Digital disruption and the nature of the firm

Mark Smith
Contributed by Mark Smith

Why do firms exist in the first place and how might digital disruption change the economics and structure of the firm?

The Nobel-prize winning economist, Ronald Coase, analysed why an entrepreneur would hire employees in the first place rather than contract with the open market. Coase postulated that firms exist because they are able to maintain lower transaction costs for the development of products and services than the costs for an entrepreneur to contract mutiple individuals in the market. Basically firms exist where it is cheaper to develop prodcuts and services internally. Coase stated that

“Whether a transaction would be organized within a firm or whether it would be carried out on the market depended on a comparison of the costs of organizing such a transaction within the firm with the costs of a market transaction that would accomplish the same result”

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Simplifying that down even further, firms existed and grew because they could perform things like production, warehousing, sales and marketing, inventory management, delivery etc at a lower cost internally than externally.

Constraints like geography, logistical efficiency, product development and payment processing were more cost effectivley managed within the firm and the same was true of market competitors. Optimisation, process improvement and systems automation were applied to stay ahead of the competition, resulting in growing sophistication of internal systems and increased internal IT capability.

So what has this got to do with digital disruption? Well, historically, due to technology constraints (networks, servers, desktops etc) this could only be achieved inside the boundaries of the firm (or the data center). The model could not be disintermediated by the market as every other firm was working with the same constraints.

Customers also lived with those constraints, they were dependent on what the firm told them about their products and services, they needed to visit the shop or store to educate themselves and physical word of mouth had no viral capability.

The impact of digital technology is that now the market can disintermediate the firm, and consumers can sever their dependency on the traditional firm, the parochial information hoarding of the firm is out and peer-to-peer information sharing is in. Traditional middlemen firms are shrinking and retrenching, and newer, leaner middlemen are appearing who are using external market capability, way less internal resource and direct customer involvement to match and beat traditional firms.

Food for thought? – absolutely, and in the next blog I’ll be looking at some more specific examples of digital disruption that offer new firms opportunities to enter the market, or that give traditional firms the opportunity to compete differently, to re-envision their products or to reengage their customers.

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