Harold Demsetz Comes Down from the Fence

Harold Demsetz, an economist I have always greatly admired, has written a somewhat  baffling article (here)  in which he attacks Coase's correction of Pigou's treatment of externalities in social-welfare economics. Demsetz's disagreement with Coase is summed up in a single sentence, which suggests that Demsetz himself has finally descended from his perch between the Chicago School of neoclassical economics and the New Institutional Economics, landing firmly on the Chicago side:

"Coase has treated the legal system and its courts as if they are parts of the economic system, when they are not."

 In a footnote expanding on the point, Demsetz adds, "The neoclassical model ... assumes that all resources are privately owned and that ownership is fully respected; there is no place in its deductions for the courtroom drama imagined by Coase." That, of course, is precisely Coase's problem with the neoclassical model, and why he rejected it in favor of a "new institutional" approach. Interestingly, just one or two pages later Demsetz himself rejects the assumption of complete allocation of property rights, when he argues, in a way perfectly consistent with Coasean analysis, that "[t]here is an efficient degree of ownership that generally is smaller than '100 percent.'"

As usual, Demsetz's article is full of insightful points and witticisms, but his attack on Coase misses the mark. Coase has never focused myopically on market failure as a category; indeed, in a brief 1964 article, Coase pointedly argued that the category of government failure should be every bit as important in economic models. Moreover, Demsetz's assertion that the legal system is not part of the economic system is mind-boggling, especially coming from someone who has spent much of his career writing about property rights and other legal institutions as they affect economic activity.