Where’s The Profit In Digital Innovation? It’s In Reduced Transaction Costs.

Economists tend to use weird and unhelpful language. One of their terms is Transaction Costs and these things are really important. They’re the reason why firms exist at all, and they’re the reason why the new digital platforms like amazon.com and Uber get to be so big and grow so fast and assume such great prominence.

Let’s see if we can unpack the language.

When a consumer or a customer buys a service, they pay a price in money. Let’s call this the final price, after all discounts and savings and haggling, it’s the amount of cash you part with or the amount on the cheque that you write.

But the final price does not reflect the total cost to you, the buyer. There are a lot of other costs involved in many transactions, some of which we think about and try to compute, some of which we are not conscious of or don’t compute.

The High Price We Pay For Transaction Costs.

Since we have already mentioned Uber, let’s use the purchase of a taxi ride to illustrate transaction costs. If you are in the big city on a dark rainy night and you’d like to get a taxi ride to a destination several blocks away, you might compute the expected price in your head as $15 plus a tip, and decide that it represents a good value to you. You stand in the rain and the wind at the edge of the sidewalk waving at passing yellow cabs, feeling like an idiot and getting yourself and your clothes wet, thinking that there may be a visit to the dry cleaners in your future. Eventually you think you’ve snagged one, but just as it pulls to the curb a burly and brutish-looking guy runs up, pushes you out of the way, yelling “This one’s mine” and you are left disappointed and disheveled. Eventually, after waiting much longer than you had planned and worrying about being late for your appointment, you do get in the cab. It’s uncomfortable, cramped, dirty and doesn’t smell very nice. Nor does the driver. He mumbles to you in a foreign sounding accent you can’t understand. Does he recognize the address you’ve given him? He seems to be taking a long way round. Should you argue? Safer not to, probably. Eventually, you arrive. The fare is higher than you thought. You consider giving no tip but fear the confrontation this may bring on, so you demur. You take out some bills, negotiate some change, then you get out feeling wet and badly treated, and you consider a stiffer drink than you had originally planned.

These inconveniences of time, discomfort, fear and undesirable aesthetics are transaction costs. The cab ride cost $15 or $20 plus tip plus all of these transaction costs. Its value to you must be greater than the money price plus transaction costs for you to feel as though you got a good deal – that’s the essence of a voluntary market transaction, that both parties feel better for having made the exchange. Odds are that you don’t feel that way. There must be a better alternative.

Smartphones And Software Sharply Reduce Transaction Costs.

Now there is: Uber. You install the software on your smartphone. On the next similar occasion, you initiate a transaction. The software knows who you are (you’ve pre-entered the information), and it knows where you are, by the magic of GPS. It finds you a car and a driver, and gives you a rating that suggests to you that you can trust the driver and will have a good experience. The car comes to you, and you can track its incoming progress. No-one pushes you out of the way, asserting they have a prior claim. After minimum time in the rain (perhaps you have to run from the doorway to the car, but no standing), you are safely ensconced, feeling good, and on your way. You pay with one tap (you’ve already entered your payment information and the system has verified it). You arrive on time. You are unstressed, happy to be at your destination, and can get by on a regular sized alcoholic beverage.

Uber has saved you a significant amount of transaction cost. The money price of the ride may be higher, yet you feel you received good value and you’d repeat the experience.

Triangulation, Transfer And Trust.

In his new book, Tomorrow 3.0, Transaction Costs And The Sharing Economy, Michael Munger tries to wrap up these transaction costs in a catchy alliterative expression of three T’s: triangulation, transfer and trust. The affectation is a bit forced, but let’s go with it.

Triangulation refers to information about who you are, who the Uber driver is, the location of the pick-up and of the destination (and the car’s location as it makes its way to you). It’s about getting two parties to the exchange together. Munger also includes making an agreement on a price in his definition of triangulation, which you can also do with the software. All of this is easier / better / more comfortable with Uber.

