<nettime> [RRE]notes and recommendations (excerpt: networks and markets)

[t byfield <tbyfield@panix.com>]

----- Forwarded [excerpt]

Date: Sun, 26 Dec 1999 15:35:16 -0800 (PST)
From: Phil Agre <pagre@alpha.oac.ucla.edu>
To: "Red Rock Eater News Service" <rre@lists.gseis.ucla.edu>
Subject: [RRE]notes and recommendations

<...>

Where did the association between computer networks and decentralized
markets come from?  With some authors, such as George Gilder, little
in the way of a coherent argument joins them: they observe that modern
digital networks put the computer power on your desk, not in the guts
of the network, and so they suppose that social power will therefore
become equally distributed (see, for example, Life After Television,
Norton, 1992, pages 47-48, 126).  But this hardly follows; while the
basic architecture of the network is surely important in political
terms, the architecture of the applications that run on it is more
so (see, for example, Larry Lessig, Code and Other Laws of Cyberspace,
Basic Books, 2000).

A more common, more serious argument is economic.  According to this
argument, computer networks reduce the costs of doing business, this
will improve the efficiency of markets, and as markets become more
efficient hierarchical firms will wither away from competition and
governments will become both unnecessary and impractical.  In more
technical terms, computer networks are said to reduce transaction
costs: the costs of buying and selling things in the market.  These
transaction costs are likened to friction, and computer networks
are supposed to reduce that friction to zero, thereby perfecting
the market and dissolving all of the remaining "islands of conscious
power" into a great sea of freely contracting individuals.

This argument sounds compelling in the abstract, but it is actually
quite false.  To see this, it will help to return to the origin of
the concept of transaction costs, Ronald Coase's paper "The nature of
the firm" (Economica NS 4, 1937, pages 385-405; reprinted in Oliver
E. Williamson and Sidney G. Winter, The Nature of the Firm: Origins,
Evolution, and Development, Oxford University Press, 1991).  Coase's
paper asks a deep question: if the market is the most efficient way
to organize economic activity, why do firms exist?  Why aren't the
activities that take place within the firm coordinated by markets?
Why aren't these zones of hierarchical command obliterated through
competition?  The reason, Coase suggests, is that the mechanisms of
the market have costs of their own.  Buyers and sellers expend time,
effort, and resources to find one another, negotiate a deal, enforce
the deal, and so on.  Coase refers to these costs as marketing costs,
but they have come to be called transaction costs.  And he suggests
that firms arise when the costs of coordinating activity through them,
which might be called organizing costs (the concept tellingly does not
yet have a single widely accepted name), are less than the transaction
costs of coordinating activity through the market.  (For another view
of the nature of the firm, one wholly compatible with my own argument
below, see John Seely Brown and Paul Duguid, Organizing knowledge,
California Management Review 40(3), 1998, pages 90-111.)  Transaction
costs are both numerous and diverse, and Coase's most sophisticated
follower, Douglass North, has estimated that they amount to nearly
half of the economy.  This is amazing, given that the neoclassical
theory of economics presupposes perfect markets and thus assumes that
transaction costs do not exist.

Framed in this way, Coase's theory would seem to suggest that markets
would work better if transaction costs were reduced.  And indeed a
large and vigorous school of economic and legal theory has grown up
around the idea.  This "law and economics" school is predominantly
conservative in its politics, inasmuch as reduced transaction costs
would seem to obviate the need for government intervention to correct
defects in the market.  Law and economics scholars have been immensely
influential, and they include some of the most prominent contemporary
judges and legal scholars.

Unfortunately for the law and economics school, and for the country
whose legal system they have helped to shape, their entire project
is based on a logical fallacy and a misinterpretation of Coase.  The
argument in Coase's paper is *not* that lower transaction costs imply
a greater reliance upon the market and a lesser reliance on the firm.
It is true that, on Coase's argument, an economy with zero transaction
costs would behave according to the neoclassical ideal.  But a world
of zero transaction costs is surely impossible (not least because of
the irreducible problems of market information), and when transaction
costs are not zero, Coase's argument is much more complicated.  We do
see spectacular effects when new technologies enable intermediaries
to operate on a wider geographic scale, thus reducing the transaction
costs of long-distance trade and increasing the efficiency of markets.
EBay is a good example.  But as Burt Swanson once pointed out to me,
and as Coase himself observes, technologies that reduce transaction
costs usually reduce organizing costs as well.  According to Coase,
the size of firms is determined by a balance between the costs of
coordinating activities in the market and the costs of coordinating
the same activities within a firm.  It is the comparison that matters,
not the magnitude of one side or the other.  Let us listen to Coase:

  Changes like the telephone and the telegraph which tend to reduce
  the cost of organizing spatially will tend to increase the size of
  the firm.  All changes which improve managerial technique will tend
  to increase the size of the firm.

