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Transaction Cost Confusion

from Peter Radford

OK. Let’s have some fun.

Transaction costs were invented by Ronald Coase to help explain why we see business firms littering the economic landscape when orthodox economic theory argues that the marketplace is the superior and unequalled coordinator of economic activity. The Coasian idea, later extended and expanded upon by the likes of Oliver Williamson, is that there are costs of accessing the market which, under some circumstances, render market coordination more expensive than having production contained within the boundaries of what we call a business firm. These costs are what are now called transaction costs.

The problem is that they are also fairly vague. Indeed on of the main counter attacks by leading orthodox economists has always been that transaction costs are hard to pin down and thus ‘formalize’. And, as we all know, things that are not formal are considered to be dicey and not rigorous by orthodox ideologues.

Anyway, that’s for them to argue over, let’s get back to our fun. 

Recall that the orthodox argument is that decentralized market coordination rules supreme. Coordination by any other means — for instance via central planning in the old Soviet Union — is distinctly inefficient by comparison. Since firms are basically centrally planned economies they thus ought not to exist: hence the Coasian conundrum.

So let’s apply the orthodox argument to itself.

In this over commercialized world of excessive specialization and constant monetizing of anything that moves we can consider orthodox theory a product or good for sale. That’s how the likes of Milton Friedman would expect us to act: as consumers of theories we buy the one we like the most, and the most sought after is, by acclaim of the market, anointed as being the correct one.

That’s how markets work.

So let’s go buy ourselves a theory.

We immediately bump into the Coasian conundrum. For how do we purchase an entire theory through the marketplace? Do we buy individual words and then assemble them ourselves? Do we buy sentences? If so who assembled the words into those sentences? And where? Do we buy entire paragraphs? Or entire books?

Surely, if market coordination is supreme we don’t need some fusty tenured professor to assemble the whole theory and then present it to us as a finished article. Do we? Aren’t there transaction costs involved here somewhere?

OK enough of my snark, but you get the point. If you think my example of orthodox theory is ridiculous [as I am sure many of you will], then apply the thought process to any number of similar service or post-industrial settings. How about a movie, for instance? Are we supposed to buy our movies frame by frame? Act by act? How?

If the market is the supreme coordinator of all things economic, we ought, in principle, to be able to buy everything through its auspices. Each frame of a movie, or each component of a motor car.

After all, the adding together of the frames of a movie is analogous to the adding together of the parts of a car. We buy the entire thing. But orthodox theory denies that this is efficient. It presumes each component can more easily and more efficiently be purchased on the open market.

It must presume this because otherwise Coase would not have scratched his head over the existence of firms [or movie makers].

So, here’s the serious point in this little fun exercise: orthodox theory ignores the need for production processes. It wants to substitute the market for each step along the way of such a process. But what we see around us is large numbers of structures that house processes and shield them from the market. Coase asked why that was. He got the answer wrong.

It isn’t the cost of accessing the market at all.

It is the need for design and coordination of the information required in production.  Because economists tend to consider information only in the context of supply and demand, prices, and so on, they ignore completely the creative aspect of production. Design, engineering, and management all disappear from their economic thought process and are obliterated consequently. Products just appear magically to be bought and sold from inside some ‘black box’, the contents of which orthodox economists express little or no interest. And, I must add, little or no understanding.

Here’s another little wrinkle in the story: I have a hunch that the constant dividing of labor over the past century or so, lurks as the motive force behind non-market coordination. This is because as specialization segments production into ever smaller steps a countervailing force — which we loosely call management — comes into play to oversee whole chains of specialization and to make sure they cohere into a viable whole.

So the firm is more accurately seen as a logical counterpoint to specialization, and transaction cost are more accurately described as management costs.

And the management cost of an economic theory is the cost of a tenured professor opining about something we cannot buy piecemeal.

Well, sort of.

  1. May 6, 2015 at 4:53 pm

    The epic ping-pong of empty problem and vacuous solution
    Comment on ‘Transaction Cost Confusion’

    You say “Transaction costs were invented by Ronald Coase to help explain why we see business firms littering the economic landscape when orthodox economic theory argues that the marketplace is the superior and unequalled coordinator of economic activity.” (See intro)

    That ‘the marketplace is the superior coordinator’ is an assertion that needs proof. No such proof exists. So it is still an open question. Because of this, there is no need at all to invent a new explanation for the existence of the firm.

    All the more so, as the correct answer has already been given by Adam Smith. Remember the pin factory? Division of labor and exchange are the two sides of the same coin and reinforce each other. This interaction is the big bang of the market system’s vast expansion (see also 2014). Division of labor, clearly, presupposes the firm.

    What Coase and Williamson explain is that pigs can fly because they have yellow wings.

    “Cunningham in 1891 remarked that in the choice of premises “it is not always easy to tell when a professor of the dismal science is making a joke” and I suspect that Cunningham meant that if the professor was not joking, then he was making a fool of himself.” (Viner, 1963, p. 12)

    Egmont Kakarot-Handtke

    Kakarot-Handtke, E. (2014). Exchange in the Monetary Economy. SSRN Working Paper Series, 2387105: 1–19. URL
    Viner, J. (1963). The Economist in History. American Economic Review, 53(2): pp.
    1–22. URL http://www.jstor.org/stable/1823845.

    • blocke
      May 7, 2015 at 7:47 am

      Economists don’t know anything much about the firm and it’s purpose. Firms can exist in free markets and in cartels, they can exist in unpredictable markets and more predictable; they can serve the interests of the stockholders or the firm as a sustainable community, efficiency in them can be determined in many ways, depending on the goals set. Some years ago the economist Gunnar Elliasson said (1997). “The management teacher as well as the economic theorists needs a realistic model of the firm to support teaching and thinking, but since no realistic theory of dynamic markets exists, no good theory of the firm has been created. The moral, hence, is that so far we have excellent firms, not thanks to but despite management teaching.”

  2. May 6, 2015 at 11:13 pm

    Economies are graphs, where the people are nodes and transactions are the edges. More and repeated transactions make for stronger edges.

    A firm is like a woven fabric, or like the circulatory system of an animal. The graph is relatively fixed in time and there’s a conscious order to it. Everyone exchanges value with their colleagues in the patterns the organisation has set up. Sometimes it’s efficient, sometimes less so. At a small scale people make spontaneous connections, but it takes conscious effort to change the large structure.

    Real markets, like a village economy or business-to-business supply relationships, are like a tree or an old spider’s web. The structure has grown organically at all levels by people developing preferences to trade and keep trading with each other. At first they trade tentatively, and then they choose to continue trading and develop a de-facto relationship. Connections may wither and others grow here and there, but the large-scale pattern of trading changes slowly.

    Artificial markets like stock and commodity exchanges, the kind that classical economists get excited about, are like those decorative glass spheres that have electrical discharges inside. Trading is fleeting, it spurts instantly between two points and disappears, and there’s no tendency for trading to happen again along the same path unless you put your hands on the system to create a distortion.

    Real markets are graphs. Moreover they’re relatively permanent networks of exchange, whether they’re organised firms or spontaneous trading relationships. The sort of transient markets that some economists like are artificial and often useless toys.

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