Transfer refers to the way of transferring the service and the payment for it that is immediate, convenient and as invisible as possible. Software, and the pre-registration of a payment mechanism (your credit card) and the in-built processing capability make transfer easy and safe.

Trust is the way the software creates a feeling of assurance, anticipating honest dealing, with both sides living up to expectations, and performance of the terms of the contract. Both parties can anticipate that their expectations will be met by a trustworthy service provider and a trustworthy customer.

When all of the potential transaction costs are eliminated or highly reduced, the value received for the final price plus transaction costs is much higher in the consumer’s perception.

The Entrepreneurial Opportunity.

Munger’s major point is that there are tremendous amounts of entrepreneurial value creation available in the reduction of transaction costs. He refers to the sharing economy and paints the picture of  future where, if transaction costs are sufficiently reduced, no-one will need to own anything, and we’ll all get by on entrepreneurially-facilitated sharing. Need an electric drill to make a hole to hang a picture? Click on an app, have the drone or robot deliver the drill in a secure package to which you have the unlocking software code, use it for a couple of minutes, and send it back. Same with cars (don’t own one, borrow or rent one for a while), lawnmowers, perhaps even some clothes (like specialized formalwear).

Who is creating these low transaction cost experiences? Entrepreneurs. They see consumers saying, “I wish it were easier to ……..” or “I wish I had XXXX here right now” or “I really disliked my last experience with YYYY”, and they immediately think of ways to solve those problems and meet those needs. They can design an app, assembling the code from Github or by hiring an app developer on Upwork, go to market, and quickly find out whether they can sell the low transaction service improvement.

The new era of low transaction cost digital service provision is, in Munger’s telling, a revolution, as significant as the Industrial Revolution in the nineteenth century. Each of us as consumers will have the opportunity to lead more convenient, more efficient, and safer lives. And each of us as entrepreneurs – from Uber drivers to coders – will thrive by delivering new value creation through transaction cost reduction.

Entrepreneurs Bring Economic Progress – Which Is Far More Important To People Than GDP Growth.

Economists tend to represent economic growth as growth in the level of income and of GDP. But economic progress is far broader than that, and to focus on GDP growth is to ignore the most important elements of economic progress – the elements that improve people’s lives.

Why do economists miss this point? Because they don’t understand entrepreneurship, and the role of entrepreneurs in economic progress. In economists’ models, firms are run by managers who choose low cost resources and manage processes in order to achieve greater efficiency. In a competitive economy, this would drive companies out of business. Continuous improvement and innovation are the drivers of economic progress, and they come from entrepreneurs not managers.

We invented economic progress only recently. It began in the late eighteenth century with the industrial revolution. Before that, the standard of living and the quality of life was much the same in 1750 as it was in 1650, and it was much the same in 1650 as it was in 1550 and, indeed, as it was in 550.

Since then, economic progress has been greater in the nineteenth century than the eighteenth, greater in the twentieth century than the nineteenth, and every indication is that the progress will continue to accelerate in the twenty-first century.

In the United States, per capita GDP was nearly seven times greater at the end of the twentieth century than it was at the beginning. But looking at only growth numbers seriously misrepresents the nature of the economic progress that took place in that century.

At the beginning of the twentieth century only about 1 percent of American households had cars; by the end of the century 91 percent of households had them. Largely because of advances in medical technology, life expectancy rose from 47 years at the beginning of the century to 77 years by the century’s end. Telephones were rare at the beginning of the century, but commonplace by the end of the century. Information acquisition and entertainment were completely transformed in the twentieth century. At the beginning of the century there were no movie theaters, no radio broadcasts, and no television. By 1900 electricity was available to some, and was used mainly for lighting, but by 1950, electricity powered radios, electric washing machines, and refrigerators.

