Transaction Costs

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Why are so many things in the information 'economy' free? And what role do declining transaction costs play in Peer Production?


Introductory Citations

1.

Understanding transaction costs in general, and the cost of money in particular, helps a great deal in explaining why so much of the landscape of information goods and services has transitioned so rapidly toward a “free” (i.e. non-monetary) approach. [1]


2.

in the context of Peer Production: "the low transaction costs make a wide range of new business models feasible"

- Michael Feldstein [2]


Discussion

Agile Elephant:

"In essence, the argument is that technology is dropping transaction costs outside the Firm faster than within it, and thus the structure will shift from Firms as intermediaries between customers & suppliers- ie the green line will move to the right, and work will move to a multiplicity of suppliers and contractors in networks, delivering services at lower transaction costs. Kilpi argues:

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.

... Anyway, Kilpi argues that the outcome is that:

- 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." (http://www.theagileelephant.com/transaction-costs-lead-to-network-economies-wtf/)


How Coase's Transaction Cost Theory is related to Peer Production

when costs of participation are low enough, any motivation may be sufficient to lead to a contribution.

1. Michael Feldstein [3]

"It turns out (cfr. the above citation) that this is the key to understanding both Coase and Benkler, both capitalist firms and open source communities.

Despite a reputation for practicing the “dismal science,” Adam Smith and many of his intellectual progeny are fundamentally optimists. You have to be optimistic to believe, as Smith did, that the cumulative effect of individuals pursuing their self-interest in a free market would result in the collective good via the “invisible hand” of the markets. The genius of economist Ronald Coase is that he was able to articulate the force behind this invisible hand—and its limits—in a clear, sensible formula with predictive power. Think of him as the Isaac Newton of economics.

Coase claimed that, in a perfect world, the invisible hand would always prevail. For example, given a farmer and a cattle rancher who both need the same land, the two will always work out a mutually advantageous agreement. One will always offer to compensate the other in return for giving up access to the land such that they both benefit. Importantly, Coase argued that this would be true regardless of who owned the land. In that perfect world, property rights—which many of us have come to understand as a cornerstone of capitalism—are completely superfluous to a properly functioning market. People would trade to mutual benefit without the need for property or companies. Think of this as the economic equivalent of Newton’s First Law of Motion: economic transactions in motion tend to stay in motion.

The trouble, of course, is that friction exists. Friction (and gravity) are why baseballs don’t fly forever when you throw them on Planet Earth. The economic equivalent of friction, according to Coase, is something called transaction cost. Transaction costs are anything that contribute to the cost of something being purchased other than the cost of the production. If you pay your broker a commission on a stock, that’s a transaction cost. If you invest time researching and bargaining for your new car before you buy it, that investment is a transaction cost. If you have to pay a lawyer to write up a legally binding contract so that you have clear title to the house you are buying, that’s a transaction cost. When transaction costs are high enough, they make some economic deals too costly. In response to this problem, humans created property and companies. For example, nobody would start a car company by going out and buying all the car components on the open market and then going to yet somebody else (again, on the open market) to have them assemble the cars. The costs would be prohibitive. Instead, somebody hires workers to make the parts and assemble the cars. The automobile workers don’t have the transaction cost of constantly looking for somebody to buy the parts that they are making while the factory owner doesn’t have the transaction costs of searching to find every single part and negotiate for it separately on the open market. In return for providing a steady income to all the producers, the factory owner gets to own their work product.

Of course, there are costs to running a company too. Anyone who has ever worked in a large organization (or even a small one) knows that they are not exactly frictionless either. There is a cost to centralization. Managers don’t always know everything they need to know in order to make optimal decisions. According to Coase, this is the limiting factor on the size of companies. As long as the costs of a centralized organization are lower than the transaction costs on the open market, firms will grow. But as they grow, their internal inefficiencies grow with them. When the internal costs equal the market costs, the firms will reach their growth limits.

In the world that Coase imagined, the choice is binary. There are firms and there are markets. These are the only two means by which economies get things done. And that all makes sense on Planet Earth, where there are gravity and friction to counterbalance the force of inertia. But what about in space? What happens when we radically reduce the amount of friction in the system? According to Benkler, this is exactly the puzzle that the Twenty-first Century information economy poses. Today, an increasingly large percentage of our economy is dedicated to creating goods that are not automobiles and other industrial goods but ideas. They are software code and gene sequences and art. They are goods that have near-zero cost to reproduce and distribute (a characteristic that economists call non-rival). And they don’t require expensive machines and real estate to produce. I help design software for a living, but I work out of my home on a relatively cheap computer. Everything I produce can be reproduced as simply as selecting “Save As…” from a pull-down menu.

