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. In practice, those who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient. Users of the comparative institutional approach attempt to assess which alternative real institutional arrangement seems best able to cope with the economic problem; practitioners of this approach may use an ideal norm to provide standards from which divergences are assessed for all practical alternatives of interest and select as efficient that alternative which seems most likely to minimize the divergence.Demsetz goes on to explain that the nirvana approach is more likely to commit the following three fallacies than is the comparative institutions approach: 1) the "grass is always greener" fallacy, 2) the fallacy of the free lunch, and 3) the "people could be different" fallacy. The rest of the paper is organized around discussions of these fallacies the context of Arrow's paper and concludes with a general criticism of the nirvana approach.
The "grass is always greener" fallacy essentially assumes that some perceived problem with the way markets handle the provision of a good can be solved by government action. Demsetz argues that the effectiveness of the government action is assumed to be better; that government action can in fact determine and implement a solution that deals with the market inefficiency.
The fallacy of the free lunch, Demsetz argues, is closely related to that of the "grass is always greener" fallacy. The free lunch aspect comes into play in the discussion of the adjustment from the sub-optimal market outcome to the government induced optimal outcome. The cost of the adjustment itself must be considered since it requires the use of scarce resources.
The "people could be different" fallacy is best explained with a quote from the paper:
Do we shift risk or reduce moral hazards efficiently through the market place? This question cannot be answered solely by observing that insurance is incomplete in coverage. Is there an alternative institutional arrangement that seems to offer superior economizing? There may well be such an arrangement, but Arrow has not demonstrated it and, therefore, his allegation of inefficiency may well be wrong and certainly is premature.Perhaps some level of self-insurance is efficient if the cost of insuring due to moral hazard is too high. In this case, the insurance market isn't incomplete or failing to provide a service, the service is simply precluded by the cost of the moral hazard.
Demsetz then goes through Arrow's example of innovation and monopoly, which I'll leave to the interested reader.
Near the end of the essay, Demsetz summarizes his argument against the Nirvana approach.
It is one thing to suggest that wealth will increase with the removal of legal monopoly. it is quite another to suggest that indivisibilities and moral hazards should be handled through nonmarket arrangements. The first suggestion is based on two credible assumptions, that the monopoly can be eliminated and that the practical institutional arrangement for accomplishing this, market competition, operates in fairly predictable ways. The second assertion cannot claim to have eliminated indivisibilities, risk-averse psychology, moral hazard, or costly negotiations, nor can it yet claim to predict behavior of the governmental institutions that are suggested as replacements for the market.In other words, it's highly likely we can improve the welfare of society by eliminating legal monopolies, and it's certainly possible to do so. On the other hand, eliminating perceived market inefficiency with government policy is much less likely.
It seems as though the "grass is always greener" fallacy continues to pervade much of economic policy analysis. Some smaller schools of thought such as Public Choice, New Institutional Economics, and the Austrian School take Demsetz's critique to heart and consider government failure to be, at least potentially, as big a problem as market failure. More broadly, however, the two concepts are treated very differently. "Market failure" is a fundamental analytic category which is taught at all levels of economic education and is the subject of a prodigious amount of research. In contrast, "government failure" does not enjoy the same status as a standard subject of analysis.
A recent paper evaluating the prevalence of market failure and goverment failure concepts in 23 of the most popular Principles of Economics texts finds that, on average, there are more than 5 mentions of market failure for every 1 mention of government failure. The clear outlier, Gwartney et al. actually mentions more instances of government failure than market failure. At a distant second, Cowen and Tabarrok mentions government failure once for every 3 mentions of market failure. As one might expect, Krugman and Wells doesn't mention government failure at all.
In his 1969 article discussed above, Demsetz makes a solid argument that comparative institutions analysis is superior to the nirvana approach. Certainly all institutional arrangements can "fail" in the sense that they may not live up to unrealistic ideals. Standard tools of theoretical analysis may provide some insight into this unrealistic (and unrealizeable) ideal, but the analysis that influences policy should include a relevant alternative as a foil, not an impossibly perfect standard.
For more on this topic, see here, here, here, and here.
*Demsetz, Harold. 1969 "Information Efficiency: Another Viewpoint" Journal of Law and Economics Vol. 12 No. 1 pp 1-22