Reducing transaction costs – the end of the firm?


RonaldCoase.jpgThe man who introduced the concept of transaction costs recently passed away at the age of 102. Interestingly, his 70-year-old theory explains organisations’ vertical integration in the first half of the 20th century and their contradictory aggressive outsourcing more recently. But how is the lower transaction cost offered by the Internet revising the theory? asks Ariba’s James Marland, Vice President of Network Strategy, in this month’s SmartProcurement.

Nobel Prize-winning economist Ronald H. Coase, who recently died in Chicago at 102, first came to prominence in 1937 with his paper, “The Nature of the Firm”, which introduced the concept of transaction costs — the costs each party incurs in the course of buying or selling things — and showed that companies made economic sense when they were able to reduce or eliminate those costs by performing some functions in-house rather than dealing in the marketplace.

JamesMarland_Ariba.pngThe ideas laid out in the paper explain why, in the first half of the 20th century, organisations tended to become more vertically integrated (for example, Ford Motor Company building its own steel mills and buying its own rubber plantations rather than relying on suppliers), and why, more recently, organisations have tended to do the opposite, aggressively outsourcing even basic functions like paying their suppliers.

At a recent Aspen Institute conference, Irving Wladawsky-Berger discussed how the Networked Economy is revising Dr. Coase’s 70-year-old theory:

“The Internet has radically lowered the transaction costs of obtaining goods and services outside the firm. So, more than ever, companies need to focus their energies on their true point of differentiation instead of squandering competitive advantage by dispersing focus and investment.

“But, as firms are increasingly relying on business partners for many of the functions once done in-house, one of their major organisational challenges is how to best manage their distributed operations across a network of interconnected companies. This is particularly important because of the growing complexity of the products, services, systems, and solutions companies are now developing. Complexity generally results in unanticipated consequences and increases the risks of something going seriously wrong.” [my emphasis]

I’d certainly agree that the Internet has lowered the transaction costs of obtaining goods. This can be in using an e-auction site to run a competitive tender, using a Supplier Discovery service to locate new sources of supply, or removing transaction cost by e-invoicing. In fact, with a good business network, transaction costs can be made almost as low as the traditional vertically-integrated organisation.

Wladawsky-Berger’s concern above relates to the cost of complexity, and the fact that complexity naturally introduces risk into a business. However, I believe that an advanced business network can manage some of the increased complexity and mitigate the risk. Some examples:

• Multi-tier supply chains introduce risk, but an intelligent business network “sees” multiple levels of a supply chain so it can bubble up problems from deep down to the stakeholders further up the chain
• High switching costs mean that you are tied to suppliers. If the network allows a simple way to switch suppliers, to find alternative sources of supply from well-qualified suppliers with whom you can communicate in the same fashion, then this can also be a great risk reducer.
• Giving suppliers access to financing options so that they can manage their cash better helps them stay loyal to me, and reduces the risk of them running out of money.

This is one of the fundamental differences between a smart, intelligent network, and a series of dumb pipes that just move data around. An intelligent network has the ability to absorb a large part of the risk that is introduced into the system.

So transaction costs may be decreasing, but this is coming with a concomitant increase in complexity.

I don’t think people will still debate this article in 70 years’ time. RIP Ronald Coase.

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