21. Peter Klein on Transaction Costs

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Are you transaction cost-savvy? Peter Klein explains why it’s important.

We emphasize profitable value creation as the role of the entrepreneur. Managing costs can contribute to profitability – but there are some costs that are not easy to calculate and not even that easy to identify in some cases. They are not captured by traditional cost accounting. Economists call them transaction costs. They are the costs of acquiring, assembling, monitoring and managing and, in some cases, discarding or re-purposing the resources and assets your firm utilizes to produce output. They are not production costs per se; they are not value creation costs. They’re administrative and managerial costs.

Peter Klein explains:

Show Notes

Think of any transaction, like buying a cup of coffee at a Starbucks store. Now think of all the economic costs of that transaction above and beyond the actual dollars you hand over to the barista.

There’s the cost of traveling to the store, in both time and money (gasoline if you drive) and wear and tear on your vehicle. There is time spent on studying the menu, explaining your choice and waiting for delivery – and time is the entrepreneur’s most precious scarce resource.

Now apply that same thinking to the acquisition of any resource you want to bring into the firm to support your business model. There are many transaction costs in addition to the purchase price.

There is the time taken to research features and attributes, and comparative pricing. There may be negotiation or haggling with the vendor. There may be legal costs in a contracting process. There may be integration costs to fit the new resource into your production chain. If you’re buying from a wholesaler, there are issues of timely delivery and accurate order fulfillment you must monitor and manage. If the new resource is an employee you are hiring, there are advertising, interviewing and negotiation costs, as well as the benefits package that accompanies the salary agreement. All of these transaction costs, across the entirety of your business, add up to an amount that is pretty significant.

And, once you own the resource, transaction costs don’t disappear. They transform into monitoring and management costs.

Peter used the example of Walmart’s trucking fleet. Walmart owns many trucks and the drivers are employees. There are extensive monitoring costs associated with the ownership of these resources and the employment of the drivers and mechanics and service technicians. This group of costs can be characterized as the cost of confidence that you are getting the performance that you want out of the resource you own. In the case of Walmart’s truck fleet, these costs include monitoring the vehicles themselves (location, speed, downtime, tons hauled, gasoline used, etc), the drivers’ productivity, the maintenance burden, delivery accuracy and many more metrics. Walmart employs people and uses technology assets to implement all this monitoring, and those monitoring resources are not really creating value; they’re supervisory overhead.

Another kind of transaction cost arises when you decide you want to recombine, reshuffle or discard assets, or to use them in a new way.

In the entrepreneur’s uncertain business environment, it’s never certain that the asset you have acquired or the people you have hired are always going to be perfectly tuned to your business model. Circumstances change, and you want to make adjustments. Is the asset adjustable? Does the employee have exactly the skills you want for a new process or method? Will you be able to reprogram the asset or redirect the employee to a new job function? In many cases, you might have need of the legal system for a revised contract (legal costs are transaction costs), or there may be regulations preventing you from closing a plant or laying off workers. Any time you are constrained from making the adjustments you want at the speed you prefer, you are facing transaction costs. Could you have anticipated the situation when you first contracted for the resource or first hired the worker? Probably not – but trying to do so would be a transaction cost in itself!

Often, the issues raised by the problems of transaction costs are characterized as “make versus buy” decisions. Or rent versus own. Or in-house versus outsource.

It seems that there is a tendency today towards organizational models that are asset-lite, with a lot of the control that the firm seeks to exert over resources being exercised through renting or outsourcing, or by utilizing independent contractors rather than directly hiring employees. (Actually, Peter disputes this, suggesting that many such business models get a lot of publicity but there is no general tendency across multiple business sectors.) Does a virtual organization chart or a network model compared to a hierarchical model always have lower transaction costs?

Not necessarily. Compare Amazon, which mostly utilizes FedEx and UPS and USPS to make deliveries. Amazon still has many of the monitoring costs that Walmart has – it’s just that they are monitoring an outside vendor. Yes, FedEx and UPS bring their own tracking systems and technologies, but Amazon can’t afford to let its vendors go un-monitored.

In fact, in-house transaction costs are declining at the same speed as outsourced transaction costs.

With the advent of software HR and CRM systems and other kinds of monitoring and management technologies, internal transaction costs are not as burdensome as they were in the past. It would be unwise to make the automatic assumption that in-house transaction costs are always higher than outsourced costs.

