Information & efficiency (Demsetz 1969)

I heard about this paper [pdf] when it was mentioned in a podcast, in the context of comparing a real market failure to an imagined government intervention to fix that failure.

Demsetz starts off his paper by noting that he will be critiquing Kenneth Arrow’s claim that an imperfect market allocation invites government intervention to fix it. Demsetz (rightly) points out that government interventions, in reality, might also fail, i.e.,

The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing “imperfect” institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.

What’s crazy is that this delusion (the one Demsetz opposes) is still prevalent in many policy debates. For example: “we can’t tax carbon because we don’t know the right price, but we can definitely subsidise “energy efficiency” because that’s going to produce a predictable fall in use.”

Demsetz goes on to list a number of ways in which the nirvana fallacy leads to misguided policies, e.g., ignoring issues with information, people’s aversion to risk, moral hazard (taking risks with others’ money), and human’s general propensity to behave less as mathematical automatons and more as emotional, limited and conflicted individuals who may (not) follow social, legal and economic cues.

Demsetz also makes the obvious (and often overlooked) case for governments being composed of individuals — all with their own views and foibles — rather than the efficient calculating machine (the “social planner”) assumed by many academics — and interventionists.

He also repeats the (often ignored) argument in Hayek (1945) regarding information and innovation, i.e., that a central planner cannot hope to have as much information as many different people in distributed settings, locations and positions. The implication is that a less-than-humble planner  will make errors in calculating and implementing decisions that can be handled by those individuals.

The last part of the paper has some relatively simple maths and figures to support Demsetz’s points.

I recommend this paper to all economists — and many activists — for the important points it makes, i.e.,

I have stated elsewhere what I believe to be the basic problem facing public and private policy: the design of institutional arrangements that provide incentives to encourage experimentation (including the development of new products, new knowledge, new reputations, and new ways of organizing activities) without overly insulating these experiments from the ultimate test of survival. In the context of the problems discussed in Arrow’s paper, these institutional arrangements must strive to balance three objectives. A wide variety of experimentation should be encouraged, investment should be channeled into promising varieties of experimentation and away from un-promising varieties, and the new knowledge that is acquired should be em-ployed extensively. No known institutional arrangement can simultaneously maximize the degree to which each of these objectives is achieved¬†

 

Author: David Zetland

I'm a political-economist from California who now lives in Amsterdam.

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