His latest book, From Economic Man to Economic System, continues that tradition.

Demsetz considers a wide array of topics, all presented verbally so that the discussion can be followed without any formal economics training. They include fascinating discussions of Richard Dawkins’s selfish-gene hypothesis, how capitalism solved the Malthusian population trap, why it took so long for the market order to develop, and why political parties act differently from firms. But his greatest contributions are his defenses of the spontaneous coordination of markets against attacks grounded in logical confusion. Three are of particular note.

Demsetz devotes a chapter to Robert Frank’s Luxury Fever. Frank argues, following Veblen and Galbraith, that the wealthy seek higher stature by acquiring more luxury goods than their peers, but that the attempt is self-defeating, supposedly justifying progressive consumption taxes to control that wasteful market failure. Demsetz responds, “My objection is to those who believe that we are so locked into serious decision errors that we must be coerced into doing that which we knowingly choose not to do.” He reveals holes in Frank’s logic, then adds several societal advantages Frank did not consider, including the fact that status-seeking through consumption is far more benign than status-seeking through power over others, which history has shown to be both bloody and massively destructive of liberty. He concludes that “Free choice is much too precious to surrender just because the wealthy buy more expensive goods than some of us think they should. . . . [T]he free society does not entitle [anyone] to coerce them into submission to his idea of what is good for them.”

Similarly powerful is Demsetz’s discussion of how transaction costs are misunderstood. He refutes the conclusion, tracing it to Ronald Coase, that “positive transaction costs can make the competitive economic system function inefficiently.” That idea has spawned almost uncountable assertions of market failure, backed by proposals for “corrective” government coercion. Demsetz shows that courts can make errors in the assignment of rights, but that markets efficiently respond to those errors: “Legal error has caused the problem, not positive transaction cost. There is no inefficiency in the way the market accommodates to the court’s mistake.”

Perhaps most powerful is Demsetz’s analysis of the supposed “separation of ownership and control” in large corporations, particularly relevant when blaming out-of-control management for everything is in vogue. Demsetz shows that it is not a market failure and that government “fixes” will make matters worse. In a nutshell, the separation-of-ownership-and-control “story” is that large corporations have so many small shareholders that no one monitors management carefully and managers routinely benefit themselves at shareholder expense. Demsetz shows how that story works only by ignoring several market mechanisms that address it. For example, if shareholders know management will mistreat them, they protect themselves by paying less for shares. Takeover possibilities triggered by low share prices also restrict misbehavior. And managers will not ignore how misbehavior will undermine their advancement and future incomes as managers, typically their greatest financial asset.

Demsetz shows that “separation” claims arise from ignoring that one cannot delegate authority without agents (managers) facing different incentives from their principals (stockholders). Principals, however, would not willingly bear such costs except to capture even greater benefits. So where “separation” critics see only deviations from efficiency, Demsetz recognizes that self-interested owners would only choose the corporation form, warts and all, when they expect the gains to exceed the costs, increasing efficiency. Therefore, corporate governance does not demonstrate market failure.

Demsetz further traces these confusions to a mistaken understanding of economists’ standard model of competition, which causes many errors in antitrust and regulation. It is actually a model to explain why beneficial spontaneous coordination will emerge in markets, even in the complete absence of central planning. However, its assumption that no individual has power over any choice, useful for understanding decentralized market coordination, makes it an inappropriate standard for judging real-world competitive behavior within or between firms.

Demsetz’s understanding of real individual and institutional behavior and his defense of the market order make From Economic Man to Economic System well worth reading for those committed to defending freedom.

  • Gary M. Galles is a Professor of Economics at Pepperdine University and a member of the Foundation for Economic Education faculty network.

    In addition to his new book, Pathways to Policy Failures (2020), his books include Lines of Liberty (2016), Faulty Premises, Faulty Policies (2014), and Apostle of Peace (2013).