Transaction Costs Types

Actionable Insight

So what’s the answer for entrepreneurs? There’s no simple formula, just the admonition to be transaction cost savvy. In every situation where there are alternative scenarios, the savvy entrepreneur thinks through the transaction costs of each one, and makes a best estimate of the economic costs. He or she thinks about the present costs, the future ongoing monitoring costs, and the potential costs when there is a future adjustment to be made.

Always relate this economic calculation of transaction cost alternatives to the creation of customer value. What is the best alternative transactional mode or organizational mode to deliver value to the customer, today, tomorrow and a year from now? What is the cost of the resource control you need in order to deliver value, especially if customer preferences change and you want to change with them?

Download our transaction cost checklist to help you become transaction cost savvy.

Buy Peter Klein’s book Organizing Entrepreneurial Judgement on Amazon.

Here are extra links to information that Peter Klein mentioned in the podcast:

An article Peter wrote to commemorate Oliver Williamson’s Nobel Prize – he is the originator of “transaction cost economics,” which is closely related to today’s discussion topics, though not directly dealing with entrepreneurship.

A longer, more academic survey on transaction costs – may be a useful reference.

Also, listeners may enjoy the comments on this blog post.

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Why Austrian Economics Is The Economics You Need For Entrepreneurial Success.

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Jeff Deist, President of the Mises Institute, recently penned a metaphorical comparison of Austrian economics to the punk rock bands of the 70’s and 80’s who composed, created, and played but were denied recognition because they were locked out by the music industry establishment. They developed a do-it-yourself ethic when it came to publishing and touring and promotion; they referred to their own music as unheard. Jeff’s metaphor is that Austrian economics is unheard today, locked out by the neo-classical mainstream and its academic and publishing establishment.

Jeff pointed to specific areas of economic theory where Austrians are unheard, but have the chance to be vindicated when outcomes confirm Austrian insights: money and monetary policy, malinvestment resulting from bad monetary policy, misallocation of resources as a result of socialist welfare policies, the bureaucratic mismanagement of the interventionist state, and economic distortions that favor a political elite.

This is all macroeconomics. There is a field where Austrians are being heard and where Austrian theory is tremendously influential, and that field is dynamic entrepreneurial capitalism.1 To be sure, this is not a locus of government policy. Neither government nor mainstream economics recognizes the role of the entrepreneur in the economy. The Austrian school, on the contrary, defines that role, and builds a cogent theory of innovation, economic growth and individual and social betterment on entrepreneurship. Austrian economists build a necessary bridge between economic theory and strategic and organizational management studies.

There are elements of Austrian economics that are uniquely suitable for building this bridge, including:

Individualism

The unit of analysis for the Austrian school is the individual, both as producer and as consumer. The consumer is sovereign, the captain of the economic ship. The entrepreneur is the helmsman,2 steering toward the goal that the sovereign consumer sets. Each role is aimed at improving the individual’s circumstances. The two roles interact with the result of betterment for all. Mainstream economics start from a different place, with the focus of analysis on false aggregates, like GDP, money supply, the price level and even “gross” supply and demand. Austrian economics can help individuals make better decisions, both as producers and consumers, and that recognition is beginning to dawn.

Subjective Value

Austrian value theory is unsurpassed in its ability to help producers with the critical economic task of value creation. Value is a consumer perception, and occurs exclusively in the consumer’s mind. Therefore, it is the consumer who creates value. The descriptive adjective “subjective” means that value is personal, emotional, idiosyncratic, and inconsistent. It most certainly can not be modeled or “formalized” in any way, which places it well outside the boundaries of modern economics. Yet value creation is central to civilizational progress, economic growth, and the success of firms. Austrian economics holds the exclusive key to the understanding that guides these processes, a key that is highly prized in the business community, if not by government and its economists.

Entrepreneurship

In Austrian economics, the role of the entrepreneur is to sense, through the application of empathy, the dissatisfactions of consumers — the signal that they are not experiencing the value they seek — and to rearrange resources into a solution that addresses that dissatisfaction. Because value is subjective in the consumer’s mind, and because the future is unpredictable, entrepreneurs exercise what Austrians call judgement: the commitment to action required to bring their new solution to market for the consumer despite the uncertainty of a profitable outcome. Mainstream economics is unable to comprehend entrepreneurial judgment. Why do 9 out of 10 entrepreneurial initiatives fail? Because, explain Austrians, such a high failure rate is to be expected as a consequence of high levels of uncertainty, consumer subjectivity, the limits on present knowledge. These cause entrepreneurial initiatives to be experiments in new knowledge creation, and the rivalrous actions of multiple entrepreneurs conducting contemporaneous experiments so that the sovereign consumer can choose the best one. Entrepreneurship is the dynamism of the unhampered economy, as more and more people are beginning to understand.

