Transaction Costs, Supply Chain Management, and the New Economy

Ronald Coase is a Nobel Prize winning economist who wrote about “transaction costs” and how they impact firms and economies. Because of Internet technologies, transaction costs have fallen in many areas, and this is changing the way firms organize their work (including supply chain tasks), the fate of particular industries, and even the economic fortunes of nations.

Transaction costs fall into three main categories:

  • Search and information costs: the costs incurred in determining if a required product is available in the market, who has the lowest price, the relative utility and functionality of the product, potential service costs of using the product on an ongoing basis, and other related areas.
  • Bargaining costs: the costs required to reach an acceptable agreement with the other party in the transaction and drawing up an appropriate contract.
  • Policing and enforcement costs: the costs of making sure the other party sticks to the terms of the contract, and taking appropriate action if they are not.

The first place falling transaction costs became obvious was in the area of increased outsourcing. Lower transaction costs made it cheaper for companies to become less vertically integrated. High-wage Western companies outsourced production to low-wage nations. Internet technologies made it easier for companies to track the quality of the goods coming off the production line, see whether what was being manufactured matched what was ordered, and track the goods across the globe. Freer trade and lower logistics costs also helped drive this trend.

R&D was also split up into higher-value product development that often remained in the home country and lower-value tasks that were often outsourced to India. Product Lifecycle Management applications provided companies with a common development platform and a way for them to track the progress engineers in India were making.

Outsourcing became prevalent in the 90s. This trend still has legs. While new technologies lowered all three sets of transaction costs, it was dramatically lower policing and enforcement costs that were the most important.

Globalization has not run its course. But increasing fuel prices and rising wages in Asia are leading to “near shoring” — i.e., manufacturing in Mexico for North American firms, or Eastern Europe for Western European firms.

Now, some pundits are arguing that a second wave of industrial restructuring is under way because of social media tools like Facebook, YouTube, and LinkedIn.

In this case, the transaction costs falling fastest are search and information costs. Now news, including product news, finds us. If someone loves a product, they write about it on Facebook. If someone is looking for a particular product, they can tweet their network of friends on which products they have used and whether they like them. If someone wants to buy a new product, they can scan the barcode in the store and see how it was reviewed online.

This form of restructuring will affect the marketing and customer service departments far more than the supply chain function. But anything that affects demand generation can ripple back and affect the supply chain function too. The combination of social media and smart phones is also causing retailers to take a new look at multichannel fulfillment.

Some pundits argue that social media is a tsunami that will wash over all industries. I don’t buy it, at least not yet. For companies that sell their products based mainly on product attributes, having a “Wow!”product is more important than ever. Consumer electronics, for example, is a place where buzz clearly matters. With social media, “word of mouth” is thousands of times more powerful than it was a generation ago. But many products are bought based on price. There is just not going to be much online buzz about the best brand of ketchup.

One place where falling information costs will matter in supply chain management is in relation to hiring, a topic that I will write about in a future posting.


  1. Steve,

    You said “This form of restructuring will affect the marketing and customer service departments far more than the supply chain function.” If social media is the domain of the consumer and all business does is eaves drop on the conversations, then I agree. New demand signals may affect the Supply Chain.

    But if a business begins to use secure, enterprise social networking tools such as Chatter and Yammer, they can transform their Supply Chain. Social networking has taught us the value of collaboration and pop-up IT. Sophisticated groups form according to interest and the content is driven by the user. The same can happen for employees, vendors and customers as they coalesce around the transactions, data, process and technology of the Supply Chain. Collaboration on unexpected events can be streamlined and “memorialized” so that good decisions are continued and bad decisions avoided.

    The output of the collaborative team can be taken one step further, into the underlying process, data and technology of the supply chain transactions, yields even greater results. The ability to enhance the transactions of the entire supply chain with agile, light enterprise technology creates the transaction cost reduction that hits the bottom line.

    While it is reasonable to remain skeptical about anything that is going to change everything….collaboration does drive down transaction costs. Social networking has impacted consumers and empowered them with more valuable technology at home than they have available to them when they go to work. That wasn’t the case just a few short years ago.

  2. Hi Steve,

    Thanks for your comment.

    I went to Chatter to see if I could understand what you were talking about. There was a section on the benefits and one benefit was “Connect with the Experts”. It showed an interaction over a broken zippers on a new shipment and asked the expert to explain it. This kind of interaction would traditionally have been handled by email. Your point about “memorializing” the problem, having a place where a record has been kept and can be examined, is a good one. In theory, this could be done on a portal, but this is a more user friendly format.

    I think we still get into the whole structured versus unstructured data issue here. Ideally, these data points would go into some sort of database for the procurement guys and design guys to help them make better procurement decisions in the future. This would be structured data and the appropriate folks would know where to go.

    But a priori we can’t know everything, we can’t have applications with structured data for every possible contingency. So a place for unstructured data and for group visibility is nice. The risk is after the fact, at a time when someone should go back and review the incident before they make a decison or take an action, they don’t. They don’t because it is just too unwieldy. There is no perfect solution to this problem.

    In short, Chatter looks like a nice tool. I see value in it. I see it as an incremental improvement. But I don’t see this as a game changer.

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