THINK ACT

REPORT: THE MODULAR ECONOMY
“When should companies outsource parts of their
production to others who do certain things better,
than they do?”
have traditionally attracted more sympathy than
Goliaths. Of course, Glenn Reynolds’ opinions are
generalizations. Yes, these success stories do exist,
and technological standardization and the Internet
make life easier for small businesses, but the army of
David’s theory is based largely on anecdotes.
Look more closely and you soon realize that
mass production and distribution are expanding
inexorably. The online world is dominated by behemoths
like Amazon, Google, Facebook and Zynga,
and they’re getting bigger by the month. Offline,
car manufacturers form alliances with big players
in the electrochemical industry, and the insurance
industry continues to consolidate, McDonald’s
has cruised out of the doldrums and is expanding
globally, and many big banks are riding the crest
of a wave again.
Reynolds’ opinions are still thought-provoking.
They prompt us to ask an old but important business
question from a new perspective: how vertically
integrated do companies need to be in order to
collaborate effectively in ecosystems? Or to put it
another way, when should they outsource part of
their production to others who do a better job?
One person who tried to answer this question
was awarded a Nobel Prize for his efforts. The
British economist Ronald Coase won the Nobel
Prize in 1991 for his essay The Nature of the Firm,
written more than fifty years prior in 1937. In his
work, he expressed doubts about the Ford business
model, which involved doing everything in-house
from start to finish. In those days, Ford didn’t
just concentrate on building good cars; it made its
own steel, generated its own power, made its own
windshield glass, and sold cars directly to customers.
To a socialist economist, this was inefficient, and
the solution was the Coase theorem, a milestone in
economic history.
The theorem says that there are always transaction
costs involved in the division of labor and that
these can be divided into categories. There are search
costs, the cost of finding things such as employees,
capital, materials, and information about production
processes; there are contract costs, the costs
of negotiating agreements, such as lawyers’ fees;
finally, there are coordination costs which are the
costs of the effort involved in ensuring that everyone
involved works together efficiently. Coase concluded
that companies would always seek vertical integration
if their bottom-line external transaction costs
were higher than the cost of the employees doing
the job in-house.
The Power of small parts
The one thing that has changed since Coase analyzed
Ford’s vertically integrated production is transaction
costs. Today’s economy works on the Lego principle;
the bricks snap neatly together, they don’t fall apart,
and they can be combined in many different ways.
Over the last few decades, the supply chain has
28 THINK ACT SEPTEMBER 2011