"Killzone" Economics. Why You Should Care.

Decreasing interaction costs and sublinear enterprise productivity could create market volatility that can be your friend, or your enemy, when building and managing your enterprise. Are they your friends?

Let’s start with some definitions.

Killzone is a military term, or at the very least a gamer term (from Urban Dictionary):


“A military term describing an area of ground that is well defended, possibly including pre-sighted machine guns, mortars, artillery, as well as a variety of obstacles such as razor wire and tripflares. (Weapons will be pre-sighted to these obstacles, as approaching troops will get caught in them, making them ideal targets.) This creates a literal "killing zone," hence the name.”


Clearly from that definition, this is not somewhere you want to end up as a company. Your odds of surviving a trip to the Killzone are low.

To understand interaction costs, you need first to understand transaction costs. Transaction costs, which were the focus of Ronald Coase’s Nobel Prize winning work in the 1930’s, include the costs related to the formal exchange of goods and services between companies, or between companies and customers (ie. How much does it cost me as a company to sell you, the customer, my goods or services?).

These costs play a critical role in determining how large your firm can grow. Coase’s work included a linkage between transaction costs and the size of a firm. Simply put, Coase’s Nature of the Firm suggested that a firm will continue to grow to the point where an internal transaction can be outsourced more cheaply than if executed within a company. When a transaction can be accomplished more cheaply outside of the firm, there is no incentive to continue growing.

Interaction costs are now more widely used than transaction costs as they include transaction costs, but also add the costs of exchanging ideas and information. Thus they cover a more full picture of economic interactions between companies and their customers. Interaction costs are comprised of search, information, bargaining, decision, policing and enforcement costs. As more and more work is information related in our economy, interaction costs can be incredibly important to watch and manage.

Most importantly perhaps, interaction costs are exactly the kinds of costs that are rapidly decreasing due to the ubiquity of connected devices and the growing power of functionality facilitated by this connectivity.

Now for sublinear enterprise productivity. Wha? Yes, sublinear enterprise productivity. In short, this refers to some interesting work done by Geoffrey West and his collaborator Luis Bettencourt recently where they discovered when studying 23,000 publicly traded companies, that as the number of employees grows, the amount of profit per employee shrinks. Corporate productivity then, was shown to be entirely sublinear. This should not be taken as the last word on the topic, but they are interesting results. In particular their assertion that, “the bleak reality of corporate growth, in which efficiencies of scale are almost always outweighed by the burdens of bureaucracy.” Furthermore, they go on to state that, “the inevitable decline in profit per employee makes large companies increasingly vulnerable to market volatility.”

So what if your firm is experiencing both decreasing profit per employee from the growth dynamic described by West and Bettencourt, and is also seeing interaction costs drop as value chain activities migrate more to information-driven interactions so as to be more exposed to interaction cost decreases? Wouldn’t that lead to even more volatility? Wouldn’t that that promote unequal rates of change inside and outside of companies?

It’s a hypothesis at this point. And it’s probably not original. I’m inclined to invoke Bob Sutton’s law in this regard, “If you think you have a new idea, you are wrong. Somebody else probably already had it. This idea isn't original either; I stole it from someone else."



 

If there is any validity to the hypothesis, it might suggest there is a systemic way to identify which markets and companies are ripe for disruption. If interaction costs are dropping around you in your market, and your profit per employee is declining, perhaps it’s time to think about disrupting yourself before someone else does? At the very least, you’d better get a grip on your interaction costs so they are in line with the market.

If you’re an insurgent, this seems to be a particularly good time. Dropping external interaction costs and decreasing profit per employee might suggest a market which is stumbling into your Killzone.

 

[Author’s note: I am not an economist. The post above is based on a hypothesis only. The underlying science surrounding transaction and interaction costs and sublinear enterprise productivity are well-known and evidence-based to the best of my knowledge. However, my leap to a meaningful connection between the two is only hypothetical at this time. Contributions and refutations are welcomed. My goal is to explore some of the possible underlying reasons (outside of the current political and monetary policy upheaval, of course) for what I perceive to be the current economic conditions for enterprises: characterized by hypercompetitiveness and increasingly volatile markets.]

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