The Invisible Hand . . . . .

Ronald Coase has taken his leave, leaving behind several intriguing propositions that still twist in the crucible of the Internet….

Years ago with the advent of the World Wide Web all sorts of experts proclaimed that we stood on the threshold of a new economy, see The New Economy Primer, before us was a world whose prospects were filled with riches and whose oceans were rife with monsters. In this uncharted frontier the rules of ordinary economic wisdom would no longer prevail and the race belonged to those who could anticipate the profound changes that were about to take place and arrive at the future ahead of their competition. And it was this kind of thinking that created colossal failures like Webvan and turned a sock puppet into the mascot of the opening eon, the beginning boom and bust, of the first age of the Internet.

Only thing is most of the experts were wrong.

There was no new economy. In fact, many of the expected behaviors of established economic theory became amplified and grew more visible such as the relationship between demand risk, asset specificity and transaction costs. After all, why own assets if you can’t be certain they will be amortized against the demand they are meant to service? Why concentrate capital if the expected returns could be generated through simple bartering between unrelated parties? However the Internet did become something of a living laboratory where some of the fundamental hypotheses of established economic wisdom could be more closely observed.

More than one of those fundamental hypotheses belonged to the late Ronald Coase. Back in 1937 in a paper entitled “The Nature of the Firm”, Coase first posited that there are fundamental reasons that give rise to the formation of corporations, concentrated hierarchies of proprietary, value creating processes. They were not somehow preordained but came about as a result of the self organizing and self governing principles that directed the “invisible hand”, Adam Smith’s original metaphor for the “deus ex machina” that controlled the flow and form of economic activity. Coase reasoned that if transaction costs, the cost to source, negotiate, contract, acquire and manage inputs into a complex value creating process were greater than the costs of owning those inputs and processes then an entity whose economies of scale and scope would emerge under whose governance the activity could be more efficiently pursued and whose existence would significantly reduce or conserve the cost of producing a like good or service through the use of market based transactions.

In other words, where the cost of numerous arms length exchanges of value in the creation of a specific good or service exceeds the cost of the proprietary governance of inputs to produce the same outcome, firms will emerge. Now this is not without a lot of caveats along with a certain amount of conjecture as to where the limits of proprietary governance may lie. One immediate caveat to this notion quickly appears when it comes to the use of capital to support the formation of a proprietary governing entity. In theory, capital always seeks a higher rate of return within the limits of acceptable risk. In this instance, risk is the likelihood or certainty of demand for the good or service produced by a proprietary governing entity. Where demand is highly uncertain, the use of capital to create a proprietary governing entity is challenging at best and down right fool-hardy at worst. However, recent evidence also suggests that, in part thanks to technology, firm formation can occur with increasingly lower amounts of capital, faster cash conversion cycles and with lower expected rates of return.

Back in 1937 Coase had no idea that something might come along that could basically alter the respective transaction costs that would influence the formation of firms. But the Internet is just such a phenomenon. Costs associated with information asymmetry have for the most part evaporated. Costs associated with the exchange of value have also been lowered dramatically as have the cost to pool and allocate capital in the formation of proprietary governing entities. Under existing conditions one might expect an enormous dissolution of firm based economic activity; giant, globe striding entities slowly crumbling into their free-standing constituent parts, loosely knit together by the lower cost of exchanging value. But it hasn’t happened. Similarly, the largest percentage of capital formation and allocation remains for the most part tightly controlled, concentrated in banks, corporations and to an increasing extent sovereign sources seeking to establish economic advantage on a global basis. While crowd sourcing and crowd funding have begun to gain traction they have yet to produce a basic, fundamental shift in the overall organization of economic activity.

But this could change.

We may yet see the balance of economic activity tilt and reorganize along Coasian principles due to changes in transaction cost between private enterprise and free markets. In a very real sense this would be something that Coase himself may have predicted. Or it may be that the future no longer belongs to the invisible hand but instead to regulatory influences that inhibit degrees of economic freedom, a concept that Coase also put forth towards the end of his career.

In 1960 Coase offered another take on transaction costs in a paper called “The Problem of Social Costs”. In it he attempted to reconcile ownership with social outcomes. While not explicitly directed at the notion of the Tragedy of the Commons, many assumed that it could be used to promote the view that any resource whose ownership was not explicitly declared automatically belonged to the common good and therefore could be regulated by government through the use and control of transactions costs. Consequently, and inadvertently, Coase ended up putting his fingerprints all over things like carbon trading and by extension any thing else that governments might wish to control. Say for instance healthcare. In the long run it might be his work on social costs, and sovereign regulation, that become the dominant feature of the landscape of future economic activity.

Stay tuned…we’ll be right back.

Graphic courtesy of Dean Snow/Society for American Archaeology

Just a quick PS, recent research supports the notion that hand prints such as the one shown here, dating back as far as 40,000 years ago, were mostly made by women.