By 2000, most people classified as poor in the United States had indoor plumbing, air conditioning, telephones, and automobiles. The Internet revolutionized communication and allowed business ventures to span the globe. While only a few computers existed in the world in 1950, many people had more than one computer in their homes by 2000. Computers did not become common until the 1980s, and the World Wide Web did not exist until the 1990s. The first airplane had not yet flown at the beginning of the twentieth century, but by the end of the century travel throughout the world in jet aircraft was commonplace. Despite the tremendous GDP growth over the twentieth century, when one reflects on economic progress over the century, it is apparent that the primary component of economic progress is not the amount of income growth, as impressive as it was, but rather the substantial change in the qualitative nature of the economy’s output, and the extent to which people enjoyed consuming it.

They were also able to enjoy producing progress. At the beginning of the twentieth century the average work week in the United States was about 50 hours, and by the end of the century it had fallen to about 35 hours. Again, this quantitative change in hours worked, while impressive, does not reflect the changing nature of work, which became less dangerous and less physically demanding. People worked more with their minds and less with their bodies by the end of the century, and this is reflected in the fact that at the beginning of the century only 22 percent of adults had completed high school, while by the end of the century 88 percent had at least a high school degree. Accidental deaths, including those on the job, fell from 88 per 100,000 to 34 per 100,000 over the course of the century.

While people work fewer hours for more income, the more significant element of progress in the work people do is not the quantitative reduction in work hours or increase in output, but rather the qualitative changes in the nature of work. At the beginning of the century the reward for work was money, and most jobs were mainly manual labor. While money was still a primary motivation at the end of the century, people considered the pleasantness of a job, including intellectual stimulation, challenges, and workplace amenities as significant rewards for employment. Many people enjoy the work they do: something that would have been much rarer in 1900, when work was often physically demanding, dangerous, and tedious. One can look at growth in terms of increased output per hour of work, but the progress in terms of qualitative changes at the workplace is at least as significant as the quantitative growth.

Henry Ford was the entrepreneurial innovator who brought assembly line production to the automobile industry, which enabled a substantial increase in the output of automobiles per worker. But focusing on growth in output per worker misses the much more important truths about the transformation of lifestyles that resulted. People’s transportation options were greatly enhanced, making automobile travel available to a large segment of the population. This changed many other things – such as shopping for example. Supermarkets, shopping malls and large discount stores would not be feasible if people could not drive their own cars to transport substantial quantities of goods. Because shoppers can buy more each time they shop – because they can transport more in their automobile – stores can offer a greater variety of goods at a lower cost. Entrepreneurs who supply the retailers are encouraged to think up a larger variety of new goods for sale.

Because of the introduction of low-cost long distance telephone calling – and now the internet – these entrepreneurs can contact sellers thousands of miles away to order new products immediately. Sharp declines in transportation costs make it feasible to ship individual purchases thousands of miles to buyers. The variety of goods and services offered for sale continues to expand. Progress in one area leads to progress in others. Life gets better. Progress brings economic growth with it, but growth is a minor component of economic progress.

Progress is not brought to us by managers striving for efficiency, but by entrepreneurs developing specialist knowledge about their area of expertise and thereby discovering new opportunities to serve customers better and to make a profit doing so. The profit-and-loss system amplifies progress. Profits reinforce the pursuit of ideas that are wealth-enhancing for entrepreneurs, and losses terminate the ideas that are not. As a result, the positive impact of successful entrepreneurship is much larger in magnitude than the negative impact of unsuccessful attempts. That’s how progress occurs. Specialization is an important element – something Adam Smith knew at the beginning of the Industrial Revolution.

Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object, than when it is dissipated among a great variety of things. . . . It is naturally to be expected, therefore, that some one or another of those who are employed in each particular branch of labour should soon find out easier and readier methods of performing their own particular work, whenever the nature of it admits of such improvement. (Adam Smith, Wealth Of Nations, 1776)

Entrepreneurs invest in producing the specialized knowledge that will enable them to make future entrepreneurial discoveries. Their pursuit of knowledge makes innovation and progress more likely.

To read more, see Progress And Entrepreneurship; Randall G. Holcombe; QJAE Fall 2003.