Nobel laureate Ronald Coase proved that companies could only grow to the size where executing a transaction internally has the same cost as executing that transaction in the open market. Thus we understand that the efficiency of executing a transaction defines the limit of growth for a company.
Executing a transaction consists of two sets of costs — organizational and fulfillment. Organizational costs include the one-time costs of choosing a supplier, of negotiating the contract and of establishing infrastructure. Organizational costs also include the added costs of managing across company boundaries when outsourcing the transaction. Fulfillment costs cover the per-instance costs of executing the transaction, i.e. fulfilling the contract.
Internally executing a transaction minimizes organizational costs because any suppliers are pre-determined (they are other departments within the company). Executing a transaction in the open market has higher organizational costs — even with long-term contracts. Consequently, fulfillment costs must be lower in the open market because customers will not bear a price greater than their internal costs plus the value of distributing risk. Open-market structures minimize fulfillment costs; large companies minimize organizational costs.
How do companies minimize internal fulfillment costs as the open market does?
Companies already know they must minimize fulfillment costs for internal transactions. They spend trillions automating and reorganizing to find the most efficient means of executing transactions. But can companies increase the efficiency of this ongoing process? Yes, when companies structure so that they induce and leverage technological change as the open market does.
The open market has three mechanisms driving its efficiency:
Technology is simply the codification of new efficiencies. Entrepreneurial spirit drives the discovery and application of technology. The market provides direct feedback — confirming whether a new technology is actually valuable and suggesting areas for further improvement.
In addition to a foundation of entrepreneurial spirit spurred by feedback, the open market is modular. Its inherent, structural flexibility speeds the adoption of new technology. The modularity also allows the recombination of transactions in order to reduce organizational costs or to free a business unit to grow independently.
To instill the entrepreneurial spirit, the feedback and the modularity that is such an advantage in the open market, companies must themselves operate as network economies. Structured as a network economy, a company will:
To operate as a network economy, a company must transform its transactions into loud transactions.