Digital Strategy and Markets · Week 2

The forces that shift: the cost of the market and the cost of the firm

Forty activities, indexed by specificity s ∈ [0, 1], can each be bought on the market at TCm(s) = m0 + m1·s — contracting and hold-up get harder as the activity gets more specific — or made inside the firm at TCi(s) = i0 + i1·s — bureaucracy carries a fixed overhead but handles specificity better. Coase's rule: integrate every activity that is cheaper to organize than to buy; the boundary of the firm sits where the two lines cross. Digital technology moves both lines. Move them and watch activities cross the boundary — in both directions. Coase's second argument is the management strain slider: organizing costs more at the margin as the firm takes on more, which is why one firm does not swallow the whole economy. The second chart replots the same costs against firm size.

Platforms, standard contracts, escrow, reputation systems. Lowers the market line — the fixed cost of a transaction most of all. Baseline = 0.
ERP, messaging, dashboards, remote monitoring. Lowers the internal line — bureaucracy gets cheaper to run. Baseline = 0.
Attention at the top is scarce, hierarchy grows, and incentives inside weaken as the firm organizes more activities. Raises the internal cost of the marginal activity, by more the further down the ranking the firm reaches. Coordination tools (κ) relieve part of it. Baseline = 0.
Ratings histories and data trails let markets handle even specific activities without hold-up: flattens the market line's slope only.
Firm boundary (s*)
0.50
 
Firm size (n*): activities made inside
20 / 40
 
Avg. governance cost per activity
–
 
Moved into the firm
0
buy → make since baseline
Moved out to the market
0
make → buy since baseline
The boundary of the firm sits where buying an activity costs the same as making it inside. Digital technology lowers the cost of using the market and the cost of coordinating inside the firm at the same time, so activities can cross the boundary in both directions: cheaper market transactions push the least specific activities out, and cheaper coordination pulls the most specific ones in. The boundary moves only when the relative cost of the two options changes, so both can fall together while no activity flips.
With management strain at zero, nothing stops the firm from growing except specificity, and the first chart's straight lines cross once. Raise γ and the internal line bends upward as the firm reaches down the ranking, because organizing the next activity costs more when management already runs many of them. The second chart is the same comparison with firm size on the horizontal axis: activities are ranked from most specific to least, the market cost of the marginal activity falls along that ranking, the internal cost of the marginal activity rises, and the firm stops at n*, where the two are equal. Coordination tools relieve part of the strain, which is how better internal information lets a firm grow.