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Do-it-yourself and nirvana economics



Published with the kind permission of the author

Revisiting the academic contributions of P D Henderson and H Demsetz 

In the last few months, two old friends andeconomist colleagues, whose work deserves to bebetter known in India, died.

The first, P D (David) Henderson died at the end ofSeptember aged 91. In a varied career, he was an Oxforddon, economic advisor to the UK Treasury and chiefeconomist at the UK aviation ministry before becomingdirector of the World Bank’s Economics Departmentin 1971. That was when I first met him when he wasvisiting Nuffield College Oxford, where I was a researchfellow completing a book on a cost-benefit study ofsmall-scale irrigation in Maharashtra (Wells andWelfare, OECD, 1972).

As David was keen to promote a systematic analysisof the Bank’s main business offinancing public investment projectsat the time, he asked me to come andspend some summers in his departmentwriting a short book (Methodsof Project Analysis, JohnsHopkins,1974) appraising the alternativemethods of project analysisthen vying for the Bank’s attention.He was a stern taskmaster in ensuringthat the resulting book was clear,cogent and concise. But he soon fellout with the then IBRD president,Robert McNamara, and in 1975 joinedUniversity College London or UCL (where I was a lecturer)as professor of political economy. We becameand remained close friends. David had graduallymoved away from the political Left to the classical liberalismendorsed by Margaret Thatcher. Encouragedby her then economic adviser Alan Walters, she senthim to the Organisation for Economic Co-operationand Development (OECD) as its chief economist.

During his UCL years, he produced devastatingcost-benefit studies of the follies of the supersonicConcorde project and the Central Electricity Board’sadvanced gas-cooled reactor in his inaugural lecture.But his major economic contribution was in the BBCReith lectures he gave when he was at the OECD(Innocence and Design, Blackwell, 1986). In these, heargued that it was not the ideas of economists or vestedinterests that guide economic policy but the “do-ityourself(DIY) economics” of laymen who believe theyintuitively know how the economy works. No betterIndian example is Prime Minister Narendra Modi’sdemonetisation decision.

After retiring from the OECD, he was an itinerantapplied economist at various institutions in the UKand the Antipodes, during which he wrote a devastatingcritique of ‘corporate social responsibility’. Finally,he took issue with various exaggerated claims aboutthe extent and costs of anthropogenic carbon emissionson climate change as propagated by theIntergovernmental Panel on Climate Change (IPCC).This led to his persuading the formerUK chancellor of the Exchequer Lord(Nigel) Lawson to set up the GlobalWarming Policy Foundation, ofwhose academic council he becamechairman, and of which I remain amember, as I had some influence inconverting him to climate-scepticismthrough my Wincott lecture (TheLimits of International Cooperation,IEA, 1990, reprinted in my AgainstDirigisme, ICS Press, 1994).

The second recent victim of theGrim Reaper was my UCLA colleagueHarold Demsetz, who died at the age of 88 in earlyJanuary, just a week before we were due to meet him.He was one of the most important micro-economistsof the past century who — as many of his obituaristshave noted — deserved but did not get the Nobel prize.

When I took up the new James Coleman chair inInternational Development Studies in the EconomicsDepartment at UCLA in 1991, the leaders of the UCLAeconomics school were Armen Alchian, and HaroldDemsetz who had been at UCLA for over 30 years.They were microeconomists who are wrongly identifiedas creating an imitation West Coast Chicago bythe sea. Though influenced by many Chicagoeconomists — in Demsetz’s case by Ronald Coase andGeorge Stigler — they created and taught a distinctive price theory which was not dependent on Chicagoeconomists claim that a competitive economy can bereasonably be fitted into the Arrow-Debreu model ofa perfectly competitive economy. The UCLA price theorywas based on the older classical notion of competitionas the process of a rivalrous search for unrealisedprofit opportunities whose outcome is the uniformityof rates of return on invested capital and in prices ofidentical goods and services, but not because producersare price takers incapable of making prices. Thisolder view of competition emphasising the process ofdisequilibrium adjustments leading to a competitiveequilibrium it is to be found in Marshall and the modernAustrian theorists like Hayek.

Thus in his famous 1969 paper “Information andEfficiency-Another viewpoint” (reprinted in his TheOrganization of Economic Activity, vol.2, Blackwell,1988), Harold coined the notion of the “nirvana fallacy”in criticising Kenneth Arrow’s claim using theArrow-Debreu framework (in his Economic Welfareand the Allocation of Resources for Invention) that with‘market failure’, government intervention could makemarkets more efficient. Demsetz argued that thisassumed a perfect government whilst failing to considerif the actual intervention could be perfect.“Those who adopt the nirvana viewpoint seek to discoverdiscrepancies between the ideal and the realand if discrepancies are found, they deduce the realis inefficient.” It is child’s play to show that becauseof incomplete markets, external effects, and the existenceof public goods, ‘market failure’ defined as deviationsfrom a perfectly competitive norm is ubiquitous,but the corollary that this then requires massivecorrective public action is unwarranted. Yet we stillfind many interventionist policies advocated ongrounds of ‘market failure’.

Harold made a seminal contribution to industrialorganisation, law and economics, and institutionaleconomics. Of these, I have used his 1968 paper “Whyregulate utilities?” to think about privatising Indianinfrastructure in my 1996 B R Shenoy Memorial lecture“From Planning to Regulation: Towards a newDirigisme?” (reprinted in my Unfinished Business, OUP,Delhi, 1999). Harold argued that instead of regulatingnatural monopolies there should be a competitive auctionfor becoming the incumbent to run the naturalmonopoly. This ‘competition for the field’ differs fromthe later notion of ‘contestable markets’, which is basedon competition between an existing incumbent andpotential entrants to the natural monopoly. If they canenter and exit without incurring any transition costs,the monopoly would be perfectly contestable, and theinsider incumbent would not be able to garner anyrent from consumers. By contrast in ‘competition forthe field’, competition takes place before productionbegins and the potential rents are competed away bythe best bidder becoming the incumbent, Thereafter,there would be a distinction between insiders and outsidersand substantial transition costs for the latter --in sharp contrast with contestability theory.

I would urge readers to read Harold’s collectedessays for the lasting theoretical contributions of amaster economist written in rigorous and lucid prose,without the resort to unnecessary mathematics whichhas become the contemporary hallmark of ‘scientific’contributions and which perhaps deprived him of theNobel prize.

Source: Business Standard