Economics Works
By David R. Henderson
The Liberty Classic title Economics Works is a double entendre. One meaning refers to many of the more important articles by Armen Alchian, such as those contained in Economic Forces at Work: Selected Works by Armen A. Alchian.1 The other meaning is that economics works: economics explains much of the world. The second meaning sums up how the late Armen Alchian looked at the world and what motivated both his research and his co-authored textbook in economics. He saw economics as a powerful tool for explaining much of human behavior in both market and non-market settings. A subtheme is that once one understands certain aspects of competitive markets, one would view many institutions that people object to in a more sympathetic light. Another subtheme is that some of people’s objections to free markets, such as racial discrimination in employment, are actually due to restrictions on competition.
Alchian’s work spanned a number of disciplines within economics. Though generally thought of as a microeconomist—using economics to explain and predict behavior in individual markets—he also wrote or co-authored important articles on macroeconomics, especially in the areas of inflation and unemployment. This volume is a nice compendium of his articles in both areas. In this review, I highlight six areas in which Alchian had important insights: (1) unintended effects of regulation on racial discrimination; (2) the faulty rationale for taxpayer subsidies of higher education; (3) why collusion by electrical equipment manufacturers was successful mainly against government buyers; (4) why non-profit entities behave the way they do; (5) how costly information explains unemployment; and (6) why it matters whether inflation is anticipated or unanticipated.
Armen Alchian was born in 1914 and grew up in a tight-knit Armenian community in Fresno, California. I never, as a student in his classes or in conversations with him, heard him complain about facing discrimination due to his ethnicity; he tended not to complain about anything. But my guess is that he did face such discrimination and that, instead of making him feel resentful, it made him curious. He asked under what institutional structures discrimination is more likely. A 1962 article in the book, co-authored with the University of Chicago’s Reuben Kessel, is titled “Competition, Monopoly, and the Pursuit of Money.” In it, they argue that when a regulated monopoly bumps up against the profit limit that regulators have set, discrimination becomes a free good. If the firm’s profits were not regulated, they argue, following the reasoning of Gary Becker, then discrimination against employees on grounds other than productivity would cost the firm some forgone profits. But if a firm has hit its profit constraint, there is no further gain from forswearing discrimination to pursue profits. They argue that even firms in industries in which the government has restricted entry, but has not imposed explicit restrictions on profits, face an implicit profit constraint. They write, “Their cardinal sin is to be too profitable.” So, Alchian and Kessel conclude, one should see more discrimination in employment by regulated firms than by unregulated ones. Indeed, that is what their data show. Using a sample of 224 non-Jewish and 128 Jewish MBA graduates of Harvard Business School, Alchian and Kessel studied their employment in ten industry categories. Of the ten, they write, the two with the greatest restrictions on entry are “transportation, communication, and other public utilities” and “finance, insurance, and real estate.” Sure enough, although the relative frequency of Jews in all fields taken together was 36 percent, their representation in these two industries was only 18 percent. The probability of that outcome happening randomly, they note, was less than 0.0005.
I was pleased to see that the first of Alchian’s pieces that I ever read—at the tender age of 17—is in this volume. It’s a 1968 article titled “The Economic and Social Impact of Free Tuition.” In it, Alchian is at the top of his analytic game. Indeed, I found his analysis so persuasive at the time that I stated it in my own words in a submission to a University of Winnipeg committee that had sought input on whether tuition should be reduced: I argued, based on Alchian’s work, that it should be increased.
The first major argument for low or zero tuition that Alchian addresses is that large government subsidies are needed to help poor people attend college. Alchian points out that people who are capable of making it in college are not poor, even if their income is zero and their parents’ income and/or wealth are very low. He uses the analogy of a person with zero income who owns the rights to oil beneath his land. Although his income is zero, he has enormous untapped wealth. Similarly, the low-income college student has untapped wealth in his head that college will help him turn into actual wealth. Alchian writes, “It is wealth, not current earnings nor parents’ wealth, that is the measure of a student’s richness.” Alchian notes that the low income of the student would argue for, at most, a loan, not low tuition. Granting a college student a subsidy so that he can exploit his talent, writes Alchian, “is equivalent to subsidizing drilling costs for owners of oil-bearing lands in Texas.”
Alchian pursues this reasoning further. He writes, “To think that college-caliber students should be given zero tuition is to think that smart people should be given wealth at the expense of the less smart.” He also notes that “One poor, ‘uneducated’ resident of Watts, upon hearing Ralph Bunche says that he could not have had a college education unless tuition were free, opined, ‘Perhaps it’s time he repay us out of his higher income for that privilege granted him by taxes on us Negroes who never went to college.'”
Moreover, says Alchian, even if it is wise to subsidize college students, doing so with zero tuition, rather than with direct grants to students that they get to spend, takes away the students’ power as consumers. If students received subsidies that allowed them to choose which college to spend them on, argues Alchian, “publish or perish” would become less common and high-quality teaching more common.
