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Why is it that the Internet transforms certain industries while in
other industries it doesn't make a difference?
That's a question that we want to discuss today, and the lens with which we
want to look at the transformation phenomena is called transaction cost.
Before I jump into the topic, let's ponder over some broader issues.
Hopefully, these are interesting questions for you to think about.
Number one, we all know that people trade.
I mean, that's what a market economy's all about.
Trade makes buyers and sellers better off.
Why is it, even then, when buyers and
sellers want to interact, they want to trade, certain trades do not take place?
Even where there are willing buyers and
willing sellers, some trades just don't take place.
Think about another dilemma.
We all know that much of the trade today happens between Western economies and
Asian economies,
and the production cost in Asian economies is a whole lot lower.
So despite the cost of production being lower,
the Asian sellers are unable to find buyers.
Why are buyers still reluctant to buy from Asian sellers?
What's the fundamental reason?
Think about something even more fundamental than all these particular
questions, which is the following.
Why is the economic world structured in the way that it is?
We all know that we rely on a market economy.
In a market economy, you have hundreds and thousands of companies.
Why are companies organized in the way that they are?
For example, take a company like an automobile company. Take a company like
General Motors, they used to make great cars, I mean, they still make great cars, but
why is General Motors organized in the way it is, why do they deploy,
why do they employ thousands of people who then work for them and they produce cars?
So you say, what's the alternative?
Well, here's an alternative model.
The alternative model would be, you hire people on an as-needed basis.
They make cars,
they all disperse,
and then if you need them again, you hire them again.
Sounds ridiculous, right?
It sounds somehow strange.
The same way in a University. Why do we employ people?
Large universities, we employ 3000, 4000 people.
Why not hire them on a course by course, on an as-needed basis?
Sounds strange, but why does it sound so
strange, why are we organized in the way that we are?
My premise is,
I like to claim that the fundamental reason why all these particular
questions exist, the reason is the same behind all these particular whys.
Including the reason behind the following why,
which is a little bit more interesting.
Which is that, even if you ask the most avid of beer drinkers, and
ask them, have they had India Pale Ale, the answer's going to be no.
Most people haven't tried India Pale Ale.
Why? What is this particular why all about?
And that's an issue that we want to discuss.
And actually the reason, if you think upon and ponder about these particular
questions, you will say, hey look, all these, the things are hard.
So what's hard?
It's hard to find India Pale Ale.
It's hard to go out and look for people on an as-needed basis who come and
do the work.
It's hard for buyers to trust sellers in overseas market.
It's hard, right.
We know it's hard.
There is something going on here.
This particular concept is what we want to study,
this whole notion of hard.
How do we quantify it, what's a formal way of looking at this whole notion,
why are markets hard in some particular way?
So, what's hard? Let's try and know it, understand it more formally.
See, when we do a transaction we rely on markets.
Markets are the most fundamental unit of economic exchange, but
every time you use the market, of course, there is a price to be paid.
Something you want to buy, something somebody wants to sell.
There's a price, but the operation of a market has its own particular cost.
It's that particular cost which makes transactions hard.
That's what makes it hard to find something,
that's what makes it hard to trust something, that the operation of a market
costs something. And this has been a fundamental premise, we all experience it,
but perhaps we don't pay enough attention to it. And this
was the concept which won the Nobel prize winner, I'll come to that in a minute.
This was the concept which basically says there are costs to using the market. And
the premise is, if these costs are too high, no economic exchange takes place. For
example, you want to go buy something, you say,
hey look, I'm going to go have to drive somewhere and
it's going to be too much of a hassle, I've got to be jostling with the crowds,
forget it.
So you will not go and make that particular transaction, or no
economic exchange has taken place. There has been a question of market failure or
there has been an incident of market failure because these costs are too high.
What are these particular costs?
Formalizing these particular costs and naming them was one of
the notable achievements of Nobel Prize winning economist Ronald Coase.
What Ronald Coase basically said,
there is a cost to using markets which rely on a price mechanism.
Okay.
Let's think about markets.
What do markets do?
