The Transaction Costs Revolution and the Death of the Firm
After realising that I no longer want to be a regular 9-to-5 employee, I recently became quite interested in all the initiatives launched by many people around the post-work era, the Sharing Economy, the Digital Nomads mouvements , or the rise of the Freelancers. Therefore, I decided to dig into this mutation of the Firm and the mutation of the Work as we know it.
To understand this new revolution, we need to get back to our Economics books. Ronald Coase, an Economics Nobel Prize, in his famous essay The Nature of the Firm answered the question: Why do firms exist?
The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of “organizing” production through the price mechanism is that of discovering what the relevant prices are. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information. The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account.
To sum it up, companies mainly exist because it’s cheaper to internalise some tasks instead of outsourcing them as the price mechanism is not efficient enough and the Transaction Costs associated to outsourcing would be too high (thing about Information Costs, Negotiation Costs, Trust Costs, Law Enforcement Costs, etc.).
Companies will grow as long as making internally is cheaper than buying/renting from another individual/company. This reasoning can also be applied to individuals. If you are a Rational Agent, you’ll decide to rent something if it’s cheaper than buying it (taking into account the Transaction Costs).
For instance, it’s cheaper to use Uber than to buy a car when you want to go from A to B as long as the price per trip is cheaper than the price of owning a car (this computation will depend on how often you want to go from A to B within a time period). One of Uber’s main goal is to make Uber prices so low that it’s cheaper to use their service than to buy your own car even if you drive pretty often. How is it possible? The main reason is because Transaction Costs have drastically decreased since the rise of the personal computer and the Internet. Uber is cheaper because the company built an efficient platform maximizing the Supply and Demand process in order to get the most efficient prices. Searching for a driver is as easy as pushing a button, trust has been built thanks to a review process, and payments are highly secured. Most of the Transaction Costs previously supported by the end-user have been erased and (partly) internalised by Uber itself.
But that’s only the tip of the iceberg. Uber not only took advantage of decreasing Transaction Costs for the end-user, but also within its own organization. Uber has more than 200,000 drivers but less than 10,000 employees. Once again, Transaction Costs are the keystone. It’s cheaper for Uber, thanks to the platform it has built, to outsource its workforce than to internalize it (make vs. rent).
This example illustrating the Transaction Costs revolution leads us to two gigantic changes in the recent history of Human Being.
- We’re obviously moving from an ownership economy to a shared-ownership economy
- The death of the firm as we know it and the rise of a new type of workers
Transaction Costs and Ownership
It’s probably the change that will be the hardest to get implemented in our daily lives because we’ve been raised to believe that owning things is a symbol of success. This was true a few years ago, but things are changing. Transaction Costs are decreasing at an increasing rate. How and why are they changing? how do they affect the transition from ownership to the Sharing Economy. Basically two important points:
- New technologies and the rise of The Internet
- The evolution of our culture
New technologies and the rise of The Internet
The quantum leap of New Technologies and the rise of the Internet have been the propellent of the Sharing Economy. One of the most interesting fact of this quantum leap is that we’ve reached a point where the price of information is basically zero (unfortunately not in every countries). What does this free access to information mean? For instance, it means that you can search for whatever you want at no cost. It seems to be trivial but it’s actually what fuels the Transaction Costs revolution. Free information. This free access to an endless stream of information is pushing down the entire cost structure of most of the things we consume/own.
Let’s start with a great example widely used in the Economics litterature to illustrate this. It’s 1979, you want to drill a hole in your wall. What are you doing? You’re going to your closest hardware store and you buy a driller. Why? Because regarding the information you’ve got, it’s the best and cheapest possible thing to do. If you ever think about renting one, you’ll have to:
- search for someone willing to rent it to you (Information Costs)
- figure out if this person is trustworthy or not (the Information Costs incurred in screening different trading opportunities, outlets and partners)
- negotiate the price with this person (the costs of negotiating trading agreements)
- write a contract so you can legally use this person’s driller (the costs of actually transferring goods, services and ownership rights + the costs of enforcing stipulated terms through legal, social or other means)
- safely pay this person
When you look at this, knowing you don’t have any access to The Internet, it seems that all these tasks will take you days, even weeks to be completed.
