Platt Perspective on Business and Technology

Business and convergent technologies 16 – transaction costs and friction in information economy systems

Posted in book recommendations, business and convergent technologies by Timothy Platt on December 2, 2009

In physics, and in the physical sciences in general we always at least seek to start with simpler models for describing and predicting and we then add in complexities as necessary to achieve the required levels of predictive and descriptive accuracy. So for example, it is possible to launch a spacecraft into Earth orbit and send it out from there to orbit another planet in our solar system and with a precisely calculated flight path using the level of simplifying resolution obtained from Newton’s laws of motion, and without recourse to the added complexities of the special theory of relativity, the general theory of relativity or quantum mechanics. That is not to say these more elaborate approaches to describe and predict are not of value – just that they do not significantly apply to the motion of larger objects at slow speeds (quite large relative to atoms and quite slow relative to light). Economics follows a similar, Occam’s razor-driven approach so we tend to at least start with the so called frictionless economic models that do not account for messy details like transaction costs.

The simpler models of preferred first choice, however, do not and cannot always adequately apply and this is where I have to look into the mess of the real world and the costs of transactions where information per se is viewed as an economic entity.

[ECONOMIC MODELING RANT WARNING – We are currently struggling out from under what has to be the most severe recession since the Great Depression and one of the key factors cited for this happening is our collective failure to appreciate that the market can be driven by emotional and irrational factors as much as by rational ones. But the rational theories that our econometric and other predictive models are based on are all too often kept at that frictionless simplicity level without considering the possible role of truly significant transaction costs in shaping the economy and our behavior in it. So even when rational behavior could adequately explain and describe the economy for predictive purposes, these models have not always looked to the right rational behavior and what actually shapes it with its goals and priorities. And the wheels left the road and we are still pulling back from that cliff edge and trying to get back on that road again. END OF RANT – NON-STRIDENT READING AHEAD]

OK, these added complexities can be important. So how do they (and which of them) apply here to the economics of information, and how does this added complexity apply specifically to shaping our emerging ubiquitous computing and communications environment? That is what I am going to look into here, and starting with a background-reading book recommendation.

• Downes, Larry. (2009) The Laws of Disruption: harnessing the new forces that govern life and business in the digital age. Basic Books

I also want to start this by paying grateful acknowledgement to Ronald Coase, the 1991 Nobel laureate in economics for his elucidation of the costs of transactions in shaping firms and in a larger sense shaping the economy as a whole.

The basic argument is that there are costs associated with the underlying processes needed to effect buying and selling, and the conduct of business and organizational function at all levels. For buying and selling per se, this includes friction and cost generating requirements like:

Search costs for finding options for purchase/finding best cost options to buy.
Information costs to know what options to look for, for both sides of the buy and sell equation and with what priorities.
Bargaining costs to secure the best terms for these transactions.
Decision costs – an ongoing due diligence requirement for comparative buying and selling to the best price points.
Policing costs and legal assurance to make sure that terms of agreements are honored and if not, that effective and cost-effective remediation is carried out.

The basic, traditional argument as to how this works is that businesses seek to limit these extra costs to reduce their ongoing expenses, and one way to do so is to carry out as many of the processes that can generate transaction costs as practical in-house. So businesses grow and certainly in a rivalrous product and service marketplace, at least in part to meet these specific needs.

The same argument is also generally advanced, and in the above book as an example, to suggest that as information is a non-rivalrous product many of the traditional sources of transaction cost no longer apply for it and for information-intensive businesses, at least with anything like their level of potential impact for the organization that you would find with rivalrous products and services. So the pressure to bring in-house more and more of the processes that can generate these costs is reduced and smaller firms and even the lone business person can compete effectively and on a much more level playing field with even the largest businesses.

There is a significant measure of truth to this, and certainly with the advent and proliferation of open standards, open source and the growing range of freely available and readily interconnectable information infrastructure that is available to all. But simply dismissing transaction costs and the complexity and friction they generate cannot yield descriptive or predictive models that adequately cover the real world of information as an economic entity for any real business, long term. Perhaps more than that, simpler-seeming frictionless models cannot accurately model the information economy as an aggregated macroeconomic whole. And a failure to take real world sources of friction such as transaction costs into account is simply going to increase the chances of a recurrence of the problems that our recent economic mismanagement lead us to [see rant, above].

So what are the new and emerging transaction costs inherit to the information economy and to the ubiquitous computing and communications environment and marketplace that it functions in? A couple of contenders come readily to mind as fundamental cost centers here.

Information sourcing costs, and finding the right information worker with the right information needed to make decisions, set priorities and complete information-based products and services.

If you have the right people in-house or readily and consistently, reliably available from third parties (channel partners, etc.) then you do not have to search for them and vet them and validate their presumed expertise as a novel expense for every instance your need their particular types of claimed knowledge. This is a transaction cost that actually increases pressure to grow in an information economy, and if not entirely within the individual organization, at least within its tightly knit value chain.

Organizational disorganization costs with silo walls and other barriers that prevent knowledge of or access to the range of talent, knowledge and experience available in-house already.

Structural inefficiencies in the table of organization and in the channels of communication and information sharing, and human resource sharing within the organization are simply going to grow in range, scale and bottom line impact as businesses move into a more information-centric economic model and marketplace.

Together, these transaction costs create a requirement on the organization for:

• Developing effective in-house staffing with the right mix of information workers.
• Developing a more effective system for attracting, bringing onboard and retaining these workers.
• Developing the right organizational structures with proactive, dynamic, interactive information architecture to sustain this system more cost-effectively and to tap into its capabilities for cost reduction and revenue generation.

The next entry in this series is going to look into the diversity of interactive apps, social networking sites, etc. and how this connects into our emerging ubiquitous computing and communications environment.

2 Responses

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  1. Neprestano Pobedujte na Ruletu said, on December 29, 2009 at 7:38 pm

    Hey, ok, I get it, I guess – but does this really work?

    • Timothy Platt said, on December 29, 2009 at 7:45 pm

      Thank you for asking this, as the key to anything related to developing economic models for information is that they should work at a very practical level. I do not claim my approach is perfect by any means or complete but my experience suggests that it does work. It is certainly an improvement over our current approaches of shoehorning information into models that are becoming obsolete for manufactured goods.

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