The cost of markets

Companies exist because it's expensive to rely on markets. But it's expensive for individuals too.

There is, wrote (pdf) Ronald Coase, “a cost of using the price mechanism.” It comprises such things as discovering suppliers; finding the best prices; forecasting future changes in one’s requirements; and negotiating and enforcing contracts.

It is because of these costs that companies exist. They, in effect, replace the market with a hierarchical relationship. Rather than finding a contractor for every job the employer can simply tell an employee what to do. Instead of looking for a supplier of parts, the company can make them itself. And rather than worry about having to renegotiate contracts if things change, a company can simply order its workers to do different tasks.

Every time a company asks: should we do this in-house or contract it out? it is posing the question Coase asked 89 years ago. And so we have the large field of transactions cost economics.

So far, so conventional. But, but, but. It is not just entrepreneurs who face costs of using the market. So too do all of us, especially in a world where we must be on guard against scams and enshittified products. As the great Dan Davies has said:

Every transaction is a decision, and decisions cost energy. Removing the price mechanism, for a while, can be intensely relaxing.

Back in 1970 Alvin Toffler coined the term “choice overload” to decribe how having more options causes people to have a harder time deciding and to be less satisfied with their choices. Even a well-functioning market (in fact, especially a well-functioning market) is costly not only in terms of time and effort in using it but also in terms of the cognitive load it imposes on us. That was the message of Barry Schwartz’s book, The Paradox of Choice.

We’ve big evidence of this. Since the 1960s American women have had much more market choice - more opportunities to find good jobs. But Betsey Stevenson and Justin Wolfers found that this entry to more parts of the labour market actually made women less happy on average. They wrote (pdf):

The increased opportunity to succeed in many dimensions may have led to an increased likelihood of believing that one’s life is not measuring up. Similarly, women may now compare their lives to a broader group, including men, and find their lives more likely to come up short in this assessment. Or women may simply find the complexity and increased pressure in their modern lives to have come at the cost of happiness.

That’s a downside of more participation in the labour market.

Individuals, then, like companies, need ways of escaping the market, of avoiding the cost of using it.

In fact, we have many of them.

Historically, one has been marriage. Arthur Pigou famously said that “if a man marries his housekeeper or his cook, the national dividend [what we now call GDP] is diminished.” This is because doing so replaces a market transaction with a non-market one. The problem is that, as Marx and generations of feminists have both noted, non-market relationships can be as oppressive as the market relationship.

Another escape has come from trades unions, who undertake the task of negotiating pay and conditions, thereby saving members the cost of doing so.

Of course, unions are weaker now than they once were, but their role has been (in part) replaced by regulation, such as minimum wage laws. This is no accident. Philippe Aghion and colleagues have shown that unions and legislation are substitutes for each other. Such is our need to escape the costs of using the market that if we cannot do so one way we’ll do it another. And it’s not just labour market regulations that do this job. Consumer protection laws save us the cost negotiating and enforcing contracts. (Optimists might add that regulators also do this - which is true to they extent that they haven’t been captured by the industries they oversee.)

Not that we need others to help us escape the market. We can reduce cognitive load by force of habit. We go to the same supermarkets and pubs and keep the same bank and utility providers for years, until service drops below an acceptable level. As Herbert Simon said (pdf), satisficing saves us the bother of optimizing.

We also have hobbies that keep us out of the market. DIY and gardening save us the bother of hiring tradesmen and gardeners. And we like all-inclusive holidays as they save us the trouble of finding good bars and restaurants in unfamiliar places.

And then there are price comparison websites and Google reviews, though these are flawed: reviews can be gamed, and those websites are funded by their industries.

We also, though, simply choose to stay out of the market, to not buy or sell. Millions of us achieve Timothy Leary’s dream of dropping out of the labour market simply by retiring. And before then many of us want jobs for life to save us the trouble and uncertainty of changing job. I stayed at the IC because I didn’t want the bother of going to job interviews or having the hassle of starting a new job, and I certainly hated the thought of freelancing - having to pitch stories to comissioning editors, chase payment and deal with HMRC. Equally, we don’t move house unless we need to, not only to avoid the deadweight financial costs of doing so but also to avoid the stress of dealing with lawyers and the fear of regretting the move. And we avoid making home improvements because of the uncertainty of finding decent builders or bathroom fitters.

Of course, many people don’t use these escape routes. Quite the opposite. The self-employed choose to leave corporate hierarchies and go to the bother of finding their own customers and so on. In doing so, though, they are asking Coase’s question, and weighing the costs of using the market against the costs of being in a hierarchy. Transaction cost economics isn’t just for companies; it’s for people too.

Trouble is, some of our ways of escpaing the market are inefficient from the point of view of a market economy. Staying out of the markets reduces GDP. Habit can be a barrier to entry; it keeps companies that are just adequate in business, and retards the growth of more efficient companies who cannot prove their merits. What Marko Tervio said of the labour market applies also to consumer markets: mediocrities (pdf) win out over unproven talent. Also, if we stay in an adequate safe job rather than risk changing, there can be a loss of productivity caused by a mismatch between workers and roles. And our reluctance to move house results in an inefficient allocation: some people stay in houses that are too big whilst others are cramped together.

Of course, the notion of perfect market efficiency is a fantasy as silly as those of any teenage leftist. “There is a great deal of ruin in a nation” said Adam Smith. Nevertheless, anyone who was serious about wanting a well-functioning market economy would ask whether these inefficiencies could be reduced. One way to do so would be to foster the growth of strong independent consumer advice and advocacy groups - trades unions for customers if you like - which would cut the costs of market transacting by searching for the best suppliers and prices on customers’ behalf.

In the absence of such powerful groups there is a case for regulation. It reduces the costs and uncertainty of market transacting and so encourages us to enter the market. Labour protection laws encourage us to change jobs and consumer protection laws give us confidence to buy goods knowing we can take them back to the shop if they’re defective, for example. The alternative to regulation could be us choosing not to buy or sell at all, making us all poorer.

In saying all this I am echoing Karl Polanyi. A market society, he wrote in The Great Transformation, is “entirely unnatural”. The “tendency to barter” which Smith thought a natural human propensity, wrote Polanyi “is not a common tendency of the human being in his economic activities, but a most infrequent one.”

This is not to say we must ditch markets: if you think they impose a cognitive load you want to try participatory planning. What it does mean, though, is what Adam Smith knew - that markets, if they are to work for everyone’s benefit, must be embedded in particular institutions and cultures. It’s far from clear that 21st century capitalism has these.