Austrian Capital Theory

In the real world, as opposed to the world of economic models, Austrian capital theory (ACT) provides a guiding light to entrepreneurs on how to assemble, organize, and manage their companies. In Austrian economics, capital is called heterogeneous. That means, every unit of capital is different, and entrepreneurs can combine these units in innumerable ways, reflecting their own knowledge, preferences and experience, and the results of their previous experiments. They can continue to reshuffle and recombine assets in dynamic adaptation to market signals, so that the resultant capital structure can be viewed as unique. The value of the capital structure is based on its ability to facilitate the experience of value by the consumer, so that the entrepreneur-assembled capital structure reflects consumer preferences. This is all anathema to neo-classical economics and its static concept of the production function. For entrepreneurs, ACT guides them toward dynamic and flexible capital structures and new forms of organization which facilitate that dynamism. Modern “virtual” organizations and new commercial processes such as Direct-To-Consumer are reflections of the insights of ACT.

Innovation

Modern mainstream economics lacks a theory of innovation, primarily because there is no role for the entrepreneur. The field has been left to business writers who attribute it to creativity in the “design process,” and promote innovation processes and innovation workshops. In Austrian economics, innovation emerges as the result of consumer sovereignty, subjective value, and entrepreneurship. Austrian economists can help businesses to innovate not through process and tactics, but through understanding the mind of the sovereign consumer (via insights tools such as the means-end chain), capacity development, and dynamic resource allocation accelerated by consumer-response capabilities.

In addition to these principles, entrepreneurship is also a decentralizing process. Knowledge is highly distributed, and because entrepreneurial initiatives stem from individual entrepreneurs’ empathic knowledge of a small number of consumers’ dissatisfactions, so is entrepreneurial action. Entrepreneurial specialization will tend toward increasing narrowness in the search for unique capabilities and unique capital combinations. This decentralization runs counter to the centralizing tendency of government regulation and intervention and of crony capitalist and globalist corporations. In this sense, the dynamic entrepreneurial capitalism of Austrian economics represents not only a route to personal and societal betterment, but also a better route to freedom than political action.

1.See, for example, The Theory Of Dynamic Efficiency, Jesus Huerta de Soto, https://www.jesushuertadesoto.com/the-theory-of-dynamic-efficiency/

2.Bureaucracy, Ludwig von Mises, p226 https://mises.org/library/bureaucracy

20. Dr. Keith Smith on How Austrian Economics Helped Me Innovate

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Dr. Keith Smith is an anesthesiologist and founder of both the Surgery Center of Oklahoma and the Free Market Medical Association. Surgery Center of Oklahoma has innovated in healthcare with a completely free market offering of transparent pricing with no hidden fees, with a radically patient-centric organization and different and better patient and doctor relationship protocols. Free Market Medical Association is a movement to encourage medical practitioners throughout the country to pursue a similar pathway of radical innovation. Dr. Smith took inspiration from Austrian Economics principles. Here are the seven principles he talks about on the Economics For Entrepreneurs podcast:

1. Subjective Value

This was the first Austrian principle that Dr. Smith learned from reading Menger and Mises. He applied subjective value thinking to the healthcare industry by asking, “Who is the customer?” and “Are health care industry participants focused on creating customer value?”

He realized that, since the patient is not paying the anesthesiologist or the surgeon, then there was no value exchange between the customer and the service provider. Therefore, there is no market relationship. The customer was not in a position to evaluate the quality and efficiency of the medical service that Surgery Center Of Oklahoma and its surgeons provided.

When a third party payer is paying the fees, the patient is not acting as the customer. The fee from the third party can never represent the right price — the one that properly reflects customer preferences — and much of what is dysfunctional in the health care system stems from this arrangement. The industry can not accommodate the fact that patients who wish to consume medical services value different aspects of the service in different ways. Some will pay any price to experience the value of immediate service: surgery today. Some will defer service to a later date to pay a lower price. Some want a surgeon that spends a lot of time with them before and after surgery. Some prefer speed and efficiency. All individuals create value in their own minds, and should be able to decide what price they will pay for that value. Subjective value theory guides Dr. Smith to run his surgery center to serve patients’ preferences.

2. Preference Rankings

The idea of preference rankings may sound theoretical, but Dr. Smith has found a practical way to make them a tool for building an organization.

