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Wealth of Networks

A Friction-free Future? Transaction Costs and Internet Markets
Tim Oren

Bill Gates says:
"The information highway will extend the electronic marketplace and make it the ultimate go-between, the universal middleman. Servers distributed worldwide will accept bids, resolve offers, control authentication and security and handle all other aspects of the marketplace, including the transfer of funds. This will carry us into a new world of low-friction, low-overhead capitalism, in which market information will be plentiful and transaction costs low. It will be a shopper's heaven." (The Road Ahead)

On the other hand, cybermaven Esther Dyson sees some friction left in virtual space:
" But all the world's not a market. We'll be seeing friends in cyberspace, shopping for things by
browsing around, asking for peers' advice, watching for what others buy and how much they pay. There's more to shopping than efficient transactions."

And Mitch Kapor, erstwhile competitor of Gates, warns that 'friction-free' is a stalking horse for:
"Control of key interfaces, for instance those of an operating system such as Windows, creat[ing] so much leverage that a company can insulate itself from normal market pressures, hardly an example of perfect competition."

What's going on here? Since when did notions like 'friction' and 'transaction' take on the supposed power to rearchitect markets and society? Are these people using code or reciting some mantra?

In a way they are. The word 'transaction' itself is a likely source of confusion - most folks may think of credit cards or ATMs, or maybe database operations. The allusion in each of these passages is instead to a specific economic concept, transaction costs. 'Friction' is an attempt at an everyday metaphor for the same thing. My intent here is to unpack the notion of transaction cost, and why some bright people see explosive consequences when it's combined with the Internet.

Transaction cost economics was originated by Ronald Coase, for which he won a Nobel Prize. 'Transaction' here is meant in a very broad sense. In addition to credit cards and ATMs, it includes just about any exchange of value which one can write into a contract or accomplish with a handshake (virtual or real). Coase's contribution was to focus on the overhead inherent in finding, negotiating, and governing exchanges of value. He reasoned that when the overhead - the transaction cost - was low, that markets would form and find efficient prices, but that high transaction costs would be a predictor of market failure or value exchanges that occur by non-market means.

A notion central to transaction cost is asset specificity. Specificity relates to the scope of value of a good or service. For instance, a house is location or site specific. So is cogeneration steam from an industrial plant, or a T-1 link between two offices. An original artwork can be highly specific in its value. A cargo of fresh fish, or an lot full of Christmas trees, are highly time specific. From the technical realm, a program written in assembly language to take advantage of a graphics accelerator is specific to that hardware, but it would be less specific if written in high level language to an abstract software interface.

The value of a specific asset is highly contingent or ambiguous. Advertising or otherwise finding the buyer for which the value is maximized, and then negotiating a fair exchange, is a relatively expensive proposition: the transaction cost is high. Less specific assets are easier to take to market; there are more potential buyers and they need less information to reach a fair deal. Consider the difference between a part for a 70 year old antique car on one hand, and a gallon of 87-octane gas on the other. Much of the value of standardization (like octane ratings) is creating assets which are less specific and more understandable. The transaction cost of matching up a standard product up with a standards user is relatively lower.

Once the parties understand there's likely a useful exchange to be had, then the terms have to be spelled out and a settlement made. And that's part of transaction cost. Sometimes this is extemely simple: The ice cream vendor hands me a chocolate bar, I hand over a dollar, and walk away never to see him again. It can also go the other way: Hammering out a multiple year contract with intermediate milestones, late delivery contingencies, and specification change procedures can take months and hundreds of thousands of dollars. That level of transaction cost may work for office buildings or very large techical systems, but it would kill more mundane deals.

And the costs don't end when the handshake is made. Real people (and companies) have a characteristic called 'opportunism.' That means they cheat. Or, more charitably, they interpret unanticipated events to their own favor. Consider the 'dispute resolution' procedure built into using a credit card: If you think the merchant cheated you, you can get the bank to withhold payment until the matter is worked out. Having that contingency available isn't free, it's built into the overhead of using a credit card; it's a transaction cost.

The longer the duration of the deal, and the more specific or contingent the values being exchanged, the better the chance for something to go wrong, or for parties to be opportunistic if a contingency wasn't spelled out. Commercial contracts may have elaborate price adjustment and arbitration clauses to maintain the relationship in spite of outside changes, and even then may end up in court - a very high transaction cost. It should be obvious that having a trustworthy trading partner, and a general level of trust in the market and society, is worth real money in the form of reduced overhead when creating and governing a deal.

OK, if you've lasted this far, let's reinterpret the statements by famous persons above:

Bill sez:
"The Internet is great because it removes site specificity for many transactions. All the goods of the world, at your fingertips. Forget driving around to obscure bookstores, just order that odd-ball book from over the Web. Sure you may not know the merchant on the other end of the wire, but you'll still be able to trust them. They have to price publicly in an cybermarket you can browse, and they're running standard security software.
That's the key phrase, of course, standard software. Because this whole friction-free market scheme only works if there's a standard way for all the shoppers and all the merchants to meet and transact over the net. Otherwise the specificity - the problem in matching up buyer and seller - reappears through the rear door and the market fails again. Standards make markets, and market makers make money. In software, we call a standard a platform. Guess who owns the platform? It will be heaven for shoppers, heaven for Windows and NT, and heaven for Microsoft."

Esther replies:
"I don't dispute that we need standards, Bill, but you've missing the point with your bidding and authentication gabble. Geek toys don't build trust, people do, and markets don't cause social cohesion, it's the other way around. If you just think of the Internet as a big distribution chain driven by better credit card standards, you're missing the point. Unless the people can interact on the Internet in ways that promote trust and reputation, they won't deal at a distance, and transaction costs will kill the market, standards or no."

And Mitch:
"Wake up and pay attention to what's going on here. All those Microsoft standards may define a market, but since when did we let a market maker trade in it as well? And isn't that what's happening when Microsoft not only sells servers but content, and both operating systems and applications? All the benefit derived from reducing specificity through standards may go out the window if you let Windows win everywhere, unless you trust Mr. Gates not to be a bit opportunistic somewhere down the road. And what contractual recourse will you have then, I might ask?"

Next Time: How to Make Platform War or Can a Guy Worth $20 Billion be a Public Benefactor?


clm said:

What strikes me as important about WebTV is that it is a proof of concept for the notion that the "client-side" can itself be implemented using a client-server model and extremely inexpensive clients. Or, another way of saying it, WebTV exploits the three-tier model of distributed app deployment.

Microsoft (and others) have been promoting this model for quite some time.

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