New York Times article on Ronald Coarse and transaction cost

OUGHLY 68 years ago this week, a 21- year-old professor by the name of Ronald Coase gave a lecture to students of the School of Economics and Commerce in Dundee, Scotland. He explained why businesses exist as they do ?why, for, instance, they choose to produce some goods themselves and contract with outside companies to provide the rest.

Five years later, in 1937, Mr. Coase turned the lecture into a paper, "The Nature of the Firm," which in 1991 was cited by the Royal Swedish Academy of Sciences as it awarded him the Nobel Prize for economics. Despite that fame, Mr. Coase's ideas on the nature of business were rarely mentioned inside corporate boardrooms and executive offices.

Then came the Internet economy.

Mr. Coase, now a professor emeritus at the University of Chicago's law school, has recently witnessed a revival of his ideas, particularly among dot-com executives and leaders of established companies as they forge Internet initiatives. And though his theories do not provide a road map for e- commerce success, they do provide a compass for executives whose strategic vision has been blurred by a sandstorm of alliance offers, shifting business models and new competition.

"What Coase ?and everything that follows from him ?helps us do is answer the question, `What's the boundary of the firm, and how hard should that boundary be?' " said Charles Conn, chairman of Ticketmaster Online/CitySearch. "It helps you think about things like whether to buy, build or partner."

At the core of Mr. Coase's theory is this notion: When a company tries to determine whether to farm out or instead produce goods or services on its own, market prices are not the sole factor. Rather, there are significant "transaction costs," in Mr. Coase's language, generated by the search for the right company to strike a supply agreement with, and the time and expense of cutting the deal. Those costs, he theorized, frequently determine whether or not a company will seek an outside supplier or service provider.

At the time Mr. Coase wrote his theory, transaction costs were prohibitively high. Because information flowed at a glacial pace, and supplies moved only slightly faster, companies strove to manage the entire chain of production within the walls of their own corporations. For instance, the Ford Motor Company, a paragon of the "vertically integrated" corporation of the early 1900's, once bought a rubber plantation rather than cede control of that part of tire manufacturing.

Sixty years later, transaction costs have plunged, thanks to the Internet. Within the so-called new economy, information itself is typically the product, and that information moves at the speed of a T1 line. As a result, companies can get complete information about potential suppliers and business partners within a few clicks, and can therefore set up supplier agreements or form alliances with other companies for a fraction of what it would have cost even a decade ago.

That, in turn, helps explain why Internet companies have cluttered the airwaves with alliance announcements in the last two years. Of course, part of that owes to the fact that before the dot-com bubble burst, Internet companies frequently trotted out alliance partners as a way of building pre- I.P.O. buzz. But analysts say that even with the window-dressing alliances, Mr. Coase's theory still holds: with diminished transaction costs, more alliances are inevitable.

"With lower transaction costs, companies are able to focus on narrow product slivers or business activities, and have other parties do the rest," said David Ernst, leader of the global alliances practice of McKinsey & Company, the consulting firm.

The implications are that "there are a lot more big winners ?and big losers," Mr. Ernst said. "Because if you have a network of partners you can attract incremental business, and plug the revenues back into your core business," he added. "But if you don't, then you're the one whose market share is getting taken away."

David Jefferds, co-founder of CyberElves, a Web development company with about 40 employees, said he understood the pressure to partner up. "Since we're a small-to-medium sized company, we don't have every skill set, like Web hosting," he said. "And we could probably target that by partnering with firms, getting expertise, and then making the buy-versus-build decision."

But an alliance "isn't always necessarily a perfect fit, because you're still referring your client to someone else," Mr. Jefferds said. "So you're taking a risk with a client that you're really not compensated for," he added.

Mr. Ernst, of McKinsey, said that managing alliances was critical, "because the outcome of your business depends increasingly on how you do that." Still, he said, most companies have "mixed results with their alliances and are struggling to be pro-active, amidst a huge deal flow."

Rather than have a one- or two-person business development staff overseeing partnership programs, Mr. Ernst said companies should "invest more heavily in building the business development staff to track the performance of each alliance, and link those performance metrics to the corporation's overall performance metrics." But, he said, fewer than one in four are doing such things.

Of course, managing alliances is sometimes a strange science, particularly given the array of relationships that can result from an alliance network. Mr. Conn, of Ticketmaster Online, pointed out that among his company's alliances, two were with competitors, Yahoo and The Denver Post. "In the old economy, the question was, `Compete or buy?' " he said. "Now, anything goes."

As for how to manage the boundaries of his own company and the dozen or so companies he has invested in, Mr. Conn said he applied Mr. Coase's theory about transaction costs to a few other truths of the modern economy. "Now that workers are the principal source of a company's cost, and they're all shareholders, there's a real advantage of having people see the value of their work on a daily basis," he said. "So where that's true, there's an advantage to having a smaller operation."

To maintain that spirit, he said, "it often makes sense to have alliances and partnerships, rather than buy and merge."

For his part, Mr. Coase predicts that understanding transaction costs in the new economy will bring people back to the ideas of the economist Adam Smith. "It enables you to have more specialization and greater production, because you're more efficient," he said in a telephone interview from his home in Chicago. "You'll get more small firms as a result, but large firms will also get larger, because they can concentrate on core activities and contract out what they can't do well."

For all the attention his theory is getting in the dot-com context, Mr. Coase, 89, said he was not paying much attention to e- commerce. "So much is wrong with economics that I'm trying to correct some other things now," he said. "And one doesn't need to study the actuarial tables to know there isn't a lot of time for that."