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Demsetz on the Costs of Markets

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One of the papers I’ve assigned to my Spring 2011 ECON 612 (Microeconomics II for Masters students) is Harold Demsetz’s classic 1964 article, from the Journal of Law & Economics, “The Exchange and Enforcement of Property Rights [2].”  (Only persons with access to JSTOR can gain full access to this article at this link.)  Demsetz [3] is one of my all-time favorite scholars; he’s an economist’s economist – and it’s a damn shame that he and his UCLA colleague Armen Alchian [4] have not yet been awarded the Nobel Prize.

Here’s a key passage from Demsetz’s article, making a point that is still largely ignored in public-policy discussions about, say, the effects of industrialization on the environment.  (Just a tad bit of background for non-economists: A standard claim is that economic inefficiency results whenever markets fail to price some scarce good, such as a unit of cleaner air; the follow-up conclusion – one that is usually jumped to – is that government must intervene to correct this inefficiency either by regulating, taxing, or creating a market [think cap-and-trade] for the heretofore unpriced scarce good).  Now here’s Demsetz:

But, this [standard welfare-economic] reasoning generally fails to take account of the fact that the provision of a market (for the side effect [e.g., smoke-stack emissions that fall on nearby houses]) is itself a valuable and costly service….  In asking the implications of the nonexistence of some markets, we seem to have forgotten the cost of providing market services or their government equivalent.  The existence of prices to facilitate exchange between affected parties has been too much taken for granted.  A price for every produced good or service is not a necessary condition for efficiency, so that the absence of a price does not imply that either market transactions or substitute government services are desirable.  If we insist either that all actions (services or commodities) be priced in the market or that the government intervene, we are insisting that we do not economize on the cost of producing exchanges or government services [emphasis added].

[This passage is from page 130 of the reprint of Demsetz’s article in Tyler Cowen, ed., The Theory of Market Failure (Fairfax, VA: George Mason University Press, 1988), pp. 127-145.]