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ChangingMinds Blog! > Blog Archive > 25-Nov-05


Friday 25-Nov-05

Transaction costs, trust and outsourcing

In 1937, economist Ronald Coase wrote a highly influential paper called 'The Nature of the Firm', in which he described the notion of transaction cost.

When two people make some kind of exchange, it requires a degree of trust. If I do not trust you fully, I may expend some time, money and energy in managing the risk that you may deceive me or otherwise not fully keep your side of the bargain. This is transaction cost. Trust is not free, and if you do not act in a trustworthy manner, then the additional transaction costs will cost you more. 

More recently, economist Francis Fukuyama wrote a magnificent tome just called 'Trust', in which he showed that, when scaled up to the level of nations, the transaction costs within society have a huge impact on the overall economy. When individuals do not trust big companies, the result is a lot of small companies as the transaction cost leads to a preponderance of family firms, where economies of scale cannot be gained.

Economies of scale are often thought about as where a large company can beat down the price from its suppliers. The real benefit of a large organisation is in the lower internal transaction cost that can be gained. Companies are 'trust boundaries' within which people have a higher trust of one another, where they can assume that, despite local goals, everyone is motivated to support colleagues and overall company purpose.

With the relatively recent move to outsourcing, the economies of specialization are assumed to of benefit, for example where an IT operation is outsourced to an IT company. The big question here is the impact on trust and the attendant (and often hidden) transaction costs. A common experience in outsourcing is that if you just hand off the work and turn away, then, after the honeymoon period, problems with increasingly arise, especially if you focus solely on price. The real wisdom is in managing the relationship to sustain cost and hold down transaction (and hence other) costs.

The bottom line is a lesson that we learn and re-learn. It's all about people. And people need trust. Forget the people stuff, betray the trust, and it will cost you big-time, every time.

I am currently managing a project to improve the situation with our suppliers. It's not that the situations is bad, but we do recognize that transaction costs are a significant part of many relationships, and that with determined and careful attention, they can be lowered over time. Lowering transaction cost, we know, leads to lowering overall fiscal cost. The project will of course include such elements as dealing with issues around contracts and specifications, which should be sources of agreement (not just as trust mitigation devices). I will also, most definitely, be focusing on building relationships and trust, where I know the greatest and most sustainable savings are to be had.

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