When the patient and the surgeon are both customers of the surgery center, it can be hard to align the interests of both without conflict. Dr. Smith calls this desired outcome “accommodating all interests with boundaries”. Both the surgeons and the patients can make unreasonable demands that can’t both be accommodated in the service of good care. How to accommodate both? Just ask them what their preferences are and how they rank them. Many times, just having the conversation is a revelation — it reveals considerations to the patient or surgeon they had not appreciated before. For example, if a patient demands a local anesthetic and the doctor reveals a preference against it, the reasons for the surgeon’s ranking may bring new information to the patient and may change their preference.

Preference ranking provides an organizational tool to help Dr. Smith build his team of surgeons. A surgeon that frequently shows up late, or habitually takes an excessively long time for a procedure, may be revealing a preference for revenue over patient quality. By observing behavior, it becomes easy to identify a doctor (or a hospital) that is revenue focused compared to one that is truly focused on value, taking the long-term view and making every value exchange mutually beneficial. If a surgeon is observed acting in a way that is not in the patient’s best interest, Dr. Smith does not want him or her on the team. Asking preference ranking questions — what is important to you and how do you rank it? — is a good way to get to know someone you are considering for your team. It’s a troublesome thought process for some, and an enlightening one for others.

3. Self-Examination

Preference ranking can be applied in self-examination. Dr. Smith says, “I scour myself for inconsistencies”. He found one when he realized he was filing Medicare insurance claims that were paid with government funds which, he declares, is like “receiving stolen goods”. That, he realized, was inconsistent with his free market principles. And so he abandoned the practice and now treats Medicare patients at no cost. The acceptance of the market is the determinant of his business success — “to hug us or crush us”. Dr. Smith’s preference is to be consistent in his commitment to free market practices.

4. The Errors of Interventionism

The refusal to accept government money was just one step in expunging the corrupting and distorting effects of government intervention in the health care market. Dr. Smith examines every element of government intervention in the market and attempts to eliminate it from his business, to make sure his business does not benefit from it. He scrutinizes one situation after another and attempts to eliminate them all.

5. Dynamic Flexibility.

Austrian Capital Theory — and the Resource-Based View of the firm that derives from it — prescribes extreme flexibility of capital assets and resources to enable shuffling and recombining in response to changing consumer preferences. Dr. Smith describes the process of continuously looking for more knowledge, more learning and more flexibility as “radical entrepreneurship”. He looks for texts like Peter Klein’s The Capitalist And The Entrepreneur to provide new ideas and new initiatives. Continuous learning is part of Dr. Smith’s recipe, and he is always searching out readings that will change his mind.

6. Time Preference

Time preference is a core concept in Austrian economic theory. Entrepreneurship takes time. It requires patience, and the elevation of long-term goals over short term goals. It also requires foregoing present opportunities in order to pursue future benefit. What are you willing to forego in order to be an entrepreneur?

Dr. Smith found the most striking discussion — “jaw-dropping” in Dr. Smith’s words — of time preference in Hans-Hermann Hoppe’s Democracy: The God That Failed (i.e., the relevant passage starts at the very beginning of Chapter 1).

He found an immediate application in the business model for Surgery Center Of Oklahoma. As surgeons get older, their time preference changes. They want to monetize their ownership position in the partnership — to “cash out”. This often leaves junior surgeons “holding the bag”, because the partnership (or an intervening VC) may buy the departing surgeon’s position, but this is paid for out of the future earnings of the remaining partners. Through his understanding of time preference, Dr. Smith was able to anticipate this situation and organize his surgery center like a law firm — no partner pays anything to join and receives no exit payment when they leave. They also don’t own the real estate. So there is no opportunity to monetize on exit, which “saved SCO as a business” and brought stability by de-fanging an activity that doctors are known for.

7. The Austrian Way of Thinking

As important as any principle of economics is the Austrian Way of Thinking: rigorous reasoning based on logic and a priori axioms; being aware of assumptions and always examining them; respect for how others value things; understanding the difference between risk and uncertainty, and looking uncertainty in the eye; and generally exerting more logic and less emotion in conducting business.

Economics is the study of human behavior. Humans move from A to B because they prefer B to A. Understanding the logic of human action — and the motivation behind it — provides a lens through which to observe what is going on around you and to see it more clearly, obscuring distractions and perceiving conflicts of interest you might not see without the lens. The Austrian Way of Thinking brings confidence, decisiveness and calm. Physicians — and anyone — can benefit.

 

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