Why Did Armen Alchian Have to Teach Economists About Property Rights?

This isn’t the only example one could give of Armen Alchian’s mind unearthing the economic forces at work in everyday life. He wrote fundamental papers in economic theory and in applied economics, but he is perhaps best known for his book with William Allen, University Economics,2 which was first published in 1964 and sought to communicate the power of basic economic reasoning and, in particular, basic price theory to college students. The book became a classic reference for faculty and graduate students who resisted the dominant macroeconomic approach of the time. It served as the introduction to economics to generations of college students. It was the first textbook to challenge the hegemony of Paul Samuelson’s Economics, and to reassert the primacy of microeconomic analysis and micro-foundations for discussing monetary analysis and policy. Samuelson’s text, it must be remembered, did not introduce supply and demand analysis, let alone individual choice discussions, until well after the full treatment of macroeconomic concepts such as National Income Accounting and the tools of aggregate demand management. Only when the macroeconomic system was in balance, Samuelson taught, could the microeconomic analysis of supply and demand and the examination of the market economy at the industry, and even firm, level take place. Alchian and Allen effectively reversed that order in University Economics and built the analysis from the individual to the firm to the industry to the economic system.

In the UCLA oral history interviews, Alchian explains while interviewing F. A. Hayek how as a student in the 1930s two books would shape his life’s work. This comes after a rather charming moment when Alchian quizzes Hayek on the meaning of price changes in the context of inflation. When Hayek gives the “right” answer focusing on relative prices as guides to exchange and production decisions, Alchian smiles and informs Hayek that he got the answer right. In the interview, Alchian also discusses how as a student he read Hayek’s Prices & Production, which led to his own emphasis on relative prices as guides, and how reading Berle and Means’ The Modern Corporation and Private Property challenged him to provide an answer to the problem of the separation of ownership from control in the organization of firms and their governance. Property, prices, and profit-and-loss remained the focus of Alchian’s economic analysis throughout his life.

Alchian’s unique positioning within the economics profession is largely a consequence of the particularities of his time. To an earlier generation of economists educated in the late 19th and early 20th century, many of his insights were just common-knowledge among serious students of classical and early neoclassical economics. But to the generations educated in the post WWII era, Alchian’s insights were so alien to their way of thinking that either he was dismissed as a relic of an earlier age, or exalted to the status of one of the most clever and creative thinkers in the profession. My position is that Alchian was both—a relic of that earlier age, and a clever and creative thinker in possession of unique insights. The evolution of economic theory between 1930 and 1950 sought to squeeze out the analysis of property, prices, and profit-and-loss, and I might add people and politics as well. All the things studied by the great classical political economists from Adam Smith to John Stuart Mill were now pushed aside as economics became too aggregative, with the consequent loss of the individual and the exchange relationships forged in the market. Economics became too formal in presentation, with the loss of nuance, processes, and institutional framing due to a preoccupation with analytical tractability.

This is all just background to my primary purpose in this particular essay. I will consider two of Alchian’s most famous papers: his 1950 paper, “Uncertainty, Evolution and Economic Theory,” and his 1965 paper, “Some Economics of Property Rights,” as an illustration of the points he was making in the conversation with Hayek. In the first paper, Alchian enters into an ongoing debate over the behavioral foundations of economics. The claim was that people are not rational. They do not maximize utility, and they don’t maximize profits. Real people are weak of will; they are deluded; they have multiple and conflicting objectives, and they are ensnared in the dark forces of time and ignorance. Economic theory, the critics argued, was grounded in an unrealistic model of man, and thus led to unrealistic and irrelevant conclusions.

Alchian’s “Uncertainty, Evolution and Economic Theory” sought to respond not by insisting that individuals are perfectly rational, but instead by arguing that the optimality conditions that economists often identify, such as the equimarginal principle, the MR=MC rule, etc., are by-products of the competitive filter in a market economy. Survivorship means that less-effective rules of thumb in decision-making will lose out to those that are more effective. Evolution in the market exhibits the same characteristics as evolution in nature, where variation and selection mechanisms operate. Individual firm owners are not required to know that pricing equal to marginal cost is the profit maximizing choice. “Even in a world of stupid men,” Alchian writes, “there would still be profits.” Individuals will be led to that decision by the economic forces at work within the market context. If, for a variety of reasons, individuals are not confronted with the competitive pressure of substitutes and the discipline of hard-budget constraints, then of course the economic forces at work in that situation will steer their behavior in a different direction in predictable ways.

