Tag Archives: Nature of the Firm

App Store Economics

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If you follow me on Twitter, you may have noticed last week that I have an app in the new Mac App Store. It’s called Gmail Dock, you can find more info about it here and here, and you can buy it here.

I am an economist, not a programmer, so what am I doing with an app in the App Store? This question got me thinking about the economics of the App Store, and I think I have a satisfactory answer.

As with most things, it begins with Ronald Coase (who turned 100 last month, huzzah!). What are stores? They are mechanisms for reducing transaction costs. Notice that I said “reducing.” Store owners are middlemen, and they take a cut of the proceeds for their trouble. Apple takes 30% of gross sales. Nevertheless, the value of their brokering services exceeds their cut of gross sales, so on net they reduce transaction costs.

When transaction costs are lower, we know from The Nature of the Firm that firms get smaller. They outsource more. More people start firms to which other firms outsource, so there are more entrepreneurs. Most importantly, patterns of specialization change. Instead of doing something for myself, I will be more likely to pay someone else to do it for me.

I wonder what The Nature of the Firm would have said if it had been written today, when so many businesses deal in products, such as software, that are characterized by high fixed costs and low marginal costs. The specialization story changes a little. My own adventures with the App Store are instructive.

I wrote Gmail Dock entirely for my own use almost a year ago. I was tired of desktop email clients like Mac OS X’s Mail that were slow, bloated, and not as useful as the web-based Gmail. So I wrote something that attempted to bridge the gap between desktop email and webmail. I found it useful. But I didn’t try to sell it online because of the difficulty of marketing, distributing, and collecting payment. Giving it away would have made me strictly worse off because of support requests.

The App Store came along, and all of a sudden it was cost-effective to sell my software. I went into business. But the thing that is different from the Coasian story is that my pattern of specialization hasn’t actually changed. I’m still producing the same things that I produced before the store came into the picture. Lower transaction costs plus low marginal costs mean that people’s hobbies, creative outlets, and tinkering will increasingly become profitable side businesses. Who knows, maybe some day I’ll get paid to blog.

Those of us who do not spend all day in front of a TV create real value in our spare time. Lower transaction costs enable us to capture some of that surplus. To me, that is one of the important stories of how the App Store, the Internet, and the world of low marginal cost is changing society.

The Nature of the Firm

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Welcome to the first installment of our series of discussions of the Most Insightful Articles in economics. Today we are discussing Ronald Coase’s 1937 article The Nature of the Firm.

Ronald Coase wrote only a handful of academic journal articles—nearly every one is a blockbuster. He won the Nobel Prize in 1991 “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.” He is still alive at the ripe old age of 99; if you do the math, that means he wrote the article we are discussing today when he was 26. This gives me the sneaking suspicion that I am “behind.”

One useful way of thinking about the market is as a coordinating system. The price mechanism serves as a means for directing the flow of every resource to its highest valued use. Suppose that a hurricane hits New Orleans, and as a result the price of plywood increases. That increase in price performs an important coordinating function. As a Virginia resident, when I observe the price of plywood going up, I am induced to delay my plans to build a shed in my backyard. That is, I conserve plywood. This leaves more plywood available to go to New Orleans, where it is most needed. The price system is impersonal, meaning that I don’t even have to know or care about the people in New Orleans in order to behave in a way that is beneficial to them. We will talk much more about the role of prices in the next installment.

However, the market is only one of two main ways that resources are directed. The other mechanism is command and control. Within firms, the autonomous impersonal coordination of the price system is replaced by a conscious interpersonal coordination mechanism. The boss has to gauge or guess if employees are pulling their weight, and to figure out if there are enough computers and office space and coffee and so on. The whole purpose of a firm is to engage in production without the coordinating assistance of the market mechanism. Why should this be? Why would anyone want to avoid a system that sends resources to their highest valued use?

It must be the case that there are costs intrinsic to using the price system. These “transaction costs” include the cost of discovering what the relevant prices are and the cost of negotiating complete contracts that plan for all contingencies and eliminate opportunism. When an entrepreneur starts a firm, she is making a bet that she can direct resources within the firm with enough efficiency so as to produce at a lower cost than the market could produce. That is, she is betting that she can economize on transaction costs. This, Coase argues, is the raison d’être of a firm.

