There are three fundamental structures that govern the nature of all economic activity: customers, producers and the way, the mediating infrastructure, in which value is exchanged between them.
The ways in which each of these elements relate to the others are not in any way set in stone. Vladimir Lenin (1870–1924) famously said that the economic system in Russia would be run as one big factory where everything would be planned in a centralized way. Many economists at the time said that this was impossible. Yet there were already big factories in the West then, and there still are, so why not? Is there a limit to the size of a firm that cannot be surpassed, or is it because the factory logic cannot be used outside a real factory?
The typical form of a firm is meant to simplify communication, accountability and the coordination of tasks. In theory an employee needs only one connection, to the boss. This is far easier, and used to be a lot cheaper, than communicating with all and trying to coordinate actions with everyone. And accountability? The worker is accountable only to her manager. That manager reports to her manager on the next level up, and the chain goes further, leading in the end to — Lenin.
During the centuries since the publication of “The Wealth of Nations” by Adam Smith (1723–1790), the principal theme of most economists has been that centralized planning was not necessary, or even welcome, in order to make an economic system function well. The necessary coordination would be the result of pricing and information mechanisms in markets. Lenin and the communists were advised to move to a market economy. The parties in this system follow their own self-interest and are “governed”, when it comes to the actual choices they make, by the system of prices and the information they possess. This is the polar opposite of centralized planning. Adam Smith was an early proponent of extreme decentralization and equal opportunity.
Ronald Coase (1910–2013) was one of the first economists who started to question mainstream thinking in economics. If a system of prices and competition could perform all the coordination that is necessary, why did we have centralized planning, not only in the now bygone communist countries, but also in well-functioning and successful firms? Why did we need management, whose function was to coordinate? Why didn’t we rely on markets?
Ronald Coase set out to bring these two different views together. It is almost impossible now to fathom that he found the answer as early as during the summer of 1932, at the age of 22. He realized that there were costs involved in using the pricing mechanism. The needs and offerings have to find one another. The prices have to be discovered. Negotiations need to be undertaken. Contracts have to be made. There may be disputes that later have to be settled. Adam Smith did not see this. These costs were not part of his “invisible hand” equation. Ronald Coase called these costs transaction costs.
The revolutionary argument was that a firm would emerge, exist and continue to exist successfully if it performed its planning, coordination and management functions at a lower cost than would be incurred by means of market transactions, and also at a lower cost than would apply if the same things could be performed by another firm. This is where competition should keep firms internally efficient and where non-competition in the public sector creates complex, non-efficient governance models and units that are too big.
Managerial overheads increase as the organization grows. Whenever the transaction costs inside the organization reach the level of the transaction costs in the markets, markets outperform firms and outperform central planning/management coordination in general. As the corporation grows, all its energy finally goes into maintaining itself. This was the main theoretical argument against Lenin. The same thing is clearly still evident today in big firms or public organizations such as large health care units. Many communist countries, kind of, learned their lesson, but we still haven’t.
The existence of high transaction costs outside firms led to the emergence of the firm as we know it, and management as we still have it. A large part of corporate economic activity today is still designed to accomplish what high market transaction costs prevented earlier. But the world has changed.
What really matters now is the reverse side of the Coasean argumentation. If the (transaction) costs of exchanging value in the society at large go down drastically as is happening today, the form and logic of economic entities necessarily need to change! Coase’s insight turned around is the number one driver of change today! The traditional firm is the more expensive alternative almost by default. This is something that he did not see coming.
Accordingly, a very different kind of management is needed when coordination can be performed without intermediaries with the help of new technologies. Digital transparency makes responsive coordination possible. This is the main difference between Uber and old taxi services. Apps can now do what managers used to do.
For most of the developed world, firms, as much as markets, make up the dominant economic pattern. The Internet is nothing less than an extinction-level event for the traditional firm. The Internet, together with technological intelligence, makes it possible to create totally new forms of economic entities, such as the “Uber for everything” -type of platforms/service markets that we see emerging today. Very small firms can do things that in the past required very large organizations.
We stand on the threshold of an economy where the familiar economic entities are becoming increasingly irrelevant. Technological advances, like smartphones together with cloud computing, allow people to have a computer in their pocket that is more powerful than any in the world 20 years ago. This creates the biggest decrease in the price of productive capacity in economic history and changes the relations and structures that govern economic activity. The seeds of the next industrial revolution are truly here.
Our views of markets and hierarchies are going to change in ways that Adam Smith or Vladimir Lenin could never have imagined. But Ronald Coase did much to explain what is happening today, and he did it as early as 1932.