03 September 2013

OBIT: Ronald Coase, Nobel-Prize Winning Economist, May Have Predicted the Coming Transformation of the Corporation

Ronald Coase died Monday. He was 102 and had just published a book last year. Nice life.

Here is my mention of him in my book, The Fourth Economy. He explained the rise of the corporation as a function of high information costs. Now that information costs are so much lower, I suspect that the corporation will be transformed.

First, how Coase's theory explains why the corporation became so important.

As Alfred Chandler points out, the corporation grew in response to the complication of work that came along with the evolution from manufacturing work into knowledge work. Rather than the invisible hand of markets coordinating this work, it was the visible hand of management that now coordinated work.

Ronald Coase won a Nobel Prize in economics for explaining why organizations rather than markets emerged as a means to organize work. Simply put, his theory is that the information costs were too high to justify one-on-one transactions, and it was more efficient to establish companies as a means to organize work instead. Take the example of the guy who wants to buy a burrito. Imagine that each time he wanted to get a burrito for lunch he had to find the guy who made and sold tortillas, then the guy who made and sold beans, and so on for carnitas, guacamole, salsa, and whatever other ingredients he wanted. And then to top it all off, he had to hire someone to assemble all of this into a burrito. Not only would this be a terribly complex task to perform over the course of his lunch break, but the guy who would have to perform the few minutes of burrito assembly would likely charge him for a full hour’s work, since it would take him that long to get there and back—and this does not even factor in the place and the tools (the capital) that would be needed to perform all this. A burrito in this scenario might cost hundreds of dollars and take hours to procure. It is much simpler for a customer to just go to the local taco shop, where all the knowledge, the labor, and the capital are pooled into one place, under one manager, and where our hungry hero can buy the burrito for, say, $6 instead. The cost to find each person and item involved in making the burrito is too high. And of course, the average person can actually assemble a burrito (assuming that he doesn’t have to raise the chickens, grow the beans and rice, etc.), something he can’t do with a really complex product like, say, a number 2 pencil. By about 1900, many products had become too complex for any one person to make. By early in the twenty-first century, many products had become too complex for any one company to make, as outsourcing became more and more common.  Complexity makes it challenging to coordinate production through one-off market exchanges, or single transactions. It is easier to set up a company and then manage such tasks and transactions (or as they are called within the corporation, process steps).  Coase’s thesis is that information and transaction costs were higher than the cost of institutionalizing these activities. So, instead of market transactions for each task or project, organizations were formed to turn potentially sporadic transactions into relatively stable processes.

In 1800, individual farmers or artisans conducted most economic activity. By 2000, corporations conducted most economic activity. Rather than being left to markets, work was managed. It was, as shown by Coases’s analyses, too expensive to orchestrate all of this by market forces alone.

Then, this excerpt from later in the book, arguing that if Coase is right, the corporation could be dissolved by lowered information costs.

It seems likely that the Internet will do for the corporation what the Guttenberg press did for the church. That is, it’ll break up structures we had always assumed were permanent: it’ll render temporal what we thought was timeless.

Ronald Coase won a Nobel Prize in Economics for his work on the firm. The question he asked is, “Why, if markets are so effective, do companies have employees?” The simple answer is that information costs are too high to turn every task into a transaction, making it cheaper to rely on contracts than markets. That is, it is simply too hard to coordinate the work that goes on inside of a company any way other than through job descriptions and assignments. Yet Coase’s work was largely done long before the Internet as we know it. Information costs have plummeted in the last couple of decades. One consequence of these falling information costs may be a growth in the portion of the economy that is managed by the invisible hand of markets rather than the visible hand of management. Savvy corporations might tap this potential to create a growth in market forces within corporations.

What does this mean in practical terms? If a programmer in the Ukraine should get an idea and can find a designer in Italy and an assistant in India, the work can be done through informal arrangements that may or may not include a corporation. I actually think that one of the social inventions of savvy communities will be the simplification of what is required to form a multinational corporation, if only to make issues of ownership more clear and simple. (It is one thing to say that people from different countries collaborated to create something and quite another to say that everyone is clear and happy about the way its success is shared.) Regardless of how many and what type of social inventions will be necessary for this to work, however, the fact is simply this: technology around the planet has never before so lent itself to self-organizing activities. The Internet could replace organizational structures. This alone could revolutionize the corporation.

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