In the late 1950s, there was a major antitrust case against electrical equipment manufacturers who were alleged to have conspired to fix prices. In an unpublished and undated article, presumably written shortly after the case, Alchian shows that what happened was consistent with economic theory. The collusion was successful, he notes, mainly against government buyers who used sealed-bid contracts. Why would that matter? Alchian explains that one of the major problems colluders have is enforcing their collusive agreements. If they cannot know who cheated on the agreed-upon price, then enforcement is difficult, and there is a strong tendency to cheat by undercutting the agreed price. What makes enforcement relatively easy is if the buyer identifies who bid what price. Guess what government buyers do? They announce all bids with bidders’ names attached to specific dollar bids. By contrast, notes Alchian, private buyers tend not to use sealed-bid systems and, thus, are less vulnerable to collusion. One reason that private buyers tend not to use such systems is that they want to play off one bidder against another, and they realize that broadcasting all bids to all bidders would undercut that strategy. The government employee on the other hand, no matter how high-level, does not have the same incentive to save money because any savings go to the government entity. However, owners of private firms, even if ownership is dispersed, give larger incentives to their agents within the firm to save money.
And that brings us to an issue that Alchian is famous for analyzing: the very different incentives faced by non-profit and for-profit organizations. I still remember, as if it were yesterday, my first day in Alchian’s graduate price theory class at UCLA in September 1972. He claimed that economics can explain not only what happens in for-profit businesses, but also what happens in non-profit organizations. When you have to line up for half an hour to get a parking permit, he said, you shouldn’t feel angry. You should feel happy. Why? Because it means that economics works. The UCLA bureaucracy that underprices the permit would not gain from setting a market-clearing price. The added revenue would go to the bureaucracy. By underpricing the permit, the bureaucrats do benefit themselves and their friends. Here’s how Alchian puts it in one of the articles in the book:
- Attenuated property rights as prevail in nonprofit enterprises, not-for-profit institutions, or publicly owned enterprises induce prices below the market-clearing level. They do so because the higher income or wealth derivable with a higher price at a market-clearing level does not become the private property of the allocator or principal to whom it may be responsible.
Those two sentences explain much of the behavior in non-profit entities.
Is a zero unemployment rate ever optimal? Alchian says no. The reason has to do with information costs. Take a case in which an employer, facing lower demand for the firm’s product, cuts wages temporarily by five percent. An employee may think, often correctly, that there is a better job out there that pays the same as his current job used to pay, or even more. He might also think that there is a job that is more interesting or has better benefits, but he does not know where that job is. If he is working 8 to 5, he might not be able to show up at important interviews or spend time searching effectively, so it often pays to quit a job in order to find a better one. This reasoning seems simple, but in a 1969 article, Alchian explained it more clearly than anyone else had up to that point.
No review of Alchian’s work would be complete without mention of his articles on inflation, co-authored with the aforementioned Reuben Kessel. The four articles with Kessel, published between 1959 and 1962, all appear in Economic Forces at Work. One crucial distinction they make is between unanticipated and anticipated inflation. Unanticipated inflation, they note, transfers wealth from net monetary creditors to debtors. The reason is that the interest rate at which the money is borrowed is not affected by the inflation rate because neither borrower nor lender took it into account. But anticipated inflation is quite different. If both the borrower and the lender correctly anticipate the inflation rate, they will account for that with a higher interest rate to offset the inflation. The result: no wealth transfer from creditor to debtor. This was not new with Alchian and Kessel. Early 20th century economist Irving Fisher had already made the point clearly, but Alchian and Kessel’s contribution was to remind the economics profession of that point.
I have not even touched on Alchian’s distinction between the effect of higher production rates on costs and the effect of higher volume on costs. All else equal, when the annual production rate of a good is raised, there’s a good chance that average costs rise. But all else equal, when the rate of production is held constant, but the volume of production is increased, average costs fall. The economics profession has yet to integrate that distinction into its thinking. One reason is that Alchian did not write numerous articles repeatedly making the same point, which is what might have been required if he had wanted badly enough to change the profession’s thinking. But Alchian’s style was to come up with an insight, write it up, and move on. That got him more insights per page and certainly benefited those who learned from him in class and those who have learned, and will learn, from this fantastic book.
*David R. Henderson is Emeritus Professor of Economics with the Graduate School of Business and Public Policy, Naval Postgraduate School in Monterey, California. He is also a Research Fellow with the Hoover Institution and a Senior Fellow with the Fraser Institute. He blogs at EconLog and is the Featured Articles Editor for the Library of Economics and Liberty.
David R. Henderson earned his Ph.D. in economics from the University of California at Los Angeles, where he was a student of Armen Alchian.
For more articles by David R. Henderson, see the Archive.