Coase's Law: Cost of Collaboration

One of the interesting things i read in Wikinomics is Coase’s Law. I had never heard of it. Here’s the deal:

Ronald Coase was a badass and won the Nobel Prize in 1991
Ronald Coase was a badass and won the Nobel Prize in 1991

Many companies today are turning to collaborative b2B models where consumers, employees, partners, and even competitors co-create value for a company. This is all happening due to the declining cost of collaborating.

It began in 1937 when a English socialist, Ronald Coase, published a paper called “The Nature of the Firm.” Coase was both fascinated and bewildered by american industry. He toured Ford and General Motors and wondered aloud why economists could say that Stalin and communism was mistaken to try to run the Soviet Union like one gigantic company when Henry Ford adn Sloan ran their own gigantic companies (Ford & GM) in similar ways. After all, the marketplace is the best mechanism for matching supply and demand, establishing prices, and getting maximum utility from limited resources.

He studies more the cost of information. Producing things (bread, a car, a hospital ER) involves steps where close cooperation and common purpose is essential. You can only break down day-to-day tasks so much before incurring costs that outweigh the savings of doing in under the same roof. These are called transaction costs:

  1. search costs (finding different suppliers and determining if they are good)
  2. contracting costs (negotiating prices and contracts)
  3. coordination costs of meshing products and processes

Most businesses in 1937 determined it was best to do all of these in-house. All of this encompasses “Coase’s Law” which states: A firm will tend to expand until the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction on the open market. Basically, as long as it’s cheaper to perform a transaction inside your firm, keep it there.

The internet makes a difference because basically now transaction costs as so low that it has become much more useful to read Coase’s Law backwards: You should shrink a company until it’s harder to do things externally than internally, then bring it in-house.

It’s interesting because Coase’s Law does both a great job of explaining why old-school corporations were so big and powerful and does an equally good job of explaining why traditional companies are on the way out and why new businesses are smaller and more nimble.

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