Free Market Road Show: The Sharing Economy

On April 19, I had the privilege of addressing the Free Market Road Show audience at the Kohelet Policy Forum in Jerusalem, Israel. The subject of my panel was Jobs, The Sharing Economy, and the European Demos, and I spoke alongside John Fund of National Review and Barbara Kolm of the Hayek Institute of Vienna, Austria. Here’s the text of my remarks. They can also be found as a PDF here.

Good evening. My colleagues and I have heard a lot over the past couple of days about the start up nation. So trying to give insights on entrepreneurship to the start up nation is a bit like taking coals to Newcastle. However, as I come form Newcastle, I think I’m entitled to do so.

What I’d like to do this evening is talk a bit about a couple of free market economic concepts behind the sharing economy, before going on to illustrate how these concepts apply in practice, and finish with a warning about how laws from a different era are being used to crack down on sharing economy firms in the USA.

I live about thirty miles south of Washington DC. Because of the ludicrous traffic I get a bus in to work so I can work on the bus. American buses only run during peak commuter times, so if I have to work late, I used to be stuck with getting a taxi home. Including tip, this would normally cost over $100, so I didn’t do it very often. Then Uber launched in DC, and I could get a black limo home, riding in style for $20 less than the grimy cab would cost me. Today, with UberX, where ordinary people share their cars with people who need rides, I can get home for $40 on average. Unfortunately, this means my boss asks me to work late more often now, so it’s not all good news.

What’s happening here? It’s all about an economic concept called transaction costs.

In his 1937 essay, The Nature of the Firm, Nobel laureate economist Ronald Coase noted that firms only exist because of the costs associated with market transactions. Whereas the natural arrangement for any transaction is to use the market, costs in finding a party willing to provide the goods or service may prove prohibitive. Therefore the transaction may not take place, or, as Coase observed, a party might hire a servant or employee to do the work directly instead. The market inefficiencies of transaction costs therefore dictated the existence of firms rather than individuals trading with each other on the basis of their differing skill sets (which Adam Smith called “the system of natural liberty.”) For simplicity’s sake we will call the costs of using market transactions “transaction costs” and the costs of employing people “organizing costs.”

Transaction costs come in many forms. If I want to find a carpenter to make a table leg, I will need to research the local market of carpenters, find one, research her enough to make sure that she is reputable, negotiate a price with her, arrange a suitable timeframe for delivery, arrange for delivery, arrange for payment, and (potentially) incur legal costs if the job isn’t up to snuff or the job is never done at all. That’s a lot of considerations that go into one transaction. Each of them represents a cost, and the carpenter has to go through a similar set of considerations on her end of the transaction. If the table leg wasn’t important enough to you, you’d let you table continue to wobble. If you needed to mend a bunch of different table legs repeatedly, you might take the organizing costs and hire the carpenter full-time.

So, using the example I started with, many people would think that Uber is a taxi firm with lower organizing costs. It is not. Uber does not employ people. What Uber does through its app is three changes in transaction costs. First, it creates a marketplace. It brings you, the person who wants a ride, together with the person who can provide one. Transaction costs are lowered on both sides. You don’t have to waste time standing on a street corner in the rain to hail a cab, and the driver is directed to you by the app rather than driving around looking for people with their arm out. You also both have a measure of the other person’s reliability in the rating system Uber uses, and neither of you have to worry about payment, as the app takes care of that. It’s no wonder that taxi firms, which still have high organizing and higher transaction costs, are losing out.

Now, there are much wider implications for the economy if transaction costs can be lowered like this.

Read the full remarks here.