Coase Theorem and Network Effects

Both of these topics merit way more than a single blog post, so I’m fairly confident that I’ll come back to them sometime in the future. I’ve been obsessed with Network Effects in particular for more than a year now. This post will start explaining why, through the work of Esko Kilpi:

The Future of Firms. Is there an App for That?

One Theory to Rule them All

I’m going to try to keep my own summary short as both of these posts are well worth a deeper read.

In the first Esko introduces Coase’s Theorem, defined in 1932 by 22 year old Ronald Coase (22!, and did I mention that he was 103 when he passed away 3 years ago?). Coase challenged the common wisdom at the time that prices and competition are the perfect mechanism for coordination. He argued that there are non-trivial “transaction costs” involved in market transactions that lead to inefficient outcomes. Therefore, the driving force behind the formation of firms is the assumption that their planning, coordination and management functions can be done with lower transaction costs than the ones in the outside market. At some size, as the complexity of the company increases, the transactions costs inside the company increase as well, until it’s being outperformed by the market.

I’m fascinated by the idea of thinking about management and hierarchy as a “coordination solution” meant to decrease transaction costs. It clearly illuminates a path towards less management and less hierarchy: reducing transaction costs in a more market based approach for coordination side the firm. Transparency is a vital tool in that game.

In the second piece Esko ties Coase’s Theorem with Network Effects. He argues that in a world in which transaction costs are lower, platforms through their network effects, are much more effective vehicles for enabling coordination than industrial firms and their asset base / economies of scale.

What assets were for the industrial firm, network effects are for the post-industrial firm.

Interestingly, while the focus of the second piece is on the way the firm interacts with its ecosystem/customers, the connect that Esko makes applies inside of the firm as well. What happens when you think about the company not just as a platform for its customers, but also as a platform for its employees?  How can one  go about creating network effects inside the company that offset the need for more management and bureaucracy as the company scales?


Coase Theorem and Network Effects

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