In this world, Benkler argues, dramatically reduced friction makes practical certain organizational structures that we simply wouldn’t see in an industrial economy. The less resistance there is to overcome in a system, the less formal structure is required for transactions to happen. I didn’t have to lead an organized movement for my practical joke or the Wikipedia page to succeed. If I did, then neither would ever have happened. But because the costs of participation and coordination were so low, a wide range of people were able to find a wide range of reasons that were sufficient to motivate their useful participation.

And we don’t have to assume only non-financial motives such as the ones in my first two examples. To the contrary, the low transaction costs make a wide range of new business models feasible. For example, we know that that upwards of 50% of the total cost of big enterprise software systems are support and maintenance costs. If a company can invest a small fraction of the total resources required to develop a content management system by contributing to an open source project but sell support and maintenance to their customers, then they may be able to beat their proprietary competition on costs while still making a good profit. This economic model has been particularly successful for a little company called IBM. When business analysts say that IBM has transformed itself into a services company, part of what they mean is that it now makes less of its income selling licenses for its proprietary software and more of its income selling support for open source software such as linux and apache." (http://blog.worldcampus.psu.edu/index.php/2007/10/31/coases-university/)


2. Esko Kilpi in an essay on Medium, “The Future of Firms,” reflecting on economist Ronald Coase’s theory of 20th century business organization [4]:

“The existence of high transaction costs outside firms led to the emergence of the firm as we know it, and management as we know it….The reverse side of Coase’s argument is as important: 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 and organizational entities necessarily need to change! The core firm should now be small and agile, with a large network.

The mainstream firm, as we have known it, becomes the more expensive alternative. This is something that Ronald Coase 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. Apps can do now what managers used to do.

Today, we stand on the threshold of an economy where the familiar economic entities are becoming increasingly irrelevant. The Internet, and new Internet-based firms, rather than the traditional organizations, are becoming the most efficient means to create and exchange value.” (https://medium.com/the-wtf-economy/networks-and-the-nature-of-the-firm-28790b6afdcc)

How Transaction Costs impact Open Source Software projects

Langlois and Garzarelli:

“More typically, one hears the following kind of story: markets are good at exchanging products for compensation, whereas firms are good at exchanging effort for compensation. The economics of organization can be understood from this perspective as a set of stories about why it is often costly to cooperate by trading products and often necessary to cooperate by trading effort.26 Ever since Coase (1937), it has been more-or-less taken for granted that the only way to trade effort is through an employment contract: I pay for your time and the right to direct your effort within agreed limits (Simon 1951). In other words, the only way to trade effort is by setting up a firm. Perhaps the most intriguing aspect of the open-source model is that it flies in the face of this assumption: under the right circumstances, it is possible to cooperate spontaneously on the effort margin, not just the product margin.

Rather than giving up their decision rights to others, open-source collaborators combine effort “voluntarily.” Voluntarily here means not that the collaborators do not receive pecuniary compensation (though that may often be true) but rather that the collaborators choose their own tasks. Assignment of individuals to tasks – and, to an extent we will explore, even the overall design of the division of labor itself – arises from these voluntary choices, in much the same way that assignment of sellers to products in a classic market arises from self-selection.” (http://web.uconn.edu/ciom/Open1C.pdf)


The costs of modularity

“The first of these is the (fixed) cost of establishing the visible design rules (Baldwin and Clark 2000). A (nearly) decomposable system may solve coordination problems in an elegant way, but designing such a system may take a considerable amount of time and effort.32 There may also be costs to communicating the design rules to participants and securing agreement on them. Another cost is that, at least in principle, it may not be possible to finetune a modular system as tightly as an integral one. For many kinds of software, this may no longer be an important issue in the face of Moore’s law. But for other kinds of systems, there may be important performance losses from building a system out of modules. Automobiles, for example, may be have an inherent “integrality” that prevents automakers from taking advantage of modularity to the same degree as, say, makers of personal computers (Helper and MacDuffie 2002). One can’t swap engines like one swaps hard drives, since a different engine can change the balance, stability, and handling of the entire vehicle. Clayton Christensen and his collaborators (Christensen, Verlinden, and Westerman 2002) have argued that integral designs, which can take advantage of systemic fine-tuning, have an advantage whenever users demand higher performance than existing technology can satisfy. As the fine-tuned system continues to improve in performance, however, it will eventually surpass typical user needs. At that point, these authors argue, production costs move to the fore, and the integral system (and the integrated organization that designed it) will give way to a network of producers taking advantage of the benefits of modularity discussed earlier.

