A Tale of Two Transactors
Scenario 1. After six years of work, Mike finally established his own retail business on Gotham Street in the Big City. His first week was a heady mix of first sales, getting to know neighbors, and realizing he’d accomplished his dream.
On Monday of Week 2, Mr. X came to visit. “Nice store you’ve got here,” he said to Mike. “Be a shame if something happened to it.”
“Why would anything happen to it?” enquired Mike, part disbelieving and part enraged.
“You just never know,” said Mr. X, slapping his walking stick repeatedly into his palm. “Things can happen. You got no control over ‘em. But we can help.”
“How?” asked Mike, dreading the answer.
“Think of it as insurance. A little extra off the top line, nothing happens to the bottom line. Safest neighborhood around, if you know how to get along.”
“Why me?” asked Mike. “I haven’t got the money, I can’t afford it.”
“Cost of doing business,” shrugged Mr. X. “You raise your prices, you cut your costs—you figure it out.”
“But it’s not fair!” shouted Mike. “Why can’t you cut me a break?”
“Not fair–that’s a good one! Listen, if I cut you a break, everyone wants one. If it was up to me, I’d do it, I like you. But Mr. Big—he wouldn’t like that.”
“Maybe I could talk to Mr. Big,” said Mike.
“Oh I don’t think that’d be a good idea,” Mr. X said drily. “All right, I think we’re done here, Mikey. I’ll come by on Monday for your first payment.”
Scenario 2. After six years of work, Mitchell finally formed his own subcontracting business, taking the plunge with a big deal from his former employer, BigCo.
As he read through the fine print of the contract, Mitchell noticed several clauses that surprised him. He called BigCo’s in-house counsel, Mr. Z.
“Mr. Z, this is Mitchell. I’m going through this contract, and it says I have to buy millions of dollars of insurance coverage, with BigCo as beneficiary, to cover things like lawsuits filed by anyone anywhere in the world for things like bodily injury, automobile crashes, etc. Look, I’m just an actuary—I’m hardly ever going to set foot there, much less cause all kinds of harm. These things will never happen.”
“Well, the most unlikely things have a funny way of happening, Mitch,” said Mr. Z. "It’s a big world, you can’t be too careful. We’re just managing risk. Think of it as insurance. Which of course it is. It’s really for your benefit, you wouldn’t want to be liable for these catastrophes, now would you?”
“But why me,” asked Mitchell. “I can’t afford this kind of extra insurance. And you want me to buy insurance on people I sub to as well? Does this ever end?”
“Oh don’t worry about that, Mitch—you just pass it on to your subs in your agreement. That’s what we did, when our customer demanded we do it. It’s how it works.”
“Is that where it starts, with your customer? Couldn’t we talk to them?”
“Oh I don’t think that’s going to happen, Mitch. Just work out the cost and pay it.”
“But it’s not fair, Mr. Z.”
“Mitchell, Mitchell, you know better than that,” said Mr. Z.
So here’s my question about the two scenarios:
What’s the difference between them?
My lawyer friends (I hope I still have a few) will say, “That’s insulting! Come on, one of them’s legal, and one’s criminal—how can you confuse them?”
But my economist friends (some of them anyway) will say, “Ha! It’s a trick question. There is no difference, they’re exactly the same.”
“Both of them involve non-value-adding transaction costs. There is some amount of risk transfer between parties—swapping around, really–but to the system, there is no gain.
“In fact, at the system level, there is a net cost; and the distribution of that cost is disproportionately downstream, to Mike and to Mitch.
To put this in context: our economy used to grow by achieving scale through transaction costs—legal agreements, accounting, contracts, commission plans.
Today, we are so inter-linked and fragmented, and so paranoid about trusting, that the transaction costs have begun to overtake the value accruing from scale.
We have become a culture not of shopkeepers, but of tiny outsourcing transactors, fearfully insuring ourselves against our fellows-in-commerce at every step.
As my friend Bill says, "What is a credit default swap except a statement that you don’t trust your customer?"
This is not the way to build a healthy economy.
