Do-it-yourself and nirvana economics

Revisiting the academic contributions of P D Henderson and H Demsetz

In the last few months, two old friends and economist colleagues whose work deserves to be better known in India died.

The first, P D (David) Henderson died at the end of September aged 91. In a varied career, he was an Oxford don, economic advisor to the UK Treasury and chief economist at the UK aviation ministry before becoming director of the World Bank’s Economics Department in 1971. That was when I first met him when he was visiting Nuffield College Oxford, where I was a research fellow completing a book on a cost-benefit study of small-scale irrigation in Maharashtra (Wells and Welfare, OECD, 1972). 

As David was keen to promote a systematic analysis of the Bank’s main business of financing public investment projects at the time, he asked me to come and spend some summers in his department writing a short book (Methods of Project Analysis, Johns Hopkins,1974) appraising the alternative methods of project analysis then vying for the Bank’s attention. He was a stern taskmaster in ensuring that the resulting book was clear, cogent and concise. But he soon fell out with the then IBRD president, Robert McNamara, and in 1975 joined University College London or UCL (where I was a lecturer) as professor of political economy. We became and remained close friends. David had gradually moved away from the political Left to the classical liberalism endorsed by Margaret Thatcher. Encouraged by her then economic adviser Alan Walters, she sent him to the Organisation for Economic Co-operation and Development (OECD) as its chief economist.

During his UCL years, he produced devastating cost-benefit studies of the follies of the supersonic Concorde project and the Central Electricity Board’s advanced gas-cooled reactor in his inaugural lecture. But his major economic contribution was in the BBC Reith lectures he gave when he was at the OECD (Innocence and Design, Blackwell, 1986). In these, he argued that it was not the ideas of economists or vested interests that guide economic policy but the “do-it-yourself (DIY) economics” of laymen who believe they intuitively know how the economy works. No better Indian example is Prime Minister Narendra Modi’s demonetisation decision. 

After retiring from the OECD, he was an itinerant applied economist at various institutions in the UK and the Antipodes, during which he wrote a devastating critique of ‘corporate social responsibility’. Finally, he took issue with various exaggerated claims about the extent and costs of anthropogenic carbon emissions on climate change as propagated by the Intergovernmental Panel on Climate Change (IPCC). This led to his persuading the former UK chancellor of the Exchequer Lord (Nigel) Lawson to set up the Global Warming Policy Foundation, of whose academic council he became chairman, and of which I remain a member, as I had some influence in converting him to climate-scepticism through my Wincott lecture (The Limits of International Cooperation, IEA, 1990, reprinted in my Against Dirigisme, ICS Press, 1994). 

The second recent victim of the Grim Reaper was my UCLA colleague Harold Demsetz, who died at the age of 88 in early January, just a week before we were due to meet him. He was one of the most important micro-economists of the past century who — as many of his obituarists have noted — deserved but did not get the Nobel prize. 

When I took up the new James Coleman chair in International Development Studies in the Economics Department at UCLA in 1991, the leaders of the UCLA economics school were Armen Alchian, and Harold Demsetz who had been at UCLA for over 30 years. They were microeconomists who are wrongly identified as creating an imitation West Coast Chicago by the sea. Though influenced by many Chicago economists — in Demsetz’s case by Ronald Coase and George Stigler — they created and taught a distinctive price theory which was not dependent on Chicago economists claim that a competitive economy can be reasonably be fitted into the Arrow-Debreu model of a perfectly competitive economy. The UCLA price theory was based on the older classical notion of competition as the process of a rivalrous search for unrealised profit opportunities whose outcome is the uniformity of rates of return on invested capital and in prices of identical goods and services, but not because producers are price takers incapable of making prices. This older view of competition emphasising the process of disequilibrium adjustments leading to a competitive equilibrium it is to be found in Marshall and the modern Austrian theorists like Hayek. 

Thus in his famous 1969 paper “Information and Efficiency-Another viewpoint” (reprinted in his The Organization of Economic Activity, vol.2, Blackwell, 1988), Harold coined the notion of the “nirvana fallacy” in criticising Kenneth Arrow’s claim using the Arrow-Debreu framework (in his Economic Welfare and the Allocation of Resources for Invention) that with ‘market failure’, government intervention could make markets more efficient. Demsetz argued that this assumed a perfect government whilst failing to consider if the actual intervention could be perfect. “Those who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce the real is inefficient.”  It is child’s play to show that because of incomplete markets, external effects, and the existence of public goods, ‘market failure’ defined as deviations from a perfectly competitive norm is ubiquitous, but the corollary that this then requires massive corrective public action is unwarranted. Yet we still find many interventionist policies advocated on grounds of ‘market failure’.

Illustration: Binay Sinha

Harold made a seminal contribution to industrial organisation, law and economics, and institutional economics. Of these, I have used his 1968 paper “Why regulate utilities?” to think about privatising Indian infrastructure in my 1996 B R Shenoy Memorial lecture “From Planning to Regulation: Towards a new Dirigisme?” (reprinted in my Unfinished Business, OUP, Delhi, 1999). Harold argued that instead of regulating natural monopolies there should be a competitive auction for becoming the incumbent to run the natural monopoly. This ‘competition for the field’ differs from the later notion of ‘contestable markets’, which is based on competition between an existing incumbent and potential entrants to the natural monopoly. If they can enter and exit without incurring any transition costs, the monopoly would be perfectly contestable, and the insider incumbent would not be able to garner any rent from consumers. By contrast in ‘competition for the field’, competition takes place before production begins and the potential rents are competed away by the best bidder becoming the incumbent, Thereafter, there would be a distinction between insiders and outsiders and substantial transition costs for the latter —in sharp contrast with contestability theory.

I would urge readers to read Harold’s collected essays for the lasting theoretical contributions of a master economist written in rigorous and lucid prose, without the resort to unnecessary mathematics which has become the contemporary hallmark of ‘scientific’ contributions and which perhaps deprived him of the Nobel prize.