Now imagine you want to drill a hole in your wall today (2016). What are you doing? You’re going to Google driller and will probably find a website offering to rent out a driller to another person. You go on the website, type driller in the search bar, find someone (professional or individual) living nearby and willing to rent out his driller, click on a button, screen his reviews, click on a booking button, create an account, and pay through a secured platform which is also enforcing legal agreements so that both the renter and rentee are protected during the transaction. Payments are, of course, secured through a third party payment platform. All these actions took you less than 10 minutes and cost you less than a 20th of the price of a good driller. In this case renting is way cheaper than owning because you only need to drill one hole, if you’re a professionnal and have to drill thousands of holes everyday, of course it’s cheaper to own you own device. This can also be applied to many other things like housing, transportation, offices, etc. As long as the price of owning > price of renting in the long-term there’s no rational reason to buy something.
Today tech platforms are basically selling reduction of Transaction Costs, not products. Airbnb is selling reduction of Transaction Costs by facilitating demand and supply mechanisms, same for Uber.
This brings us to the second key factor of the Transaction Costs Revolution:
The evolution of our cultures
As we pointed out earlier, a big part of the Human Beings alive today have been raised to favor ownership over renting things. But things are changing. the Y generation is seeing the benefits of the new kind of Economy under development. People are using Uber and Lyft instead of buying their own cars as the price goes down. People are realising that owning is usually more expensive than renting. Even when it comes to real-estate, the flexibility offered by renting your apartment/house instead of buying it makes it preferable than owning it.
The new generations are beginning to understand that ownership is becoming more and more expensive because renting is becoming cheaper and cheaper. It means that our culture is evolving in the same direction as the Transaction Cost revolution. We can see more and more community blooming all around the world. Food communities, sharing the Transaction Costs linked to buying directly to farmers, communities sharing pieces of land to grow plants, communities sharing and building software together, communities sharing knowledge to expand their own knowledge, etc.
Just like Technology, our Cultures are evolving so that it becomes easier and easier to lower Transaction Costs.
The death of the firm as we know it and the rise of a new type of workers
We’ve seen that Transaction Costs are decreasing thanks to new technologies and to a new way of thinking. What does it mean for the way we work? What does it mean for a company when you can outsource instead of hire? What does it mean for an employee when he can work for many companies without being tied to any?
When you realise that companies likes Uber or Airbnb have way less employees than their “Old-Economy” competitors (taxi companies, hotel chains), you begin to realise that the future of the firm, of the organisation of work, will be very different than what we can observe today. Once again, the make vs. rent question. If it’s cheaper for a company to outsource most of its work, it’ll do so. Technology and culture will allow these companies to outsource more and more easily just like Airbnb or Uber are doing.
Technology platforms will allow companies to easily adjust their workforce. More and more tasks will be automated or some robots will take over because it’ll be cheaper than to have a Human Being performing the task.
It means that most of the current jobs will disappear. Most of the repetitive-tasks-intensive jobs will be replaced by robots (because it’ll lower Transaction Costs).
Before this transition is fully achieved, we will see the rise of the on-demand workers, working for many different companies. This workforce allows prices to decrease because companies no longer have to pay a fixed cost every month but a variable one matching what they’re actually selling and reflecting the actual Demand.
The current precarity of on-demand workers is just a phase that will pass. We’ve been through a pretty drastic change that needs some adjustments and our governments were not prepared, it’s not even sure that they will ever be, but I’m pretty confident that private companies will take over and help the future independent workforce to fulfill all the layers of the Maslow’s pyramid before we no longer need this on-demand workforce.
Once most of the jobs previously done by on-demand workers will be automatised, Human Beings will be able to do what they’re best at: being creative. Creative jobs will be the most important ones and probably the only one performed only by Human Being before we invent an AI capable of the same level of creativity as a Human.
The Creative Destruction of Schumpeter is becoming more and more violent because the rate at which technology is becoming better is increasing, which leads to the reduction of Transaction Costs at a higher and higher rate. Automation is affecting all the tasks that could only be performed by Humans in the past. From physical tasks to creative ones like the robots used by Amazon in their warehouses to this Japanese Art Director bot
Huge workforces are no more needed in most industries thanks to new technologies. Almost anyone can launch a product that needed hundreds of people in the past because Transaction Costs have reached a record low.
As a consequence, firms are mutating, they’re getting smaller and smaller. More and more employees are deciding to quit their job to become independent workers.
As I have a background in Economics, I found this shift amazing, When I started studying Economics about 10 years ago, the landscape was completely different than it is today. The on-demand/Sharing Economy wasn’t as widespread as it it today. It’s pretty hard to grasp as we’re right in The Eye.
Be prepared for the Revolution. Be creative ✨
