intrust

In his famous essays, "The Nature of the Firm", from 1937 and "The Problem of Social Cost", written in 1960, the economist and Nobel laureate Ronald Coase investigated the dichotomy of firms (command mechanisms) and markets (price mechanisms). He asked why would we choose one method of organizing business over the other. If the Soviet Union was such a bad idea – why is General Motors a good one? Why not give all the workers at General Motors their freedom, close down the GM corporation for automobile manufacturing and replace it with the GM market place of automobile manufacturing? And while we are at it, integrate it with the marketplace of car sales? Let Adam Smith’s invisible hand take care of it all.

Assuming that markets are the most efficient method of conducting business, Coase postulated that the only rationale for the existence of firms is that they reduce transaction costs. We know from personal experience that it is often a lot easier just to tell people what to do – without haggling about it first. From the aspect of an industrial output, the USSR didn’t do too badly, at least in the beginning, though eventually the Soviets hierarchical command mechanisms fell short in dealing with the complexity of manufacturing and distributing goods.

In a marketplace each actor absorbs their own cost of participation. If one sums up the total of each individual actor’s costs this makes for a tidy sum. An argument in favour of firms is that by incorporating all these individual actors into a command hierarchy many of their participation costs will be eliminated. The firm reduces the costs for each individual it commands and internalizes the savings.

General Motors experienced, (is still experiencing) the same sort of problems of inefficiency and waste as did the Soviet Union, but has been partially able to mitigate them by shaving off bits and pieces of their firm and turning them into markets. For example, instead of making car seats, create a market for car seats and let would-be suppliers bid to win GM contracts. The extent of this process of defirming, according to Coase’s theory, is, all other things being equal, a product of transaction costs.

In a hypothetical situation where there were no transaction costs at all – a so-called zero-transaction cost environment, goods and services would be created and distributed solely on the basis of supply and demand and the appropriate system would be the that which dealt best with the complexities involved. Coase believed that in a zero-transaction-cost environment, the firm would be outperformed by traders operating in open markets.

The argument is compelling and Coase’s thinking is often cited amongst the digerati when discussing the development of the Internet. Spellbound by the apparent infallibility of Moore’s law, designers of information systems believe that they are on their way to attaining near-zero-transaction costs in a wide spectrum of endeavour – basically anywhere human action can be replaced by machines operating on dW3. The Internet is of course seen as the prime example of a near-zero-transaction cost environment.

Just as for many other terms in economics, trying to pin down exactly what transaction costs are can be exasperating, as these costs are constantly subsumed by goods and services as they travel down the value path. Once a loaf of bread or a television crosses the threshold of your home, you don’t worry about all the metamorphosing and transactions these items have gone through. Bread costs one Euro, televisions cost 100 Euros – and that’s it. The economist Stephen Cheung estimates that the 80% of the GDP of Hong kong (mainly as a result of servicing economic activity in China) derives from transaction costs and that..

in the modern world, it would be difficult to find a rich country where transaction costs sum to less than half of national income.¹

Cheung also points out that transaction costs are most often confused with transportation costs.

The truth of the matter, of course, is that transaction cost is not the same thing as transportation cost. Changes in transaction costs, in one dimension or another, would generally lead to changes in the contractual or organizational structure. This is so because it may be possible to reduce transaction costs by rearranging institutions: the society we live in and the way we conduct economic activities depend upon the magnitude and type of cost which govern institutions in its numerous forms.

In the case of the Internet, it was the replacement of the telecommunication industry’s technological institution (dedicated circuit-switched telephone lines) by the Internet’s institution (packet switched networks) that reduced both transportation and transaction costs by an almost unfathomable factor. On the Internet, transportation and transaction costs are commingled in the packet switched technology.²

Here is an ad hoc list of transaction costs that could be assumed by trading partners::

The marketing of goods and services; the discovery of goods, services, trading partners and agents of intermediation; representations of intentions and capabilities; exploratory, committal, and post committal negotiations; contracts, and the declaration of transaction-specific assets and liabilities; declaration of compliance with laws and treaties, authorizations, certifications, authentications, escrow, bank guarantees; administration of transportation, insurances, asset transfers, settlement and clearance; post-transaction liability and dispute resolution, warranties and service agreements.