The property rights in operation provide a structure of incentives to which individuals respond. The prices they confront in the market society guide them in their exchange and production decisions. Profits lure individuals, and losses discipline them in their decisions. The fact that “a fool and his money are soon parted” is as much a critical aspect of economic forces at work, as “$20 bills don’t lie on the sidewalk without being picked up.” But how those two sayings affect human decision-making, and how urgently their force is felt is a function of the property rights in operation within which they are interacting. A $20 bill that costs me $25 to pick up may lie on that sidewalk for a long time. In fact, it will lie there until it costs someone less than $20 to pick it up!

Alchian’s “Some Economics of Property Rights” explained, following the basic logic of economics, that private property rights concentrate the rewards-costs more directly on the individual decision maker, while public ownership disperses those rewards-costs more widely. This has consequences—neither good nor bad by definition, but also not trivial. The property rights structure in operation changes the methods and manner in which objectives will be pursued. As Alchian says, he is just following Adam Smith when he writes that individuals will “redirect their activities as they seek to increase their utility or level of satisfaction of their desires” when there are “changes in the rewards-costs structure.” Whereas most of the economics literature talks about the division of labor in society, Alchian wanted to get fellow economists to think about the division of ownership in society. Under a private property ownership structure, there will emerge a pattern of resource ownership tailored to unique skills and talents. People differ, Alchian stresses, “in their talents as owners.” They have different abilities to bear risk, to make decisions about what to produce, how much to produce, the best method to produce it, how much to invest in the enterprise, and who should be employed in the processes of production and distribution as laborers and as managers. “Ownership ability,” he concludes, “includes attitude toward risk bearing, knowledge of different people’s productive abilities, foresight, and, of course, ‘judgment’.” And, this ownership structure is put to the test every day in the private property market economy. Less so, in the public ownership regime of government activity. There the test is different, the rewards-costs structure is different, and thus the behavior is different. Again, this is just as Adam Smith taught.

So, why did Alchian have to recapture such a basic point of common economics knowledge that had been recognized from Adam Smith onward? My conjecture is that Alchian was necessary because knowledge that was once firmly embedded in the training of economists was lost during the Keynesian revolution in economic thought and the Samuelsonian reconstruction of economics after WWII. In the preoccupation with macroeconomics, the development of microeconomic arguments under Samuelson tended to focus on market structure and the inefficiencies that emerged in the technical presentation when there was a deviation from the idealized model due to monopoly power, externalities, public goods, and inequality. The institutional framework, which was so critical to the classical political economists, went from being treated as given to being forgotten. And with that, any hope of critical analysis of the impact of alternative institutional arrangements on the pursuit of productive specialization and peaceful social cooperation through exchange was lost in the professional literature. The increasing distance between the mainstream literature of 1950-1975 and the earlier presentations of the competitive market process and the liberal political and legal structure within which the economy was embedded is an indicator of just how far economic theory had become derailed. Hayek’s works during the 1950-1975 period, such as The Constitution of Liberty and Law, Legislation and Liberty, were viewed as abandonments of economics. In reality he was drawing his readers’ attention to the institutional infrastructure within which economic activity is played out. But this was not understood at the time. The extent to which it came to be understood was in no small measure due to the pioneering effort of Armen Alchian, who resurrected and further developed the property rights perspective in economics and political economy.

Footnotes

[1] For a discussion of this episode see Joseph Michael Newhard, “The Stock Market Speaks: How Dr Alchian Learned How to Build the Bomb.” Available online at: https://www.semanticscholar.org/paper/The-stock-market-speaks%3A-How-Dr.-Alchian-learned-to-Newhard/16e0b86e93fd4461c7828c1cc2c14558c22b48a1

[2] Universal Economics is a new work that builds on the foundation of its two predecessors, University Economics (1964, 1967, 1972) and Exchange and Production (1969, 1977, 1983). Armen A. Alchian and William R. Allen. Edited by Jerry L. Jordan Available at: https://www.libertyfund.org/books/universal-economics