Week 41, 2021—Issue #173
Nature of the Firm: Transactions, Scarcity, and Complexity
Each week: three ideas on and about the future of work. This week: three ideas on the reason why organizations exist.
Organizations are complex and difficult to manage. And the bigger they are, the more rigid and bureaucratic they tend to become. So why bother? Why hire people when tasks can be contracted out?
Why do organizations exist? 🤔
Let’s dig in.
The answer to that existential question won Roland Coase the Nobel Prize for Economic Science in 1991. The answer: organizations exist to mitigate transaction costs inherent in production and trade. Specifically, they help mitigate the time and money we spend on things like sourcing goods and services, negotiating contracts, and enforcing delivery, etcetera.
Markets aren’t efficient. If they were, there’d be no transaction costs because everyone would have easy access to the goods and services they need, when they need them. But that’s obviously not the case. Some products and services are more scarce than others. And the more scarce they are, the higher the transaction costs will be.
But that’s not all. Some products and services are more complex than others: products might not be plug-and-play; they might require integration. Services might require not just domain knowledge but also context-specific experience. Etcetera. And with the risk of stating the obvious: the more complex the product or service, the higher the transaction cost.
Organizations are like internal markets. They exist because they provide easy access to the goods and services that the organization needs. Transaction costs are never nonexistent, but the internal market should be more efficient than the market at large. Internal markets should provide relatively low transaction costs.
But this is not always the case.
Consider the following:
- Bureaucracy tends to drive up internal transaction costs. The bigger an organization gets, the less efficient it tends to become. This is how we get red tape, endless approval cycles, and million-dollar paperclips, etc.
- Blockchain and related technologies can drive down external transaction costs. That’s the promise of the trustless economy. In fact, the building and maintaining of trust is a key source of costs in this current paradigm.
The hire-in/contract-out conundrum is far from new. But it is evolving. Bureaucracy is the reason we’re so focused on transformation, decentralization, and business ecosystems. And blockchain… well… blockchain is the wild card that could mark the beginning of the end of organization as we know it.
That’s all for this week.
Until next time: Make it matter.
PS. Today’s title “Nature of the Firm” is borrowed from the 1937 paper in which Coase first detailed his transaction-cost argument. You can read a summary HERE.