Sunday, 3 October 2010

If a new economy, what about a new economics?

Random thought for the day. We are often told that we live in a "new economy", that changes in computing and information technology, financial innovation, more globalised trade etc have changed in economy and society in which we live. If this is true then why have we not seen a similar change in economic thinking? Or do we not need a new economics for the new economy?

One idea that has found favour with who argue for the new economy comes from the world of old economics. Back in 1937 Ronald Coase argue that firms exist because for some transaction it is more effective to carry out those transactions within firms than it is via markets. That is, in some circumstances firms minimise transaction costs.

For some new economy advocates this is a compelling idea. One consequence of the information revolution is surely that it is now cheaper to communicate. This should affect firms and their boundaries since it will lower transaction costs and thus make market transaction more likely. More market transaction mean fewer within firm transactions and thus firms should downsize and rely on outsourcing to a greater degree.

However, if it is cheaper to communicate via the market is it not also true that it would be cheaper to communicate within the firm as well? In fact anything that reduces internal communication costs will lead to an increase in the size of firms.

Thus firm size could go either way. The nature of the reduction in transaction costs is all important. There are three groupings of transaction costs: information and search costs, haggling and decision costs, and policing and enforcing costs. Hal Varian has considered each of these groups:
The Internet certainly reduces search and information costs, but, as we have seen, this cuts both ways. Bargaining and decisions still require a team of managers and lawyers sitting around a table. What makes contracts easier is codification and standardization, trends that are important, but are not greatly affected by the Internet, at least so far.

Policing and enforcing costs are the most relevant category. The reason the assembly-line worker doesn't negotiate with the person next to him is that it's too easy for him to say, ''Give me a good deal or I'll stop the line.'' Putting all the assembly-line workers under command-and-control reduces this sort of opportunistic behavior, at least as long as it can be easily observed.
Two important addition factors need to be considered. One is the more general application of opportunistic behaviour. People can act opportunistically in many settings and ways. The incentive for such behaviour hasn’t been much affected, at least not yet, by the Internet and computers. The second factor is the increased importance of human capital to the production process. What we see is that human capital is now a bigger part of the value added of firms. This gives people more power within the firm and it has been argued that firms boundaries are changing because of this. Many firms are now developing structures that are looking more like partnerships than the more traditional command-and-control organisations.

But none of this however requires a new economics. In fact, as noted above, it is all based on old economics. No only in terms of years, but also in terms of method. Coase set out to apply the marginal analysis of Marshall to his theory of the firm. So the new economy seems to work just fine within an old economics framework.

1 comment:

Tim Worstall said...

To give you a sort of relevant real world example.

My day job is running a little company that deals in one of the more exotic metals. The global market for it is a few tonnes a year.

Back when we started we were based in Moscow. Had to be. Our monthly phone bill was of the order of $5,000 a month early 90s. That was just what the cost of international phone calls was then.

Our bills now run at perhaps 100 euros a month (thanks Skype!). And instead of being huddled in Moscow (a very high cost location) the three of us are spread around the world where we'd actually like to live.

The world of internet, email, cheap phone calls, added to the efficiency of the global air freight market, means that as wholesalers and brokers we really don't have a physical location in any meaningful sense at all.

This doesn't address the Coasean point directly but I do think that we'd not be able to exist as an independent company before the 1990s. The overhead required to have bases on the ground near suppliers and customers would just have been too great. We would have to have been a division of a larger company dealing with more products.