Looking at the list above we can imagine separate agents for every individual entry - the intermediaries of transaction. Imagine a bustling city street lined with offices specializing in these tasks. It could be in Algiers, where, according to the World Bank report cited below, there are 16 separate procedures for registering property. Or poor unfortunate Vientiane in Laos, where it takes 53 seperate procedures to enforce a contract. Imagine yourself wandering in and out of crowded office waiting rooms with a briefcase full of paperwork, filling in forms, paying fees, ever in search of signatures and the rubber stamp of approval.

And then think about Amazon.com. It is not just that we transport our orders to Amazon, and authorize payments via our Internet terminals, but that we can also discover goods, discover trading partners (third party used book sellers), get third party appraisals by book reviewers who themselves are appraised by book review readers, and so on. At eBay we can do even more. A recent article in the New York Times estimated that 500,000 people actually made a full– or half-time living buying and selling on eBay.

Once again we are looking at a system of layers. The employees of Amazon do not write the books, nor does eBay produce the goods sold through its network. Amazon and eBay set up markets where friction in transactions are significantly removed. Their effort is primarily a semantic one. There is nothing that is sold through either that could not be offered on other web pages, discovered found by a search engine and bought with a credit card, but these two companies offer a schema for just how information is presented and transacted, and it all happens at one trusted Internet address. Of course it is not, at least technically, inconceivable for a powerful player such as Google to organize such an effort.

The Peruvian economist Herman de Soto believes that formal property titles, or rather the lack of them, explains to a large extent the poverty of many of the poorer regions of the planet. He maintains that there is a great deal of wealth, even among the poor, that can not be put to use, simply because it is not formally accounted for. It has no place in the formal systems of ownership.

“Doing Business in 2005”, a World Bank report tracks “regulation that enhance business activity and those that constrain it” in 145 countries, using 7 sets of measures; Starting a business, hiring and firing workers, registering property, getting credit, protecting investors, enforcing contracts, and closing a business. The study leads to three main conclusions:

• Businesses in poor countries face much larger regulatory burdens than those in rich countries. They face 3 times the administrative costs, and nearly twice as many bureaucratic procedures and delays associated with them. And they have fewer than half the protections of property rights of rich countries.

• Heavy regulation and weak property rights exclude the poor from doing business. In poor countries 40% of the economy is informal. Women, young, and low-skilled workers are hurt the most.

• The payoffs from reform appear large. A hypothetical improvement to the top quartile of countries on the ease of doing business is associated with up to 2 percentage points more annual economic growth.

As the Economist points out in a leader dated September 11, 2004, Many of the problems in poor countries are the legacy of European colonists’ laws and bureaucracy, designed to control a local population, not to encourage growth. So the paradox becomes apparent. If the systems that de Soto calls on to harvest the intangible wealth of the poor are dysfunctional, whether by strategy or happenstance, they will have the opposite effect to his intentions. By entanglement in red tape, the poor of underdeveloped countries are doubly disadvantage.

The history of civilisation is also the history of a struggle between loosely and tightly coupled systems of human interaction. In the words of Nobel Laureate Douglas North:

The evolution of societies is a function of the quantity and quality of human beings, the human command over nature, and the structure humans impose on their interaction. An understanding of the interaction between demographic, technological, and institutional factors would provide fundamental insights into societal evolution.

Both formal and informal Institutions are systems that come at a cost. They represent investments, the return upon which, is the reduction of transaction costs. Transaction costs are influenced by the type of system they are transacted in. Transaction costs are primarily the cost of trust.