Blockchain, Decentralisation, and the ‘Theory of the Firm’

Transaction cost theory, and how the Blockchain can break the establishment

The theory of the firm is a framework of economic thought which attempts to describe why firms exist. Nobel prize winning economist Ronald Coase asked in his paper the ‘Nature of the Firm’, that in a world where markets are designed to drive efficient resource allocation, why do firms exist to allocate resources managerially? In his analysis, Coase introduced something known as ‘transaction costs’, which are the costs associated with search, bargaining, and cooperation between transacting parties. Sometimes it’s just easier to pay a bunch of people for the freedom to tell them what to do.

Ronald Coase’s work has been influential in modern economics. The ‘Coase Theorem’ was coopted by right wing economic liberalists — despite Coase’s disapproval— as a practical and realistic application of laissez-faire free market principles. The insight of the Coase Theorem was interpreted as being that negative externalities can be addressed simply through the bargaining of stakeholders with clearly defined property rights and low transaction costs. Coase’s Theorem was elegant, but too polished for a reality in which transaction costs are usually never low: the costs of cooperation, the fallacy of free-riders, and the emotional toll of bargaining usually prove too great a barrier for parties to solve their own problems. This is why governments exist.

But every so often paradigm shifts appear which force us to rethink some of the things we’ve always assumed. The things which are almost appliances today were science fiction just thirty years ago. What? You mean to tell me that I can summon a stranger to pick me up with a palm-sized telephone? The optimism of newness has a habit of questioning the assumptions. Is it an indestructible truth that transaction costs must always exist?

Ronald Coase died at the ripe age of 102, with the disappointment that his insight was thoroughly misused. But the principle of transaction costs is profound and enduring, and through re-architecting the notion of trust, Blockchain technology appears poised to dismantle our assumptions once again.

The Blockchain is a ‘distributed ledger’ technology, which is one way of describing a database of everything that’s ever happened that everyone has a copy of, but no one controls. The Blockchain uses various consensus mechanisms to ensure that everybody has the same version of the truth, and by design makes it extremely difficult for anyone to alter that version of the truth. This isn’t just a shared database, it’s a groundbreaking development in cryptography and computer science. Technical whitepapers for the two largest Blockchain protocols — Bitcoin and Ethereum — exist here, and here, for those brave enough to trawl the depths.

Traditionally, achieving this trust between ‘trustless’ parties requires a middleman. The role of middlemen appears initially altruistic, until they start extracting rents by virtue of their market power.

If the sky’s the limit, any activity that requires trust can make do with a Blockchain. In a supply chain, transacting parties trust that their suppliers will deliver them products as per contractual specifications, and will do so in a timely manner. In monetary exchange, we trust our debtors to be honest about their settlements, and in commerce we trust purchases to be honoured with the provision of a good or service. As musicians, we want to operate in an environment where we can trust to be rewarded for our work. It’s quite an immense opportunity.

The important thing to recognise here is that establishing trust is in itself a transaction cost. This is why middlemen exist, picking up transaction fees for what is effectively an insurance that exchange between transacting parties is conducted fairly. Our banks and credit card companies store our value and settle exchanges for us. If there are any disputes, the bank has the truth. Spotify and record labels collect rents for music distribution because they’ve built a model that means artists do get paid — even if marginally — for their work. Artists are on board because its sadly the only model they can trust.

Ronald Coase’s theory of transaction costs rears its head in almost every facet of the modern economy: we pay rents to firms to manage transactions for us, because it’s cheaper than attempting to establishing trustful relationships with every entity we will ever interact with on our own. In a world where transaction costs are greater than the costs of managerial control, the firm will thrive.

Blockchain and the minimisation of transaction costs

There are two kinds of firms. The first is firms which provide products and services to be directly consumed by end users, this includes most firms which provide you with a physical product, or services like a haircut. The other type of firm is an intermediary firm that provides value by connecting stakeholders with a desire to transact, like Paypal and Uber. Some firms can be both. For example, Facebook provides a legitimate utility, but also acts as a conduit between our personal information and advertisers. By using Facebook for free, we flag our intention to indirectly transact with advertisers. Both these types of firms can be affected by a reduction in transaction costs albeit in different ways. For the former it’s a question of management, for the latter it’s downright destructive.

Blockchain technology can drastically reduce transaction costs in what I see as three fundamental ways: the facilitation of direct transactions between ‘trustless’ entities, the concept of ‘tokenisation’ which can help create efficient, incentive-aligned marketplaces, and asset continuity through the Blockchain’s famed immutability. In aggregate, these themes offer a profoundly novel take on economics and market making.

Direct transactions between ‘trustless’ entities

Through an ingenious combination of public and private key cryptography, and innovations in decentralised database reconciliation, the Blockchain offers a way for parties to directly transact even if they don’t trust or know each other. Participants with malicious intent are by design, excluded from the network. Without the traditional middlemen required to butter these interactions, the cost of transacting can theoretically be free. Blockchain has done for trust what the internet did for communication.

This is a particularly pertinent comparison because much like trust in its current state, pre-internet communication was comparatively expensive. As such, it was assumed that firms were the size they were because communication internally was much more efficient than communication to external parties. Therefore, the logic followed that the internet would reduce the size of firms, by making it cheaper to communicate outside internal walls. What wasn’t factored in was that the internet made it equally (if not more so) inexpensive to communicate internally through intranets and email. Firms actually got bigger.

The same thought process can be applied to examine the impact of Blockchain in reducing transaction costs by automating trust. The difference here is that trust in an organisation is already assumed, it is what is purchased when talent is hired. By paying wages, firms purchase a contractual obligation for hires to cooperate and perform, with the incentives (and disincentives) to match.

