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.

Tehran Stock Exchange

I wrote this entry, originally, on July 11, 2004.

According to Iranian financial news reports I have read in the last few days, real estate grew by only 19% across Iran while stocks grew by more than 130% in 2003. It may be possible to confirm this by a look at the Tehran Stock Exchange although I have not tried it myself in any depth. Volume of exchange has grown by more than %250. More and more companies are being listed. CEO of the TSE recently called for listing of news media companies to give them greater vitality.

Chester Barnard

I wrote this entry, originally, on July 10, 2004.

I have started reading Chester Barnard's The Functions of the Executive.

It has been recommended by professor Oliver Williamson (Economics, Law School and School of Business at UC Berkeley) as an important work. Professor Williamson has reviewed Bernard's influence in Mechanisms of Governance.

The volume I have in my hand is published by the Harvard University Press, Cambridge, Massachusetts. It is the thirty-ninth printing (2002) of the book, originally published in 1938.

What sort of book is it that gets to have so many printings?

Apparently, Barnard never completed Harvard, but he wrote one of the most influential books there is when it comes to management, executive functions and organizational theory.

Is J2EE Disruptive

The answer to this question depends on the context, i.e. the market with respect to which we are asking it.

In his 1997 national best seller, The Innovator's Dilemma, the Harvard Business School professor Clayton M. Christensen coined the terms disruptive and sustaining technologies.

According to Christensen, most new technologies improve product performance. He calls such technologies sustaining technologies. In contrast, he identifies disruptive technologies to be those innovations that lead to worse product performance, at least in the near-term. He goes on to say that such initially less-performant technologies end up precipitating the leading firms' failure.

Christensen also notes that there are three reasons established companies do not invest in disruptive technologies. First, because disruptive technologies are simpler and cheaper, their use only provides low margins to begin with. Second, disruptive technologies are usually first commercialized in markets which the established firms consider to be insignificant. Third, established firms' most profitable customers cannot initially use such technologies. According to Christensen, a practiced discipline of "listening to customers and identifying new products that promise greater profitability and growth are rarely able to build a case for investing in disruptive technologies until it is too late."

Frankly, I am not sure I agree with this last point Christensen is making. I think listening to customers does not just mean listening to what it is they want. Often customers don't really know or think they know but are not sure if what they want jives with what's "there." The most important thing companies should listen for are "requirements" in a deep sense of that word, i.e. not what a customer wants from us but what their goals are, how they go about achieving it now and how they can go about achieving it in the future. This approach is quite different from just seeing what they want.

So, is J2EE an example of a disruptive technology in the Christensen sense of the word?

Well, in the enterprise market, J2EE has been proven to be the de facto platform because one can easily develop, deploy and maintain scalable applications in production environments. So, one may argue that in the enterprise market, J2EE may not be as disruptive as it once was. This may not be completely true. While some real innovations (such as JAX-RPC and Connectors) have emerged that are not just about "performance" in speed, some may still argue that these new innovations are simply about "performance" in integration. They may have a point.

However, that is not what I wanted to talk about. What I want to say is that Christensen's notions of disruptive and sustaining technologies really need to be applied and scoped with respect to particular markets.

So, let's ask the question again and scope it to the telecommunications market.

Is J2EE a disruptive technology in the telecommunications market?

Applying the Christensen analysis, we have no choice but to say that it is.

There are three classes of telecommunications applications where J2EE has a good fit as the emerging and disruptive middleware platform: OSS/BSS applications, service applications, service control function applications.

Who will take advantage of this opportunity will be offering the next-generation platform for convergence applications.

Once again for Lessig ! ! !

Institutional economists, such as Douglas North (Structure and Change in Economic History) have long argued that the protection of intellectual property was a necessary ingredient for the technology-driven economic growth of the post-industrial world.

North and others have been focusing on the importance of protecting private and intellectual property. Less attention has been given to the regulatory limits of such protection.

Over the years, copyright laws have expanded to include derivative work. It is not clear whether such expansion (to derivative work) is actually good for economic growth.

Once again, Stanford University Law professor Lawrence Lessig has written a wonderful book, this time on how new technologies affect our economic environment and our culture.

In this new book, Free Culture: How Big Media Uses Technology and the Law to Lock Down Culture and Control Creativity, Lessig examines the changes made to the copyright law and how those changes can stifle creativity and an open culture.

His writing is meant to be accessible to all, including those who do not have any training in law and its methods. He takes care to bring out some of the legal subtleties involved in a very lucid and accessible prose.

Lessig is one of the few legal scholars who have really thought hard about how new communications technologies are changing our world. Reading his works would be useful for all who play a role in the creation of such technologies.

A Bank is a Bank

Tehran, Iran (Nov. 2006)
Originally uploaded by M.Mortazavi

A bank is a bank no matter where it lives.

It does roughly the same thing everywhere.

Economizing and Strategizing

So, here I go, testing this Weblog system . . .

Oliver Williamson, the great contemporary economist, notes that there has been too much focus on triangles formed by supply-demand curves, i.e. on strategizing, and not enough attention on the larger rectangles, i.e. on economizing. A good place to read about this is in his book of essays on transaction cost economics, Mechanisms of Governance.

Time and Transactions

Tehran Bazaar (August, 2006)
Originally uploaded by M.Mortazavi

In each minutes, a tremendously large number of transactions are carried out.

Only economies that improve the volume and value of such transactions per quanta of time and resources used will survive well in crisis.

Fear in the Minds

I find this paragraph from a Financial Times editorial published today telling a big story:

It would be pointless, foolish and wrong to try and fix the dollar at its current level. Markets are the best way to determine exchange rates, and on a trade-weighted basis it is far from clear that the dollar has overshot its fair value. But what intervention might do is slow the decline, by putting fear in the minds of momentum investors who are selling short on margin.

Transaction and Transportation

Tehran Metro (2005)
Originally uploaded by M.Mortazavi

Social stability comes about when society organizes itself to reduce all kinds of transaction costs.

In modern, large cities, transportation cost contributes, perhaps more than many other specific costs, to transaction costs.

Many transactions require people to be brought together or brought to specific locations.

Looking, Buying, Selling

Tehran Bazar (2005)
Originally uploaded by M.Mortazavi

Some look.

But Some will always buy.

And that will be enough.

Choices

Friday Bazar, Tehran (2005)
Originally uploaded by M.Mortazavi

He sells watches and waits.

The customer looks, and he looks at the customer, and wonders:

He is a real one, likely to buy, likely to make a choice.

He sells watches when he is free, and then goes back to one of his three or four other jobs.