In a market, there's one fundamental governance unit, which is the price and
that's a coordination mechanism.
If you agree on the price you go ahead and
undertake that particular transaction. But price is not the only issue in a market.
There are certain costs of engaging in a market.
It's these particular costs that Ronald Coase formalized, and
that's the concept that we are talking about.
So what he basically said, what are these particular costs?
Think of the following things.
Discovering what the relevant prices are.
Would we buy something if you are not sure of what the relevant price is?
For example, you want to buy something, let's say, a used printer.
Somebody says, I want to sell it to you for 70 bucks,
would you buy it?
Until you discover what the right price is,
you will not be able to engage in that particular transaction.
So price discovery, understanding what the price is, is a hassle,
it's a cost that we have to pay.
No matter what the product,
what the market, this particular cost cannot be eliminated.
You will not buy a product until you know what the price is.
So this cost, unfortunately, cannot be eliminated.
So market cost cannot be eliminated;
they can be reduced.
For example, there are intermediaries who will sell this information to you,
but, and you might be even willing to pay something to them,
but these costs cannot be eliminated.
Think about some other aspects of these particular costs.
For example, let's say you find a buyer, but
now, you have to negotiate with this particular buyer.
Again, this cannot be eliminated.
In certain markets, there are less negotiations.
In certain markets, in certain instances, there are more negotiations.
But negotiations will take place,
especially in Asian economies.
Have you ever walked away from, let's say,
a bargain because the negotiation was taking too long?
Well, if you go to any of our Asian countries, you will know what I mean.
So, some people, this is a huge hassle.
Some people love the hassle, but this particular hassle is a cost,
and some people can bear it and others don't,
but this cost cannot be eliminated, it can only be minimized.
Right.
Some ways of minimizing some of these particular costs could be you say,
hello, instead of writing a contract for
every transaction, I'll engage in a long term contract.
But again, there are costs of the long term contract because buyers don't like
long term contracts,
because they think they are being held hostage.
So in other words, transactions take place in a market,
markets have costs, and we have to bear those particular costs.
If we do not want to bear those particular costs,
if the costs are too high, transactions do not take place.
And these particular costs are more formally called Transaction Cost.
In a more formal way, what's the definition of transaction cost?
Very simply put, it's the cost incurred in making an economic exchange.
It's not the direct price you pay.
I want to go buy a printer for $70, that's a direct price.
But the time, energy, hassle, sweat, blood, tears that I have to shed before I
buy that particular printer or something else is transaction cost.
What are some of these sources of hassle?
As I said earlier, one of them formerly is search and information cost.
Okay, I do not know who to buy the printer from,
I do not know what it's going to cost.
So, this is a cost associated with determining whether something is
available, where is it available, and its price, or what I call visibility cost.
Okay, Because something is,
the price has to be visible, availability has to be visible, you have to
spend time and energy, there's a cost involved in doing something like this.
So there's a visibility cost, that's the first part of transaction cost.
The second category of transaction cost, as I said earlier,
is bargaining cost.
So you, somebody has, you want to buy something, you got to negotiate with them,
you got to agree on certain deliverables, when something will be delivered, how will
it be delivered, what will the product promise, what will the product deliver etc.,
etc., you got to do all those things.
In another way of saying bargaining costs is, bargaining costs arise because of
information asymmetry,
because bargaining cannot take place if two people have the same information.
There's nothing to bargain.
If a seller has more information, in that particular case, they can negotiate and
drive up the price.
If the buyer has more information, they can drive up the price.
So there's information asymmetry.
Reducing information asymmetry is what bargaining is all about,
and there is a cost involved, there's a hassle involved, that's the second part of transaction costs.
The third category of transaction cost is policing and enforcement.
Once you buy something, how are you assured that the product will perform as promised?
If it doesn't perform as promised, who is going to be liable?
Can you go back to the seller and say, hey, you need to repair these things? Or it does
not work, something is missing. So there are contractual terms, agreements, or
you might have to take legal action depending on what the legal system is.
So there are policing and enforcement costs,
and policing and enforcement costs have to do with trust issues.
