This is a great piece by Dino Falaschetti, director of operations at George Mason’s Mercatus Center, whom I first met when he was a National Fellow at Stanford University’s Hoover Institution. While at Stanford, he conducted research on how political-legal institutions affect business and economics performance.

He clearly explains the important — and often missed — issue of transaction costs and the intersection between economics and politics which occurs when we manage and lead. This piece was first published on LinkedIn on September 21, 2014.

“Do well by doing good.”

So goes the business mantra. But what does it mean? And why do even well intentioned leaders have a hard time fulfilling this popular ambition?

Timeless answers can be found in a 1930’s article, “The Nature of the Firm.”[1]Building on his recent undergraduate thesis, Ronald Coase asked why business managers visibly direct economic activity if competitive markets can seamlessly move goods and services to efficient uses. His answer proved so far reaching that the then curious undergrad earned a Nobel Prize in Economics over 50 years later.

According to Coase, good managers expand business opportunities by economizing on transaction costs.[2] They make it easier to find valuable goods and services, negotiate agreeable terms of exchange, and enforce those terms after the fact. For example, they can tailor business support services to in-house demands, and thus avoid repeated searches for and engagements with external accountants whenever demands for management information arise. And the potential to create economies in this manner is eye-popping – according to a Boston Consulting Group study, “we spend more money negotiating and enforcing transactions than we do fulfilling them.”[3]

Interestingly, intermediaries like Airbnb and Uber are helping more people enjoy these efficiencies outside of firms. By making it easier to transact in the sharing economy, they are disrupting within-firm production of lodging and transportation services. Notice, however, that they do so via formal business associations, suggesting that transaction costs don’t disappear by themselves. Some form of institutional planning appears necessary, and as innovative technologies continue to reduce the cost of transacting in markets, business leaders will face stronger competitive pressures to address this requirement within their own firms.

To do well in this competition, leaders have to do better at embracing Coase’s durable lesson – create management systems only if they economize on transaction costs. Those who do so maximize enterprise value by easing the flow of knowledge throughout their organizations, delegating responsibility according to comparative advantage, and assigning accountability to those who can best leverage team performance. Likewise, they resist the temptation of empire building by making goods and services only when their management systems enjoy excess capacity – a necessary condition for bringing transactions that are relatively costly to settle in other firms into a more productive institutional structure. Finally, they embrace this strategy even when standing on the other side of the plate – that is, they guard against inefficiencies by also looking to buy goods and services in the market whenever directing resources for in-house production would be harder, but not faster or better.

In each case, the leader’s “visible hand”[4] designs institutions to help goods and services find more productive uses faster or cheaper. Establishing and continually improving such systems offers a firmly grounded strategy for doing well by doing good. People do well when the cost of transacting is low,[5] and do good when leaders establish rules and norms that promote winning with rather than from others.

So, why don’t more of us embrace this approach? The hard part about doing well by doing good is not the economics – it’s the politics. Ben Franklin famously advised that “would you persuade, speak of interest, not of reason.”[6] Early on, he appreciated that while economics has reason on its side, reason must intersect with self-interest to expand opportunity.

Finding that intersection can be difficult. The prospect of enjoying personal gain at others’ expense frequently pulls leaders away from reducing transaction costs and toward sprinkling nails (or worse) on the road to opportunity. These leaders promote winning from others by sequestering information that is organizationally important,[7]assigning projects to those who dutifully reciprocate patronage, and consulting the political calculator before applying economic discipline.[8] Each tactic increases transactional frictions, making room for political favor to trump general opportunity. Those who bite on this tempting lure may do well, but not from doing good.

Fortunately, a transaction cost approach to leadership is more than “chalk board economics.” It instructs leaders to reduce well-defined barriers to productive collaboration – a requirement for expanding business opportunities, but one that parsimonious economic models leave out.[9] It also requires a deep commitment to erasing distributional divisions as a means to establishing hard-to-earn / easy-to-lose support for institutional change.[10] Executed in concert, these economic and political tactics offer a firmly grounded strategy for expanding the value-rich intersections between reason and interest, and provide a touchstone for doing well by doing good throughout.

References

Acemoglu, Daron, Simon Johnson, and James Robinson (2001). The colonial origins of comparative development: An empirical investigation. American Economic Review, 91(5), 1369-1401.

Chandler Alfred D., Jr. (1977). The Visible Hand: The Managerial Revolution in American Business. Belknap Press.

Coase, Ronald H. (1937). The nature of the firm. Economica Vol. 4 (16), 386-405.

Evans, Philip and Bob Wolf (2005). Collaboration rules. Harvard Business Review(Jul-Aug), 96-104.

Hwang, Victor W. (2013). Is Ronald Coase’s Greatest Impact Yet to Come? Forbes, September 3, accessed at forbes.com/sites/victorhwang/2013/09/03/is-ronald-coases-greatest-impact-yet-to-come.

Lemay, J.A. Leo (2005). The Life of Benjamin Franklin, Vol 2: Printer and Publisher, 1730-1747. University of Pennsylvania Press.

Sutton, Robert I., and Huggy Rao (2014). Scaling up Excellence: Getting to More Without Settling for Less. Crown Business.

[1] Coase (1937).

[2] Applying this insight to rationalize “the managerial revolution in American Business,” Chandler (1977, p. 6) proposed that “modern multiunit business enterprise replaced small traditional enterprise when administrative coordination permitted greater productivity, lower costs, and higher profits than coordination by market mechanisms.”

[3] Evans and Wolf (2005, p. 103).

[4] Chandler (1977, p. 1) coined the term in his Pulitzer Prize winning book, describing how “The market remained the generator of demand for goods and services, but modern business enterprise took over the functions of coordinating flows of goods through existing processes of production and distribution, and of allocating funds and personnel for future production and distribution.”

[5] See, for example, Acemoglu et al. (2001).

[6] Quoted from Lemay (2005, p. 205).

[7] Evans and Wolf (2005, p. 103) emphasize that, “with the same information available to everyone, there is less chance that one party will exploit another’s ignorance.”

[8] Stanford researchers Sutton and Rao (2014, p. 194) offer a related view of such leaders: “(M)ost organizations don’t engage people, don’t bond them together, and have poorly designed incentives – but do create unnecessary friction and status difference.”

[9] Hwang (2013) offers a related opinion on how “Coase realized that managing organizations should focus on removing barriers between people.”

[10] In a complementary context, Evans and Wolf (2005, p. 99) argue that “Cheap transactions among the many fuel more innovation than expensive incentives aimed at the few. Reward the group, and the group will reward you.”


Dr. Falaschetti’s LinkedIn profile is www.linkedin.com/pub/dino-falaschetti/23/2aa/59b