In partnership with

Ronald Coase has come up in Capital Gains before, for his work on how to deal with externalities. His view is that the optimal solution is to put a price on them, and just let people decide whether that price is worth paying. This also turns out to be a descriptive view: differences in rent reflect the local amenities available near a given apartment, and airlines charging for legroom is just a more efficient form of passengers negotiating one-on-one about whether $10 or $20 is adequate compensation for reclining the seat in front of them. The only world in which we make all of these bargains is one where transaction costs are effectively zero (and property rights are perfectly clear), so that individuals can negotiate every externality without friction. Coase was describing what the theoretically optimal setup was, partly in order to explain why the real world didn't work that way, and partly as an intuition pump so policy could come up with good ways to approximate this outcome.

But Coase lived out another principle: once you have a competitive advantage, find new domains in which you can apply it. That same approach of focusing on transaction costs also explains something else: the mystery of why companies exist in the first place.

A company is a collection of people and physical assets. Legally, it's a convenient hack for allowing individuals to sign contracts on behalf of the group, and to contain legal liability so investors are willing to own the equity. But that structure doesn't necessarily lead to huge companies. You could imagine a setup where every Walmart is an independent company, with contractual relationships with the nearest node of their warehouse system, which itself would be an independent company buying transportation services from whoever offered the best deal. And there are some businesses that are, in effect, structured like this: multi-manager hedge funds and private equity firms both own a portfolio of businesses that can function semi-independently (in the case of PE, you know those businesses can operate on their own because that's what they were doing before the PE firm bought them). This setup aligns incentives very well, since the smaller business units can more easily offer equity to key employees, and can also raise money from investors who have a more specific mandate than what the overall firm offers.

But the Walmart example also illustrates some of the scale benefits: Walmart has accumulated brand equity over time, to the point that it's a default first choice for shoppers who are looking for bargains. So even if Walmart and a competitor are at pricing parity, Walmart will often get the customer because that customer doesn't check / compare all of their options. Some of the company's investments in supply chain management show up in the form of lower working capital requirements since they're holding less inventory outside of stores, but those benefits also show up at the store level, in the form of higher turnover and a better-targeted set of products.

Walmart as a collection of independent sub-businesses is also Walmart as a nonstop argument over who deserves how much credit; it's easy to imagine scenarios like stores banding together and threatening to take their supply chain business to some other retailer, or the logistics side of the company underinvesting because it knows it won't fully capture the gains it makes. The national brand is also harder to maintain: a store might hold out on contributing to brand advertising because it's in a market with little direct competition, and that same store might decide that "Always low prices" is not the margin-optimal choice, even if weakening that standard anywhere hurts other Walmarts everywhere else.

So, at least in this case, the optimal structure is to have one parent company that fully controls its subsidiaries. But this raises other questions: if that vertical integration is so valuable, why doesn't this extend further? Why does Walmart sell cereal made by General Mills when it could grow the wheat and corn itself, processes it into carbs-on-carbs, etc.?

In a Coasian world, firms are a test of where the boundaries between different institutions make sense, and where they need to shift. It's a bit like looking at a time-lapse of national borders, and seeing that after a while it made sense to have one country on one side of the Pyrenees and another on the other. The Rhine was a convenient Schelling Point for another of these borders.

But that national border analogy points to something important: the optimal boundaries change over time. Technological shifts can centralize some industries, like information-gathering—whether it's general search, vertical-specific search, or financial data, the declining marginal cost of searching for and delivering data has meant that there are bigger benefits to scale. But it's also possible for technology to fragment an industry: thanks to Airbnb and VRBO, there are probably more independent economic entities in the lodging business, because now the scale-driven part, acquiring customers, is being solved by centralized companies whose costs are low enough that they can support worse operator-level economics.

Restaurants are an uncertain case, but technology is arguably making it possible for the industry to support more fragmentation. Delivery platforms take a big cut, but they're doing this in a business where any idle time in the kitchen during peak hours is expensive. Marketing options have improved, so word-of-mouth matters relatively more and national brands relatively less. Point-of-sale systems have migrated to hardware that's quite similar to what consumers are buying, and those same products can also give companies hints about how they might improve their economics. ("Dynamic pricing" and "surge pricing" are a lot more popular when you call them "happy hours," and Toast is in a better position than your local diner to know what the best discount is.) Those brands do, of course, have the scale that allows them to negotiate better terms for all of these services, and the McDonald's experience is probably more consistent than the 4.7-stars-on-Yelp experience.

All of this ultimately comes back to asking where coordination is easy, where it's hard, and where that balance is changing. One of the functions of the financial industry is to actually put those changes into effect: when technology shifts, it impacts the synergies behind mergers and the dissynergies that lead to spinoffs and divestitures. The corporate form isn't perfectly optimal on its own, but it's a great framework for figuring out how many discrete org charts the world needs, and who should be where on them.

Coase is probably the single most influential thinker on The Diff. Some implicitly Coasian pieces about organization:

• Software and Private Equity are both trying to eat the world

• ServiceTitan is an example of this in action ($)

• So is Toast ($).

• One force for fragmentation: different levels of capital intensity at different parts of the stack ($)

Sometimes, the effects are hard to predict, like air conditioners contributing to the concentration of financial centers ($).

Simplify with BILL. Get a BrüMate Backpack Cooler.

We love our customers—and the feeling is mutual! Demo BILL Spend & Expense and get $200 to spend with BrüMate.

“BILL gives me the capability to create as many virtual cards as I want. It makes budgeting easy. I use a different card for marketing, office expenses, etc and can set budget for each. All free, no hidden fees. Makes expense tracking extremely simple.” – Dylan Jacob, Founder @ BruMate

BILL gets you:

• Customizable spending limits

• Real-time tracking

• Scalable credit lines

Take a demo and claim $200 to spend with BrüMate.¹

Request a demo

¹Terms and Conditions apply. See offer page for details. Card issued by Cross River Bank, Member FDIC, and is not a deposit product.

Join the discussion!