Coase then asks, “[W]hy, if by organising one can eliminate certain costs and in fact reduce the cost of production, are there any market transactions at all? Why is not all production carried on by one big firm?” There must be some countervailing cost that increases with firm size that makes it uneconomical for firms to continue increasing their “insourcing” forever. The main answer that Coase gives is that it gets harder for the entrepreneur to direct resources as the number of resources increases. At some point, the firm is directing so many resources internally that the cost of directing one more resource is equal to the cost of just relying on the market to direct it, transactions costs and all.

The theory can now be used to discuss what affects firm size. Factors that decrease transaction costs or increase organizing costs will tend to make firms smaller. Factors that do the opposite will tend to make firms larger. One factor that increases transaction costs is taxes on market exchange. If it costs firms extra money in taxes to buy furniture, they may decide to make their own furniture in-house. (For discussion: how does the income tax affect the household’s decision to have a second partner go to work or stay home? Hint: households are firms!) A second factor is technology. As communications technology improves, it becomes cheaper to organize over a wider spatial area, increasing firm size. On the other hand, technology also reduces the cost of using the market, e.g. locating prices, and therefore would tend to reduce firm size.

We can keep going with this. Here are some issues that Coase did not discuss. Another factor is bankruptcy and contract law. The fact that there are default rules for contracts lowers the costs of creating contracts (assuming the law is reasonably efficient). Fewer contingencies need to be specified in advance. This makes the cost of using the market lower, decreasing firm size. Next, consider employment regulations. These tend to make it more expensive to direct resources (at least human resources) internally, and therefore firms will be smaller when there is extensive employment regulation. Finally, what if there is a complete breakdown in law and order? This will tend to increase transaction costs, making markets less attractive. Firms will increase in size, and in fact, humans might revert to a tribal existence (tribes are firms!). Law and order, and markets generally, are what enable us to live our lives in a reasonably individualistic way.

Coase also spends a fair bit of space contrasting his theory with Frank Knight’s theory of the firm. I won’t spend a lot of time on this, but we can discuss it in the comments if people are interested. If you want food for thought on this, how plausible is Knight’s view if there are insurance markets and no transaction costs?

To sum up, using the price system is not free. The fact that there are transaction costs means that people will attempt to limit the number of their transactions to economize on these costs. This implies that they will seek alternative methods of directing resources, which we find in firms. The other method, command and control, does not scale well forever. Therefore, there are natural economic limits to the firm’s size.

I’ve raised a few questions above, but here are a few more. How does Coase’s notion of what it means for a firm to be large or small differ from our usual metrics? What is the role of market discipline (profits and losses) in ensuring that firms do not become inefficiently large? If you were an inventor with strong humanitarian impulses, would you want to invent a technology that lowers the cost of transactions or of organization? In a world with no transaction costs, would there still be unemployment? How does the existence of the concept of morality affect transaction costs?

The discussion is not limited to my questions, of course. Feel free to raise whatever issues in the paper you want to discuss. Our next article will be Friedrich Hayek’s 1945 piece The Use of Knowledge in Society. I will be in Las Vegas at a conference early next week, so our next discussion will not be until the latter part of the week. See you in the comments!

What are the Most Insightful Economics Articles?

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Which economics articles teach us the most about how to think about the world? Over the next few weeks, I plan to write about the articles that I think belong in this group. I am hoping that some readers will want to follow along and discuss the articles in the comments.

Here is what I propose. I will select an article and give anyone who wishes to some time to read it (optional). A few days later, I will write a post in which I give a framing summary and explanation of the article, and perhaps some questions for discussion. I will conclude each post with a link to the next article on the list.

I am shooting for ten articles. I haven’t fully decided on the list yet; suggestions, especially from my economics colleagues, are welcome. I will try to go in chronological order by publication date, though because I have not yet decided on the full list, there may be a little backtracking. The articles I am interested in are not necessarily those with the most citations or the ones that have had the most influence on the profession. I assume no one is interested in Heckman selection. I am looking for articles that provide the greatest insight into the world we live in.

If this sounds like something you’d be interested in, I encourage you to participate. I only ask that you keep the discussion in the comments civil and on topic. If you want to be uncivil, you can always post on your own blog about what an idiot I am. And of course feel free to pass this link around to other people who might be interested.

I will aim the discussion to be at the level of an intelligent and educated general reader with no prior background in economics (trained economists are of course welcome to participate as well). My hope is that this exercise will be helpful to many of you. I believe that studying and discussing these articles is a way to get a lot smarter very quickly. I also hope that by blogging about them, I will organize my own thoughts about them and their importance.

The first article in the series will be Ronald Coase’s 1937 article The Nature of the Firm. See you in a couple days.