Renowned economist Ronald Coase died last week at the age of 102. Among his many achievements, Mr. Coase was awarded the 1991 Nobel Prize in Economics, largely for his inspiring 1937 paper The Nature of the Firm. The Nobel committee applauded the academic for his "discovery and clarification of the significance of transaction costs … for the institutional structure and functioning of the economy."
Mr. Coase's enduring legacy may well be that 60 years later, his paper and theories help us understand the Internet's impact on business, the economy and all our institutions.
Back when the Internet was still called the information superhighway, I began forecasting the impact of ubiquitous connectivity. Much of my thinking was shaped by Mr. Coase's early work.
As a young economist, Mr. Coase was perplexed by large American companies run by titans such as Henry Ford and Alfred Sloan Jr. If the free market was the best way to allocate resources, why did these capitalists run their companies in much the same way as Stalin ran the Soviet Union's economy?
Mr. Coase wondered why there was no market within the firm. Why is it unprofitable to have each worker, each step in the production process, become an independent buyer and seller? Why doesn't the draftsperson auction their services to the engineer? Why is it that the engineer does not sell designs to the highest bidder? Mr. Coase argued that preventing this from happening created marketplace friction.
Mr. Coase argued that this friction gave rise to transaction costs – or to put it more broadly, collaboration or relationship costs. There are three types of these relationship costs. First are search costs, such as the hunt for appropriate suppliers. Second are contractual costs, including price and contract negotiations. Third are the co-ordination costs of meshing the different products and processes.
The upshot is that most vertically integrated corporations found it cheaper and simpler to perform most functions in-house, rather than incurring the cost, hassle and risk of constant transactions with outside partners.
It makes sense for a firm to expand until the cost of performing a transaction inside the firm exceeds the cost of performing the transaction outside the firm. This is why large, insular corporations prevailed in the industrial economy.
This is no longer the case. Many behemoths have lost market share to more supple competitors. Digital technologies slash transaction and collaboration costs. Smart companies are making their boundaries porous, using the Internet to harness knowledge, resources and capabilities outside the company. Everywhere,leading firms set a context for innovation and then invite their customers, partners and other third parties to co-create their products and services.
Today's economic engines are Internet-based clusters of businesses. While each company retains its identity, companies function together, creating more wealth than they could ever hope to create individually. Where corporations were once gigantic, new business ecosystems tend toward the amorphous.
Procter & Gamble now gets 60 per cent of its innovation from outside corporate walls. Boeing has built a massive ecosystem to design and manufacture jumbo jets. China's motorcycle industry, which consists of dozens of companies collaborating with no single company pulling the strings, now comprises 40 per cent of global motorcycle production.
Looked at one way, Amazon.com is a website with many employees that ships books. Looked at another way, however, Amazon is a vast ecosystem that includes authors, publishers, customers who write reviews for the site, delivery companies like UPS, and tens of thousands of affiliates that market products and arrange fulfilment through the Amazon network. Hundreds of thousands of people are involved in Amazon's viral marketing network.
This is leading to the biggest change to the corporation in a century and altering how we orchestrate capability to innovate, create goods and services and engage with the world. From now on, the ecosystem itself, not the corporation per se, should serve as the point of departure for every business strategist seeking to understand the new economy – and for every manager, entrepreneur and investor seeking to prosper in it.
Nor does the Internet tonic apply only to corporations. The Web is dropping transaction costs everywhere - enabling networked approaches to almost every institution in society, from government, media, science and health care to our energy grid, transportation systems and institutions for global problem solving.
Governments can change from being vertically integrated, industrial-age bureaucracies to become networks. By releasing their treasures of raw data, governments can now become platforms upon which companies, NGOs, academics, foundations, individuals and other government agencies can collaborate to create public value.
Media companies are becoming networks that collaborate with countless partners and where readers, listeners and viewers co-create value. Universities are beginning to disaggregate into networks offering courseware through massively open online courseware.
If we listen to the theories of Mr. Coase from more than 60 years ago, we can understand how the digital revolution helps us find the uniquely qualified minds and talent to create wealth, govern and educate ourselves for the future.
All that's needed is the leadership to make these changes.
Don Tapscott is an Adjunct Professor at the Rotman School of Management, University of Toronto. He is the author of 14 books, most recently MacroWikinomics: New Solutions for a Connected Planet (with Anthony D. Williams). His 1996 book The Digital Economy introduced the importance of Ronald Coase to understanding the Internet. Twitter: @dtapscott
Don Tapscott