The theory behind hierarchies, markets and market makers

by eskokilpi

Vladimir Lenin (1870-1924) famously said that the economic system in Russia after the revolution would be run as one big factory. Many economists at the time said that this was impossible. Yet there were already big factories in the West then, and there still are, so why not? Is there a limit to the size of a factory that cannot be surpassed, or is it because the factory logic cannot be used outside a real factory?

The typical hierarchical, factory, form of an organization is meant to simplify communication, accountability and the coordination of tasks. In theory an employee needs only one connection, to the boss. This is far easier than communicating with all and trying to coordinate actions with everyone. And what about accountability? The worker is accountable only to her manager. That manager reports to her manager on the next level up, and the chain goes further, leading in the end to – Lenin.

During the centuries since the publication of “The Wealth of Nations” in 1776 by Adam Smith (1723-1790), the principal theme of most economists has been that government regulation or centralized planning were not necessary, or even welcome, in order to make an economic system function well. The coordination would be the result of pricing mechanisms in markets. Lenin and the communists were advised to move to a market economy. The parties in this system follow their own self-interest and are “governed”, when it comes to the actual choices they make, by the system of prices and information they possess. This is the polar opposite of centralized planning. Adam Smith was a proponent of extreme decentralization and something that did not really have a name at the time – democracy.

Ronald Coase (1910-2013) was one of the first economists who started to question mainstream thinking in economics. If a system of prices and competition could perform all the coordination that is necessary, why did we have centralized planning, not only in the now bygone communist countries, but also in well-functioning and successful firms? Why did we need management, whose function was to coordinate? Why didn’t we rely on markets?

Ronald Coase set out to bring these two different views together. It is almost impossible now to fathom that he found the answer as early as during the summer of 1932, at the age of 22. He realized that there were costs involved in using the pricing mechanism. The needs and offerings have to find one another. The prices have to be discovered. Negotiations need to be undertaken. Contracts have to be made. There may be disputes that later have to be settled. Adam Smith did not see this. These costs were not part of “the invisible hand” equation. Ronald Coase called these costs transaction costs.

The first revolutionary argument was that a firm would emerge, exist and continue to exist successfully if it performed its planning, coordination and management functions at a lower cost than would be incurred by means of market transactions, and also at a lower cost than would apply if the same things could be performed by another firm. This is where competition keeps firms internally efficient and where non-competition in the public sector creates complex, non-efficient governance models and units that are too big.

The second revolutionary argument was that a well-functioning economic system needs both markets and planning. This depends on the size of the organization and the level of the market side transaction costs. Increasing the size increases the internal transaction costs. Running a sizable organization is difficult and running an even bigger organization is even more difficult.

Managerial overheads increase as the organization grows. Management, communication and coordination are all transaction costs. Every sales call, every offer, every agreement and every meeting also consumes limited resources and increases transaction costs. As the corporation grows, all its energy finally goes into maintaining the corporation and does not benefit external stakeholders.

Whenever the transaction costs inside the organization reach the level of the transaction costs in the (outside) markets, markets outperform firms and outperform central planning/coordination in general. This was the main theoretical argument against Lenin. The same thing is clearly still evident today in companies like GM or organizations like large health care units. Communist countries learned their lesson, but we still haven’t.

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. A large part of corporate economic activity is designed to accomplish what high market transaction costs prevented earlier.

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 firm, as we have known it, becomes the more expensive alternative. Accordingly, a very different kind of management is needed when coordination can be performed without intermediaries with the help of new technologies.

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.

For most of the developed world, corporate hierarchies, as much as markets, make up the dominant economic pattern. The Internet is nothing less than an extinction-level event for the traditional firm as we have known it for the past 100 years. The Internet makes it possible to create totally new forms of economic entities.

The Internet changes our views of markets and hierarchies in ways that Adam Smith or Vladimir Lenin could never have imagined. But Ronald Coase did much to explain the theory behind Uber, Airbnb and other new market makers as early as 1932.

Thank you @cs