A third, closely related, cost of modularity (benefit of integrality) is the tendency of modular systems to become “locked in” to a particular system decomposition. At least to the extent that knowledge gained creating one modularization of the system cannot be reused in generating a new decomposition, it is a relatively costly matter to engage in systemic change of a modular system, since each change requires the payment anew of the fixed cost of setting up visible design rules. If in addition an interface has become a standard, the problems of lock-in are compounded in the way popularized by Paul David (1985), since in that case many people would have simultaneously to pay the fixed cost of change. “ (http://web.uconn.edu/ciom/Open1C.pdf)


Money costs Money too

From Anomalous Presumption at http://jed.jive.com/?p=10 :

The author first explains that contemporary money is virtual, and therefore prone to fraud, which requires uncompressible suppression costs.

He continues:

In the case of “frictionless” network activities:

"Exponential declines in the cost of network bandwidth, storage, and computation are driving the cost of producing and distributing many services and information goods toward zero. The costs of processing transactions involving virtual money can ride these same exponential cost curves down toward zero. However the cost of enforcing honest monetary transactions cannot follow the same cost curve. Enforcement cost is constrained by the potential for fraud and error, and we can’t just depend on automated enforcement mechanisms because they are always open to automated theft and fraud.

The result is that as information goods and services become cheaper, they encounter a threshold where their price is so low that the enforcement cost of monetary transactions is greater than the value of the transaction. At this point there are two alternatives: they can stop following the declining cost curve, or they can be transferred through non-monetary transactions. While some goods and services have stopped following the curve, many have become “free” (i.e. supported by advertising and/or voluntary contribution). Advertising is a common example of a non-monetary transaction – the consumer “pays” some attention to the ad in exchange for the good or service. Voluntary contributions are more subtle, but we can consider them transactions in which the consumer “pays” attention to the producer themselves – the way we pay performers with applause and credit.

In one sense this is a normal, economically rational process, and it certainly fits Coase’s general framework of transaction costs. The peculiar thing about this case, however, is that it excludes money itself from the transaction process on fundamental economic grounds, indicating that there are intrinsic problems with using monetary value as a metric for transactions.

Note that as the likelihood of significant loss through fraud or error increases, the minimum value for feasible transactions also increases. It is especially hard to judge the value of contracting for unique goods. Thus in cases of one-time production of information goods such as software, encyclopedia articles, or commentary on current events, the threshold will be much higher than for transactions with frequently replicated outcomes.

Understanding transaction costs in general, and the cost of money in particular, helps a great deal in explaining why so much of the landscape of information goods and services has transitioned so rapidly toward a “free” (i.e. non-monetary) approach." (http://jed.jive.com/?p=10)


Transaction Costs for Work and Leisure

Walter Frick:

"In the past, the less you worked, the less was produced, innovated, etc. That’s because your choices for leisure were limited and unproductive. You could watch TV, read, hang out with friends and family in your immediate proximity, hit the local bar, or perhaps you’d find a hobby. But today the transaction costs associated with seeking out a much wider range of activites have fallen. Are you a history buff looking to write encyclopedia entries? You have Wikipedia. Interested in politics? You can become a fact-checker or a pundit from your home office (or, by now, your mobile phone). You can learn almost anything and contribute to a fantastically wide range of projects without traveling or paying. All it costs you is your time. This is what Clay Shirky has called the “cognitive surplus,” and it strikes me as at least possible that it could radically change both work and leisure.

One of the main benefits of working more hours has been that, even if your last hour wasn’t as productive as your first, it was better for the economy than just sitting in front of the TV. That totally changes when you’re spending that extra time contributing to Wikipedia, to an open source software project, or producing new music and sharing it with the world, all in an afternoon. To put this another way, the firm is no longer the only plausible way to organize people to do productive activity. That’s a huge change. I’d be surprised if it didn’t change the tradeoff between work and leisure." (http://bostinno.com/2012/09/13/the-future-of-work-doing-productive-stuff-you-enjoy-in-your-spare-time/)

More Information

  1. Summary of Transaction Costs Theory. Manuel Delanda.
  2. Coordination Costs
  3. Peer Production