Monday, August 17, 2015

Clarifying Demand Within Firms - Adam Smith vs Ronald Coase

Reply to: The Future of Firms. Is There an App for That?


Very enjoyable story! Thanks! But I think that you’re giving Ronald Coase too much credit and Adam Smith not enough credit.

You wrote that Adam Smith failed to include transaction costs within his “invisible hand”. Is that really true though?

It is thus that the private interests and passions of individuals naturally dispose them to turn their stocks towards the employments which in ordinary cases are most advantageous to the society. But if from this natural preference they should turn too much of it towards those employments, the fall of profit in them and the rise of it in all others immediately dispose them to alter this faulty distribution. Without any intervention of law, therefore, the private interests and passions of men naturally lead them to divide and distribute the stock of every society among all the different employments carried on in it as nearly as possible in the proportion which is most agreeable to the interest of the whole society. — Adam Smith, Wealth of Nations

It’s true that Smith doesn’t mention transaction costs. It’s also true that he doesn’t mention opportunity costs. In fact, he doesn’t mention costs at all. Therefore, costs aren’t a part of the invisible hand?

Smith does mention profits though… and I’m pretty sure that costs have something to do with the size of profits.

Now, if Coase had been a bit brighter, or had been born a bit later… then perhaps he would have understood that the invisible hand is just as necessary to efficiently allocate resources within firms as it is to efficiently allocate resources between firms.

Let’s take Medium for example. For a while now I’ve told Medium that it would be really wonderful if they facilitated micropayments. Next to the “Recommend” button would be some coin buttons…. penny, nickle, dime and quarter. If I clicked the quarter coin button after reading your story… then a quarter would instantly be transferred from my digital wallet to your digital wallet. Voila! You’d be $0.25 cents richer and I’d be $0.25 cents poorer! You’d have $0.25 cents more influence and I’d have $0.25 cents less influence. I willingly sacrificed $0.25 cents worth of influence to you. Why? Because you supplied me with some tasty food for thought. I gave you some of my influence because you used your limited resources to help me overcome a scarcity of brain food. Spending money is about overcoming scarcity.

After you collected enough coins… you could cash out. Medium would take a very reasonable cut and paypal you the rest. Or… you could spend the money in your digital wallet on other stories! Are any of my stories worth your money? Which story on Medium would you spend the most money on? Does it matter? Which of your stories would the crowd spend the most money on? Does it matter?

Right now we can sort stories by popularity (number of recommendations received) but with micropayments we would also have the option to sort stories by value (total amount of money received).

As you can see… clearly there aren’t any coin buttons next to the recommend button. If we assume that Medium actually bothers listening to feedback that users bother to share, then evidently Medium didn’t like my suggestion. Medium shot my idea down! Shucks! But how, exactly, was my idea shot down? Perhaps this passage will help provide some insight…

We are biased toward the democratic/republican side of the spectrum. That’s what we’re used to from civics classes. But the truth is that startups and founders lean toward the dictatorial side because that structure works better for startups. It is more tyrant than mob because it should be. In some sense, startups can’t be democracies because none are. None are because it doesn’t work. If you try to submit everything to voting processes when you’re trying to do something new, you end up with bad, lowest common denominator type results. — Peter Thiel, Girard in Silicon Valley

According to Thiel, a startup only has two options…

  1. Democracy
  2. Dictatorship

… and the second option is preferable to the first. So we can reasonably guess that Medium didn’t vote on whether to facilitate micropayments.

Is there a third option though? Sure… a market! The invisible hand! Rather than voting on the idea of micropayments… or relying on a dictatorship to decide…Medium staff/employees could have used their own money to communicate the intensity of their preference for micropayments.

Medium would essentially function as a market for ideas. More specifically… ideas on producing/consuming stories. People’s influence within Medium wouldn’t be determined by seniority/hierarchy/dictatorship…. it would be determined solely by their ability to invest their own money in the most profitable ideas. Picking winners would increase an employee’s income/influence, picking losers would decrease their income/influence.

The government should not help to save Chrysler, of course not. This is a private enterprise system. It’s often described as a profit system but that’s a misleading label. It’s a profit and loss system. And the loss part is even more important than the profit because it’s what gets rid of badly managed, poorly operated companies. When Chrysler loses money…it’s got to do something. When Amtrak loses money it goes to congress and gets a bigger appropriation. — Milton Friedman, What is Greed?

There would be far fewer bankruptcies if firms were markets operating within markets. If Chrysler had been a market… then influence/control/power within its firm would have constantly been shifting from those who made bad bets to those who made good bets. As a result of influence being determined by competence, Chrysler would have quickly adjusted/adapted its internal allocation of resources to better align with the constantly changing external allocation of resources. There would have been fierce competition for resources within the firm just like there was fierce competition for resources between firms.

Progress depends on facilitating communication. Prices facilitate communication so they facilitate progress. But if Medium facilitated micropayments would everybody pay the same price for this story of yours? Not if Medium went with my model (PWYW). PWYW is based on two essential economic elements…

  1. people don’t value everything equally
  2. people aren’t equally competent (influential)

With the one-price-fits-all (OPFA) model… these two essential economic elements are largely disregarded. As a result, what OPFA communicates isn’t nearly as accurate as what PWYW communicates. Therefore, PWYW would allocate resources a lot more efficiently than OPFA would. The efficient allocation of resources depends on accurate information.

Dictatorships and democracies (D&Ds) fail to integrate differences in valuations and influence. In other words, D&Ds fail to integrate accurate information. This is why both systems fail to efficiently allocate society’s limited resources.

Adam Smith provided the correct general model for the efficient allocation of resources. Unfortunately, Coase failed to apply it to firms. Then again, Smith failed in this regard as well. But it’s not like we can fault him that much for failing to stand on his own shoulders!

If Smith had managed to stand on his own shoulders then he would have clearly seen the immense value of applying the invisible hand to the public sector (allowing taxpayers to choose where their taxes go = pragmatarianism).

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