NCPA - National Center for Policy Analysis

How Technology Affects Transaction Costs and Firm Size

January 23, 2002

If competitive markets are such a great idea, why are businesses organized internally like socialist command-and-control economies? And why hasn't the computer- and Internet-based "new economy" allowed individual entrepreneurs to supplant bureaucratic corporations as the typical business firm?

Economist Ronald Coase provided an answer to these questions in 1937, says Hal R. Varian:

  • Firms -- from small businesses to multinational corporate conglomerates -- are a collection of activities for which it is more effective and less costly to use command-and-control than markets to get things done.
  • Instead of using markets, companies tend to be organized as hierarchies, using a chain of command and control rather than negotiation, markets and explicit contracts.
  • That's because there are costs to selling services or products and enforcing contracts, called transaction costs; when bargaining costs are high or the activity is critical to the firm, it is more efficient to control the activity internally and organize it hierarchically.

Computers and the Internet have reduced the cost of communication, and have also reduced transaction costs. But that doesn't necessarily make smaller firms more competitive.

That is because communication costs are reduced within organizations as well as across organizations. Thus as Coase himself said, "changes like the telephone and telegraphy, which tend to reduce the cost of organizing spatially, will tend to increase the size of the firm."

New technology might reduce a company's size, if it reduces the cost of using markets by more than it reduces internal communication costs, says Varian. Thus determining whether companies will be bigger or smaller requires careful analysis of competing forces.

Source: Hal R. Varian, "A New Economy With No New Economics," Economics Scene, New York Times, January 17, 2002.


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