There is a difference in the 2 scenarios. In the 1st, the shopkeeper is forced to buy the ‘insurance’ – but doesn’t know what he will get back if he gets into trouble anyway. Maybe something, maybe nothing. But if he doesn’t buy it, he’ll be forced out of business.
In the 2nd, the subcontractor can say no and still have the possibility to either negotiate or do business elsewhere. If you buy (legitimate) insurance, you choose to buy security that is valuable in itself. The reshuffling of risks is valuable to the system as well.
Fred, thanks for weighing in.
Just to push the metaphor a bit, does a new subcontractor really have the ‘choice’ you suggest? A new business, with one major anchor client, up against a business practice that is near-universal? How many businesses in that situation really feel they have a choice? I’d suggest about as much as the first case, where Mr. X might say, ‘hey you can always move outta da Big City if you don’t like it.’
I don’t feel as confident as I’d like in my comments about the systemic value of risk reshuffling. Anyone else care to shed some insight?
Charlie,
I’m not sure if the album cover image was intentional, but the title song of the album, Shakedown Street, reminds us of the outcome when a town has lost its soul.
"Nothins shakin’ on Shakedown Street, used to be the heart of town." Jerry Garcia, in a Mr. X sort of way, follows that with some sarcasm, "they tell me this town ain’t got no heart. You just gotta poke around."
Indeed, low trust = high costs and slow transaction speed.
@Charlie, in theory a business owner chooses where and with whom he does business. In practice of course this is more complicated. If you own a business that needs a physical presence (shop, or business with large inventory) you’re usually not so flexible.
‘Standard’ business practices can be dealt with by innovating one’s own business processes. Look at e.g. Apple who has done that trick several times already. I’m not saying it’s easy, but it is doable.
BTW I do agree with your (implied) point that lack of trust increases transaction costs. Some of the transaction costs are adding value BTW. For instance it’s good to have records and contracts to be able to see what’s happening, what agreements were made etc.
Fred, thanks again for those thoughts. Maybe you can help me sort out the following, as I’m no actuary or underwriter.
Suppose a company has a number of suppliers. Suppose collectively there is a certain probability of a some kind of supplier accident for which the supplier wants to be indemnified. And there is an actuarial estimate of the aggregate amount of damages which could be expected from this particular kind of accident.
Suppose that the company succeeds in insisting that all suppliers buy insurance to indemnify the company. That would mean that the total cost of insurance purchased would have to exceed the total cost of the actuarially expected damages.
The costs in excess of expected damages come about from the non-productive, non-value-adding items like the entire cost–not just the profits–of the insurance company or companies involved, not to mention the administrative costs of all the suppliers involved in complying.
Insurance looks good on a limited basis, when there is real value to redistributing liabilty for high-risk situations to larger pools, or to those capable of absorbing it.
But this situation is akin to everyone being forced to buy insurance: it is the equivalent of complete socialization of all liability within the particular accident arena.
We can tolerate this when it comes to universal health care, because it feels like a moral good. But when it’s corporations doing it, with very small, non-moral risks at stake, and doing it not for any great social good, it ends up looking a lot like extortion, minus the bad motives.
No corporate lawyer intends to extort their suppliers, customers or society for the sake of self-aggrandizement. But nearly every corporate lawyer would almost always advise their company to lay off risk to their suppliers, and to do so by building mandatory insurance into contracts. You don’t need dominant market share to do this if you have an unconscious business-social belief that all risk mitigation is good, and that all risk ought to be laid off on someone else’s company. Which I suggest pretty much describes today.
Help me out here, I’m out of my league: am anywhere right on this?
@Charlie, I’m not sure here where you’re getting at. If a company wants its suppliers to buy insurance to minimize risks, then the suppliers either do so and charge the company for this insurance (by increasing their prices for instance), or they don’t do business with that company. If the company is (very) big compared to it’s suppliers the suppliers may feel forced to buy the insurance and not be able to charge it to the company, but in the long run that is not sustainable.
The big company could offer to buy the insurance itself and therefore negotiate lower prices from the suppliers. The total amount of insurance paid would probably be lower than if each supplier would buy their own insurance.