Esko Kilpi on Interactive Value Creation

Lenin famously said that the economic system in Russia would be run as one big factory. Many economists at the time said that this was impossible. Yet there were already big factories in the West then, and there still are, so why not? Is there a limit to the size of a factory that cannot be surpassed, or is it because the factory logic cannot be used outside of a real factory?

The typical hierarchical form of an organization is meant to simplify communication, accountability and the coordination of tasks. In theory an employee needs only one connection, to the boss. This is far easier than communicating with all and trying to coordinate actions with everyone. And what about accountability? The worker is accountable only to her manager. That manager reports to her manager on the next higher rank, and the chain goes further, leading in the end to – Lenin.

During the centuries since the publication of “The Wealth of Nations” by Adam Smith, in 1776, the principal theme of most economists has been that government regulation or centralized planning were not necessary in order to make an economic system function well. The coordination would be the result of markets. Lenin and the communists were advised to move to a market economy. The parties in that system follow their own self-interest and are governed, when it comes to the actual choices they make, by a system of prices. This is the polar opposite of centralized planning. Adam Smith was a proponent of extreme decentralization.

A 21-year-old comes out with a revolutionary new theory

Ronald Coase was one of the first economists who started to question mainstream thinking in economics. If a system of prices and competition would do all the coordination necessary, why did we have centralized planning, not only in the now bygone communist countries, but also in well functioning and successful firms? Why did we need management, whose function was to coordinate?

Ronald Coase set out to bring the different views together. It is almost impossible now to fathom that he found the answer as early as during the summer of 1932, at the age of 21. He realized that there were costs involved in using the pricing mechanism. The needs and offerings have to find one another. The prices have to be discovered. Negotiations need to be undertaken. Contracts have to be made. There may be disputes that later have to be settled. These costs were not part of “the invisible hand” equation of Adam Smith. Ronald Coase called these costs transaction costs.

The first revolutionary argument was that a firm would emerge, exist and continue to exist successfully only if it performed its planning, coordination and management functions at a lower cost than would be incurred by means of market transactions, and also at a lower cost than would apply if the same things could be performed by another firm.

The second revolutionary argument was that a well-functioning economic system needs both markets and planning. This depends on the size of the organization and the level of the market side transaction costs. Increasing the size increases (internal) transaction costs. Running an organization is difficult and running a bigger organization is more difficult.

Management is an overhead

Managerial overhead increases as the organization grows. Management, communication and coordination are all transaction costs. Every sales call, every offer, every agreement and every meeting also consumes limited resources and increases transaction costs. As the corporation grows, all its energy finally goes into maintaining the corporation and does not benefit external stakeholders.

Whenever transaction costs inside the organization reach the level of the transaction costs in the markets, markets outperform firms and outperform central planning/coordination in general. This was the main theoretical argument against Lenin. The same thing is clearly still evident today in companies like GM, or organizations like large health care units. Communist countries learned their lesson, but we still haven’t.

An organization can only be successful when the costs of hierarchical coordination are lower than the gains achieved from that coordination.

The existence of high transaction costs outside of firms leads to the emergence of the firm as we know it now, and management as we know it now. A large part of corporate economic activity is designed to accomplish what high market transaction costs prevented earlier.

The Internet is an extinction-level event for the traditional firm

If the (transaction)costs of exchanging value in the society at large go down drastically, the form and logic of economic and organizational entities also change! Accordingly, a very different kind of management is needed.

Today, with social media, we stand on the threshold of an economy where the fundamental processes of communication and coordination are being transformed.  Familiar economic entities are becoming increasingly irrelevant as the Internet, not the traditional organization, becomes the most efficient means to communicate, coordinate and exchange value.

For most of the developed world, hierarchies, as much as markets, make up the dominant economic pattern. The Internet is nothing less than an extinction-level event for the traditional firm. The Internet makes it possible to create new forms of value creation and new forms of value exchange. It changes our views of markets and hierarchies in ways that Adam Smith or Lenin could never have imagined.

Thank you @cshirky