Transaction Costs of Big Companies
In my first blog entry, I wrote about how the reason I started econ grad school was because of Ronald Coase’s 1937 essay. Ronald Coase’s main idea was that the reason there are such things as “firms”, is because there is a nontrivial transaction cost, or the cost of organizing market transactions.
This got me thinking about the web2.0 trend in Silicon Valley: Internet behemoths buying teeny companies with a cult following and some cool ajax. Because one question that you might ask is why don’t these big companies just copy what these teeny cool companies are doing? Instead of paying tens of millions of dollars, they could presumably use the 1000s of people they already employ, and do it themselves.
My thesis is that big companies buy, rather than make, because there is a huge transaction cost disadvantage for big companies to releasing web2.0 products. Transaction costs can be classified into 3 categories: 1) coordination, 2) motivation, and 3) ownership.
First, large corporations have layers and layers of specialized workers. There are layers of middle managers whose sole job it is to manage people and processes, and nothing else. Add in a healthy dose of intra-departmental coordination, and everything takes more time, leaving less time for actual creation of products.
Second, motivation in a large corporation is mostly about being promoted to the next level. There is actually a micro-economic theory called Tournament Theory that explains this. The end result is that you have a bunch of people who are going to be risk-averse because visible failure is easy to punish, but invisible passivity is rarely used against you in a large corporation.
And finally, founders of teeny companies maintain product ownership, and you can see their soul and voice reflected in their products. This lends authenticity and credibility to the product, key ingredients of a successful product. In contrast, product ownership in a large corporation is not clear cut, and is subject to endless turf battles and micro-management. As the product sifts through the middle management pipeline of a large corporation, the original ideas and unique voices are watered down and sound “corporate”.
So what about these web 2.0 companies that have been the beneficiaries of the buying binge of the behemoths? Will their heart and soul survive the entanglements of middle management and workers with a 9-5 work ethic? That is to be seen, but my guess is that as long as upper management is enlightened enough to keep them isolated from the corporate suits that surround them, they will be ok. Maybe even benefit from the access to resources and distribution channels. But then again, if they were interested in the big corporate lifestyle long term, they probably wouldn’t have started their own companies in the first place.
Updated: Just read a blog entry by Guy Kawasaki, one of the original Apple employees, which gives a very perceptive antidote (very good advice, at least from my experience) about how to beat the “transaction cost of big companies” called Art of Intrapreneurship . Check it out.
