Technology and Transaction Costs Economics

I originally wrote this entry on August 9, 2004 and published it on blogs.sun.com.

Douglass C. North, the Nobel Economics Laureate (1993), has applied transaction cost economics, an economic theory originally founded by Ronald H. Coase (the 1991 Nobel Economics Laureate) to develop a new theory of institutional economics.

In the last chapter of Structure and Change In Economic History, one of his earlier books on the economic history of institutions, North gives the following assessment of technology in economic history (pp. 206-207):

. . . the stock of technology determines the gains from specialization (via scale economies) and the costs of alternative forms of organization. The greater the gains from specialization, the more steps in the production process and the higher the transaction costs.

The jump from "the more steps in the production process" to "higher transaction costs" may be surprising for some but a review of the bullwhip effect in supply chain management should clarify the connection.

The bullwhip effect, i.e. demand and inventory uncertainty amplifications upstream of a supply chain was analyzed theoretically by Jay Forrester in his famous 1961 book, Industrial Dynamics. The bullwhip effect has also been studied by more recent investigators, such as Professor Hau Lee of Stanford University.

The expenditure necessary to handle increasing fluctuations upstream of a supply chain (either on larger inventories or on better supply chain coordination) represents transaction costs. Roughly speaking, transaction costs comprise the costs of remaining in business, the cost of making a deal or a transaction go through, the cost of holding a production organization together.

As Oliver Williamson, the noted transaction cost economics scholar, has shown, transactions can be characterized by the associated uncertainties, their frequency and the specific assets devoted to them. Each one of these characteristics determine some aspect of transaction costs. For example, transaction maintenance costs increase as specific assets increase. Human know-how specific to a particular contractual relatioship is an example of specific assets.

So, what is North saying again about technology?

He is saying that the stock of technology can lead to greater specialization, i.e. to more steps in the production process and hence to greater transaction costs.

The big question is then the degree to which these production steps will be organized by the market or within a hierarchy. This is the big strategy question that each economic entity needs to consider--for example, the question: "Shall I produce my own software or shall I buy it?"

Let's end with another quote from North's book:

The degree to which these various steps will be organized by market versus hierarchical organization will depend upon the alternative costs of measurement and enforcement. Since vertical integration into hierarchical organization means the substitution of factor markets for product markets, a key determinant will be the cost of the organizing factor, and in particular, labor markets.