A while back I read a interesting blog post about British economist Ronald Coase. If you want to blame someone for all the excitement these days over web-services and web-based applications you may want to start with Coase. One pillar of Coase’s work which eventually led to his Nobel prize for economics in 1991 was a 1937 essay he wrote called “The Nature of the Firm” in which he tried to answer the question of why firms integrated vertically rather than horizontally as clusters of smaller independent firms.
In “The Nature of the Firm” Coase argues that the economy would be populated by lots of small independent contractors (rather than a lesser number of large integrated firms) if it weren’t for what he called “transaction costs”. When firms contract with each other transaction costs constitute other less tangible costs besides the cost of the good like, search and information costs, bargaining and decision costs, and policing and enforcement costs. The choice a firm made to integrate vertically was a matter of balancing the transaction costs of dealing with an outside firm and the added costs of doing things internally like increases in overhead and missallocation of resources by overwhelmed management.
Years after “The Nature of the Firm” was published the world became irrationally exuberant over the emergence of the internet and its ability to reduce transaction costs. Anyone who has used Ebay should easily see the relationship between the internet and reduced transactions costs. Pre-internet, the transaction costs of finding a buyer for your old knick-knack may have been significant, or even prohibitive, but with Ebay the costs of finding and entering into a contract with a trustworthy buyer are practically nil. Search and information costs, bargaining and decision costs, and policing and enforcement costs are virtually eliminated and you’re only left with paying a nominal fee to Ebay.
As the internet evolves, web services hold the promise of reducing transactions costs even further. The vision for web services is one where an internet based on open technology standards allows firms to discover each other, establish trust, negotiate pricing, and exchange goods and services with virtually no transaction costs.
A lot still has to happen before this vision is realized, but some have predicted that Coase was on the right track and the reduction of transaction costs will lead to a horizontal economy –an economy where smaller firms, seamlessly connected via a global data network, predominate across the economy.
So, will a horizontal economy emerge bringing about more respect, increased political clout, and a new prominence for small business overall? Maybe. We’ll just have to wait and see. And I’ll have to watch my exuberance along the way.