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By | Tim Worstall 26th November 2014 09:04

As-a-service upstarts will KILL OFF THE CORPORATES?


Worstall on Wednesday Amazingly, economists have figured out a few things...even things that can help in this brave new digital world. One of these is the "marketplaces vs firm" debate.

So I was surprised to find a fascinating little piece in TechCrunch singing the praises of all those "online freelance work marketplace" sites. You know the sort of things: ODesk, ELance, Mechanical Turk.

The point being made was that this was a great new revolution that was going to (is, in fact) eat all the companies and firms out there. And Hurrah! Brave New Dawn and all that.

I was waiting for the other shoe to drop, or at least an accurate explanation as to how the basic thesis was conceived. And I didn't find it. So, here it is.

Or, if you prefer, you can take this as evidence that some economists have, some of the time, actually made not only interesting but also useful points about the structure of the world around us.

The centrepiece of our booster for this freelance economy's piece was this:

Many startups are trying to disrupt the traditional “firm” structure. The biggest driver of adoption is the massive cost savings that these marketplaces provide.

For example, a marketplace with low fees is a very efficient delivery mechanism. Typical markups in law firms or consulting firms might be 4x - a worker making $50 per hour would get billed out at $200.

The same person on a marketplace might raise their rate to $75 to compensate for utilization, but the end price to the customer might end up at $85 – $95 per hour.

And yes, OK, one can see the point. But as I say, I was waiting for that other shoe and it didn't come. That other shoe, of course, would be Ronald Coase's paper “The Nature of the Firm”, one of two publications that won him a Nobel. Now Coase was of his time, he was at the LSE in 1937 when he published this, so he didn't quite express it in these words. But his question was: “Why in buggery do firms exist?”

The almost tautologous answer is that firms exist when they're more efficient than those marketplaces, and marketplaces exist when they're more efficient than firms. As with so many interesting things, it's obvious once it's pointed out, but not obvious until someone does.

Market transactions costs

In more detail, Coase pointed out that a firm has overheads. It also has continuity: and continuous bills that come with having that permanent existence. So, on the face of it we've got to explain why they ever arise. They're going to be, at first sight at least, more expensive than simply swapping contracts in a free and liquid market of suppliers. Yet they do exist and that is the thing that must be explained.

The answer is that at times it's still cheaper to have the firm than the contracting out the work: whether and when is going to depend upon the transactions costs in that market. It's a bit of a catch all: it can include the reputational benefit that the permanence of a firm can provide, for example. But at heart it is again obvious. If the costs of having to assemble a new team for each and every project are higher than the costs of maintaining a firm, then firms there will be, and contracting markets there won't be.

We can all think of examples: if you're running a steel mill then you're probably better off with engineers you know and trust running your billion-dollar plant than hiring whoever looks good on the street on a Monday morning. If you're hiring unskilled dock labour, heavily dependent upon when the wind and the tides will bring the boat in, you might well go for that contractual policy of hiring a few hunks onto the pier as and when you need them.

Continuity counts

The consolidation of much of the steel industry under Lakshmi Mittal shows firms are still useful

In more modern terms, almost all large firms need accountants all the time and thus employ them, but rarely need barristers, which is a contractual market.

However, that idea of “transactions costs” is at the heart of it all. And this is where we get to a corollary of Karl Marx's contention that social relations are a product of the level of technological development. This is also the case with transactions costs. They depend upon the general level of technology.

Cast your mind back 50 years, when international telephone calls were hugely expensive. You're a publisher, trying to get translations done so you can release your books in many languages and countries. Finding someone, a freelance (freelance translator, publicists, book printer and so on) for each title is going to involve vast search costs (a subset of transactions costs) and you're not going to have much information about who the hell they are, nor how good they are. The natural tendency of the business model here is going to be towards and integrated multinational firm.

Online marketplaces grow

Fast-forward to today and there are any number of such online marketplaces where you can research such things in minutes. I've not checked it but it wouldn't surprise me if it took just 15 minutes to find someone who specialised in translating pulp novels into Czech, for example.

So, given that we've got this technological change going on, we've also got an increase in the areas where a transactional marketplace makes more sense than a unified firm. And, logically, we should also be able to find areas where the firm is still more than the sum of its parts and thus we don't see that change happening: I'd argue that the consolidation of a large chunk of the world's steel industry under Lakshmi Mittal is one such example.

My point here really is that Silicon Valley hasn't found anything particularly new in these marketplaces, nor their ability to undermine the centralised firm. The idea is not emergent from competition, it's not a function of this glorious internet: it's something that has been baked into the basic view of why firms exist at all for 80 years or so now.

Rather, what they've found is a specific example of the more general case: the existence of firms is based upon transactions costs, and that these vary with technology. So, as technology varies, certain industries will be subject to the possibility of disintermediation (cutting out the middleman).

And, of course, it's the forces of competition that sort out which ones are subject to it, and full marks to the people making their billions by discerning this. But it's still not a new idea: it's a new application of an old one.

Or, as I said at the top, some economists really have worked out things which are useful, even in our modern post-crash world. It might not be quite the best way of running a banking system, that's true, but there are still useful things to know about even the most modern trades and industries in the basics of the subject. ®

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