If you do not trust a seller, if you do not think that the seller is
going to stand by all the promises when they sold you that particular product,
you will probably not buy it.
So because of all these particular issues,
three categories of transactions costs that you have,
and that's what makes, that's what markets are all about.
And in no market can these particular costs be eliminated.
They can only be minimized.
Another way of saying, what are transaction costs?
Transaction costs are a source of inefficiency.
Market systems are very efficient, but
they have an inefficiency which is transaction cost.
Before you want to engage in a transaction, there is going to be some
hassle involved, and that's why they're called friction in the market.
Certain markets have very high friction that are very inefficient.
Very, they are not that visible,
on the other hand, other markets have become a lot more transparent.
But that's what transaction costs.
Transaction costs are a friction or inefficiency in the market.
And why are transaction costs so important?
Why are we focusing on them here?
Because removing, eliminating, reducing transaction costs leads to value-add,
which people are willing to pay for.
For example, you look at an industry and say, transaction costs are very high.
What would you do?
Develop a solution for reducing those particular transaction costs.
And if you actually reduce transaction costs, this is huge value add,
which people are willing to pay for. So there's an opportunity here,
there's an economic opportunity here. For
example, an intermediary who tells you the lowest price.
You want to fly from point A to point B, how do you know what the lowest price is?
The website which tells you what the lowest prices is might charge you
a small commission, you'd say it's a small price to pay.
You want to buy something, for
example, buy something which is fairly asset incentive,
something which is going to be expensive. You hire an agent, who
the agent then negotiates on your particular behalf.
You pay them a commission.
Why? Because all
these intermediaries are reducing your transaction cost.
You don't want to do all these particular things.
You don't want to engage in that hassle.
You hire somebody who will do all those particular things for you.
So that's why transaction costs are so
fundamental, because they are great economic opportunities. 238 Okay.
So, if you have a solution for reducing transaction cost, it can be
extremely valuable and it can be a source of value-add.
Because it's valuable, it's valuable because somebody's going to be
willing to pay you for it, and that's why transaction costs are so important.
Now, let's stand back and think.
We understand the concept.
Before you engage in a transaction there's going to be hassle involved.
Let's think of the Internet a little bit, right.
This is just a snapshot of what happens in an Internet minute.
I mean, the Internet is, Internet is a marketplace where you have billions
of transactions taking place across every kind of a web model that we know.
But think about the Internet broadly, what it does?
For example, think about some of the most successful business models online. For
example, companies, all right, for example Google.
What does Google do?
It allows for more efficient search.
What's efficient search?
It reduces transaction costs.
So Google is in the business of reducing search-related transaction cost.
Think about Amazon,
extremely successful.
Jeff Bezos, an amazing visionary guy.
But what does Amazon allow us to do in addition to other things?
Well, all of us want to know what price you should pay for something.
Go to Amazon,
it allows price discovery.
Price discovery, reducing transaction costs.
Look at eBay,
another fundamentally, hugely successful model profitable from day one.
Why is it that on eBay a buyer is able to
buy from a seller they don't know anything about?
They've never bought from them but then they're willing to buy it, why?
Because eBay provides trust information.
Every buyer and seller has a trust rating.
You look at the trust rating,
you decide whether you want to engage in that transaction or not,
and trust is an important part of transaction cost.
So, what does the Internet do?
Successful Internet business models do?
They do many different things.
But through the lens of transaction costs, they reduce transaction cost.
Because they reduce transaction costs, they are successful, they're value add,
and they're valuable because people are willing to pay for a reduction in that
particular transaction cost that these particular Internet business models do.
So, the Internet is nothing but
a holistic tool for enabling reduction in all kinds of transaction costs.
The Internet has been the greatest tool, you can search, you can connect,
you can discover anything you want to, it's nothing but
an appli, it's nothing but a network for reducing transaction costs.
So with that introduction, with that introduction,
ponder over the different concepts of transaction costs,
and in the next segment, I will outline some examples and
tell you more about how business models online relate to transaction costs.