There then follows an important footnote:

  It should be noted that most inventions will change both the costs
  of organizing and the costs of using the price mechanism.  In such
  cases, whether the invention tends to make firms larger or smaller
  will depend on the relative effect on these two sets of costs.
  For instance, if the telephone reduces the costs of using the price
  mechanism more than it reduces the costs of organizing, then it will
  have the effect of reducing the size of the firm.

So if we want to know what will happen to the economy as the Internet
becomes widely adopted, we must compare the effects of Internet use
on transaction costs to its effects on organizing costs.  How can we
make such a comparison?  It would seem impossible, given the diversity
of both kinds of costs and the difficulty of comparing them.  But I
would argue that the global economy is now experiencing extraordinary
reductions in organizing costs, and that this effect swamps anything
relating to transaction costs.

Why?  Consider the benefits to a firm from a cheap, pervasive digital
communications network.  These benefits are numerous, of course, but
we need only focus on a single category: benefits associated with
economies of scale.  A computer network enables a firm to distribute
the same information (product designs, policies, marketing materials,
training materials, and so forth) to a vast number of locations for
almost no marginal cost.  It also enables a firm to gather information
in a standardized format (sales figures, market information, customer
surveys, and so forth) into a centralized organization for analysis
and action.  As the world becomes more homogenous -- shared tastes,
language, infrastructure, weights and measures, currency, regulations,
accounting standards, and so on -- the benefits of this informational
circulatory system increase.  A business can double the number of its
branches with little or no change in the size of the central office.
A competing firm with fewer branches will suffer a disadvantage; it
will experience the same central-office costs, but will have fewer
transactions over which to distribute them.  The Internet might play
a different role in a world of infinite diversity.  But in the world
we actually inhabit, the forces of homogeneity are operating at full
fury.  These include the globalization of media and culture, regional
and global treaty organizations, the advantages of compatibility of
technical standards, and the mutually reinforcing effects of economies
of scale in a hundred industries.  Thus, when the European Union
introduced the euro as a common currency across several countries,
the costs of running a business in several markets at once dropped
substantially, leading to an unprecedented wave of cross-border
mergers.  In fact, I am not aware of any evidence that transaction
costs as a proportion of the overall economy are falling *at all*.
(Indeed, North suggests that they have been rising.  See Douglass
C. North and John J. Wallis, Integrating institutional change and
technical change in economic history: A transaction cost approach,
Journal of Institutional and Theoretical Economics 150(4), 1994,
pages 609-624.  They also observe that "the firm is not concerned
with minimizing either transaction or transformation costs in
isolation: the firm wants to minimize the total costs of producing and
selling a given level of output with a given set of characteristics"
(page 613).)  Transaction costs are like highway safety: when highways
become safer, people drive faster; when transaction costs are lowered,
people engage in more complicated transactions.  But when a firm
doubles its number of branches, one can readily compute the reduction
in organizing costs: the cost of running the central office are now
distributed over twice as many transactions.

If decreased organizing costs through economies of scale are the most
important factor influencing changes in the economic role of firms,
what follows?  First, because economies of scale require a strong
element of homogeneity, it follows that reduced transaction costs
have a chance of making a firm smaller when dissimilar activities are
being coordinated.  This is one reason why firms sometimes break apart
when they find themselves spanning two or more dissimilar markets.
It is also where outsourcing comes from.  An obstacle to outsourcing
is the complexity of the contractual relationship, and communications
technologies can be used to help manage the complexity, for example
by connecting the parties' computerized accounting systems.  Yet in
many cases the main reason for outsourcing is *not* these transaction
costs, but rather the economies of scale that the outsourcing firm
itself can achieve.

This leads us to the second consequence: far from conforming to Adam
Smith's idealized market of individual artisans, the networked economy
is organized mainly by large firms that enjoy vast economies of
scale.  These firms are then supplied by large numbers of small firms
in conditions that approach monopsony, that is, competitive sellers
facing a single buyer with overwhelming market power (see generally
Bennett Harrison, Lean and Mean: The Changing Landscape of Corporate
Power in the Age of Flexibility, Basic Books, 1994).  Market power
will flow to whichever firms control the intangible resources --
intellectual property, for example -- that fuel economies of scale
in a given industry.  As economies of scale become globalized, the
result is a breathtaking concentration of power in a small number of
firms, each of which controls a certain "slice" through the global
economy (see Lowell Bryan, Jane Fraser, Jeremy Oppenheim, and Wilhelm
Rall, Race for the World: Strategies to Build a Great Global Firm,
Harvard Business School Press, 1999).  Firms will not tend to be
involved in diverse activities.  Instead, they will choose one single
activity and manage *all* of that activity throughout the world.  This
picture is emerging very rapidly and very clearly, and it is visible
to anyone who reads the business pages and ignores the abstractions of
the enthusiasts.

<...>

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