Remembering Armen Alchian

by Jerry O’Driscoll

Earlier this year, we lost one of the greatest economists of this century, UCLAs Armen Alchian, who died at age 98. David Henderson wrote a wonderful appreciation of him for the Wall Street Journal.

Alchian taught at UCLA from the early 1950s until his retirement in the 1990s. Few men have put their stamp on a department as he did. Milton Friedman comes to mind at Chicago. Alchian taught the economic way of thinking, and his approach permeated the course offerings by almost all the other professors. If you took macro from Axel Leijonhufvud, you got a dose of Alchian’s micro. In monetary classes, works like Alchian’s “Why Money” were topics of discussion.  Alchian’s analysis of price searching behavior was background in all the courses.

Liberty Fund published a two-volume collection of his writings. I can obviously touch on only a few issues.

One of Alchian’s greatest contributions was to the theory of market pricing. In his analysis, transactors do not face given prices but a situation of uncertainty with respect to prices. They search for the profit-maximizing price, and in the process move up and down an unknown demand curve. A downward sloping demand curve is not the sign of market power or monopoly, but of competitive markets and uncertainty. Entrepreneurship consists in a superior skill at ferreting out the profit maximizing price.

Alchian’s analysis of price stickiness turns contemporary efforts upside down. In his view, price stickiness is an essential feature of competitive markets. If all markets were auction markets, buyers and sellers would incur high transaction costs because they would be uncertain at what prices they could transact. If prices are to convey information across time in the Hayekian sense, they must be more than transitory.

“Posted,” i.e., sticky prices reduce uncertainty and transaction costs.  Buffer stocks smooth price adjustments. When inventories move outside desired ranges, sellers must either restock depleted inventories or cut prices to sell excess inventories.  If many sellers experience depleted inventories due to an increase in demand, their costs will rise and they will be forced to raise prices. The rise in costs results from a shift in demand, which is communicated through quantity adjustments.

It is the movement in quantities that signal to sellers the need to change prices. Absent quantity adjustments, sellers have no feedback signal telling them to change prices. Again, sticky prices are not an imperfection or an impediment to competitive markets, but essential to their operation.

Alchian’s theory of rents is central to today’s reality. As an avid golfer, he appreciated that California residents enjoy economic rents because of the climate. Rents are an attractive target for taxing authorities. As long as taxes do not exceed rents, the game continues. California authorities have proven adept at creating more rents through such measures as land-use restrictions and occupational licensure. As long as the dynamic creation of rents can be continued, the California government can finance its profligate expenditures, which, of course, create new rents.

In his theory of free (or subsidized) tuition, Alchian explained how public education, especially at the university level, transfers resources from the poor to the wealthy. Students at public universities may be poor in terms of current income, but are wealthy in present-value terms. They will earn higher incomes over their lifetimes. Public higher education is part of a regressive tax scheme.

On March 23rd, the Alchian family sponsored a remembrance for their father and husband at the UCLA Faculty Club. It was a moving event attended by 100 former colleagues and students. They came from all over the country and the world. Two former students flew in from Beijing. After the event, about 60 of us stayed for a reception and dinner of good fellowship and fond memories.

We have lost another great economist. In my opinion, the Armen Alchians, Jim Buchanans and Friedrich Hayeks are not being replaced by comparative giants.

9 thoughts on “Remembering Armen Alchian

  1. I do not agree that there are no replacements. There are lots of replacements from around the world See the Mises Institute with its numerous Austrian economists around the world.

  2. Does the modern sorting system of academic economics eliminate the “creative” thinkers of previous generations? Buchanan would not get into Chicago today.

  3. Nice post. Surprising that his analysis was not taken up on sticky wages and prices.

  4. Alchian (1969) lists three ways to adjust to unanticipated demand fluctuations:
    • output adjustments;
    • wage and price adjustments; and
    • Inventories and queues (including reservations).

    Alchian (1969) suggests that there is no reason for wage and price changes to be used regardless of the relative cost of these other options:
    • The cost of output adjustment stems from the fact that marginal costs rise with output;
    • The cost of price adjustment arises because uncertain prices and wages induce costly search by buyers and sellers seeking the best offer; and
    • The third method of adjustment has holding and queuing costs.

    There is a tendency for unpredicted price and wage changes to induce costly additional search. Long-term contracts including implicit contracts arise to share risks and curb opportunism over sunken investments in relationship-specific capital.

    These factors lead to queues, unemployment, spare capacity, layoffs, shortages, inventories and non-price rationing in conjunction with wage stability.

    Alchian and Woodward’s 1987 ‘Reflections on a theory of the firm’ says:

    “… the notion of a quickly equilibrating market price is baffling save in a very few markets.

    Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances? If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears?

    … But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.”

    Alchian and Woodward then go on to a long discussion of the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage and price revisions.

    Alchian and Woodward explain unemployment as a side-effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets.

    They note that unemployment cannot be understood until an adequate theory of the firm explains the type of contracts the members of a firm make with one another.

    Benjamin Klein’s theory of rigid wages in American Economic Review in 1984 is one of the few that explored rigid wages as an industrial organisation issue. Klein treated rigid wages as a response to opportunism and hold-up problems over specialised assets and are forms of exclusive dealership or take-or-pay contracts.

  5. Thanks, Jerry, for a nice post. And let’s not forget University Economics, one of the great books of economics. As a graduate student in the 1970s, it allowed me to break out of the gloom of Arrow/Debreu and along with the Austrians opened my eyes to what real economics could be.

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