Therefore, it will be fascinating to see whether Blockchain technologies will indeed cause a shrinkage in the size of siloed firms. With embedded tools such as smart contracts, it has never been easier to automate contractual relationships, like the ones between companies and their manufacturers or suppliers. Blockchain-based smart contracts have the ability to simulate the benefits of vertical integration, whilst avoiding the investment and commitment risk for the integrator. From a societal welfare perspective, a reduction in vertical integration enables participants downstream of the value chain to serve multiple parties, reducing artificial barriers and subsequent dead-weight loss.

Broadly, Blockchain technology paves the way for a future in which large cooperative consortiums made up of smaller, nimble firms can transact freely, and with greater fluidity. Blockchain’s trust model, and smart contract technology enables this to occur with very minimal overhead.

Evidently, typical end-consumer firms will feel the weight of transaction cost reduction perhaps by voluntarily streamlining or downsizing to simply become vehicles for management and governance. Intermediary firms face the threat of redundance however, as the Blockchain automates and mandates the trust which they traditionally provide.

‘Tokenisation’ for efficient marketplaces

Tokens are proprietary digital assets which provide the means to actually use a Blockchain-based product or service. Products and services can use Blockchain tokens and the Blockchain protocol as a spine to ensure efficient operation with multiple stakeholders.

One simple example to clearly illustrate the allure of tokenisation is a decentralised Blockchain-based Uber. Uber is effectively a marketplace which matches the needs of riders with the availability of drivers, ideally doing so at a cost that is theoretically market clearing. But Uber is also an example of an intermediary organisation that the Blockchain attempts to ‘solve’. By providing a middleman service, Uber extracts a perpetual rent which otherwise wouldn’t be necessary in a world where riders and drivers can easily discover each other and transact with trust.

An alternative would be to use a token model to develop a decentralised Uber, something known in the Blockchain ecosystem as a Dapp (decentralised app). Uber tokens will be used by riders to pay for rides, and earned by drivers. These tokens will have an inherent value that can be traded for crypto, or even fiat currency. Tokens are initially offered prior to the release of the app, sold at a specified quantity at a market clearing price. The funds earned from this initial token sale (often labelled misleadingly as an ICO: Initial Coin Offering) pay for the development and improvements to the app which now has a multi-sided user base of riders and drivers with a vested interest in the success of the platform.

Since tokens are the platform-native transaction mechanism, the platform is managed in perpetuity by decentralised nodes which earn tokens for their efforts in upholding the network (like Bitcoin miners). The developers of decentralised Uber don’t extract rents on rides, but pocket the margin between the funds of the token sale, and the costs of app development.

It’s a novel concept, but the breakthrough is in the incentive alignment, which is hard to ignore. A token mechanism like the one described above creates a network where all stakeholders — developer, rider, and driver — are aligned in their motivation to help the platform succeed. The application is not funded by investors with an interest to reap outsize returns. There is no scope to exploit other stakeholders for personal gain, the decentralised nature of the Blockchain precludes it. Additionally, since it’s decentralised, users no longer have to pay arbitrary transaction fees to a centralised entity per-ride, since the management of the system is in fact performed by decentralised nodes in the network.

With tokens, the Blockchain once again demonstrates its capacity to dismantle incumbent establishments. Transaction fees are abolished in a network where upkeep is distributed. When members can interact freely, do we need a centralised firm at all?

Asset continuity through Blockchain immutability

One of the most noted features of Blockchain technology is how it stores a history of every single transaction on the database. It’s possible to query on assets to understand everywhere they have been, and view the transaction history for Blockchain participants. This history is theoretically immutable, as the Blockchain’s design requires significant effort and network consensus to alter this history.

This continuity gives Blockchain assets and participants the characteristics of tangible entities, employing the imperative limitations that make the physical world possible. On the Blockchain, it is impossible for assets to be in two places at once, double spending is nullified, and property rights are hardened in code. Blockchain accounts are dynamically reactive to the activities of the entire network since Blockchain consensus ensures everyone knows the state of anything at any given time. The significance of this cannot be understated.

This feature can plug into many applications where we’re interested in the transaction history of an asset, like in verifying the provenance or legitimacy of an end product. The utility of this technology to financial services in maintaining the integrity of society’s value token (fiat money) has been clear for a long time. Banks, initially sceptical, are seeing how the Blockchain can assist in payments clearing and reconciliation.

Broadly, continuity forms the basis of fundamental existential themes: like agency, autonomy, and identity.

What if there was a technology that could bring these aspects of physical existence into the digital world? It’s an unsolved quandary that has built and destroyed industries in decades past. Digital commodities are naturally anarchic, with a propensity to be sharded, scattered, and duplicated. The virtually costless duplication and distribution of digital commodities gave us the software revolution, but also gave us music piracy.

Blockchain technology can provide the continuity that permits the identity of things and people. In the music industry, tracks can be represented by a sole source of truth with transactions conducted against a single asset.

If identities can be validated and stored on a Blockchain, this empowers individuals with an ownership of self not currently possible in the virtual world. Instead of relying on social platforms to trustfully represent our identities to potential transactors, we can represent ourselves. For example, we can allow advertisers to access us directly providing the metadata we’re comfortable with, and get paid for it. Continuity provides a new element of trust, removing the transaction costs of intermediaries which usually do it for us.

A brave new world

This is an aspirational, but wholly achievable synopsis of Blockchain’s potential. Transaction cost theory is a pertinent way of framing this technology’s impact, providing an academic framework of identifying and assessing the applications well-suited to a Blockchain incursion. We’re early in the process, but I imagine the way we’re thinking about the Blockchain today is how we were thinking about the internet some 20 or 30 years ago. It’s an incredibly exciting time. As always, timing and dependencies are crucial to understanding how this technology will progress. A developmental analysis of Blockchain is warranted, in due course.