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The Nature of the Firm—75+ Years Later

Why do successful companies grow larger? Why does the growth in size of a successful firm at some point level out?

In 1937, in a seminal article titled “The Nature of the Firm,” economist (and future Nobel laureate) Ronald Coase answered both of these questions with a theory of transaction costs. Coase pointed out that doing any kind of non-core work outside the firm has the advantages of leveraging someone else’s capital investment and expertise, but procuring the right product or service from the right vendor—and managing the relationship with that vendor and the work¬flow connecting the two companies—imposes a transaction cost. When that transaction cost exceeds the benefits of outsourcing, then it behooves the successful company to bring the function in-house. That, of course, increases the size of the firm.

At some point, however, the transaction costs of performing a function inside the company also begin to increase. The organization’s larger size and the bureaucratic processes that govern internal transactions begin to impinge on the benefits gained. Eventually, a point of equilibrium is reached where the cost to do the transaction internally approximates the cost to do it externally, and the growth of the firm attributable to internalizing non-core workloads levels out.


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That is a very elegant idea, and it sheds important light on changes in the global business landscape over the past 50 years. But in the last decade of the 20th century, developments in information technology began to erode that model’s power base. Nowadays, smartphones and tablets are reengineering whole swaths of the consumer economy, from information access (Google) to communication (Facebook and Twitter) to media and entertainment (YouTube) to transportation (Uber) to hospitality (Airbnb) to dining (OpenTable and Yelp), and beyond. At the same time, the big data analytics and cloud computing that enabled consumer IT to scale are now also being co-opted by enterprises to help them scale their reach and increase their efficiency and effectiveness. The end result is an IT infrastructure that is transforming before our very eyes, which in turn is transforming the way private and public enterprises will conduct their affairs going forward.

What happens to the transaction costs of an enterprise once it has adopted both the global systems of record deployed in the 1990s and the human-centric systems of engagement established during the current decade? Not surprisingly, transaction costs decrease dramatically. As transaction costs decrease, the value of services relative to products increases. That’s because one of the key selling points of a product is that it eliminates future transaction costs once it has been purchased. Software as a service, media as a service, transportation as a service, manufacturing as a service—these are the engines driving economic growth in a digital economy. Their rise to prominence entails a shift to consumption economics, a world in which risk has been transferred from buyer to seller.

Considering both the opportunities and the challenges of digital disruption, here are some key implications for business leaders looking to shape their companies’ futures:

Low-cost operational excellence based on supply-chain efficiencies is becoming so sufficiently universal that is no longer a strategy for differentiation in a developed economy. It will still be possible to differentiate on price, but that will largely be based on revamping sales, marketing, and distribution processes leveraging big data and analytics—factors beyond the bill of materials.

Product innovation will continue to be rewarded under this new system, but the length of time that differentiation can be maintained will be shortened by virtue of an increasingly quick-to-respond supply chain. Products themselves will be reconfigured as services wherever that is to customers’ benefit, which will also entail considerable use of big data and analytics.

Digitally enabled customer service on the demand side is the new battleground, where companies can seek to neutralize (catch up) or differentiate (gain a competitive advantage). Mobile devices and social communications networks have become pervasive and powerful. Companies cannot afford to stand by their old nondigital approaches, regardless of how successful they have been in the past.

Removing the cost of the middleman will be the primary source of funding to pay back investment in the next generation of digitally enabled customer service. Service providers whose primary differentiation has been helping customers navigate the complexities of an inefficient marketplace will find themselves disintermediated by digitally enabled systems that either mask or bypass complexity. That’s already commonplace in the financial services and technology industries, well under way in retail, media, and advertising, and on the horizon for health care, education and other citizen services.

These are not new ideas. Prognosticators have been forecasting much of this for decades. The whole “dot.com” fiasco was based on making big early bets on just these trends. But as with all things disruptive, we humans tend to overestimate the impact in the short term and underestimate in the long term. All we are saying now is: The long term is arriving.

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