In January 2022, I did a 30-day project on “Why Your Business Needs to Adapt to Blockchain”. This post is a part of it. To know what I covered, learned, and executed in the project, visit this page.

Innovative technologies face opposition when they are first introduced because they disrupt how we are used to living and working. Although it doesn’t mean every new technology improves our lives, some do. One example is the internet. 

But, what exactly did the internet do? The biggest impact of the internet was in reducing transaction costs in our lives. How? I’ll discuss that in a while.

In this article, I touch upon the dialogue of blockchain being the next big step in reducing transaction costs. But first, let’s understand what Nobel Laureate Ronald Coase’s biggest contribution to the fields of economics and law – ‘transaction costs’ really means. For that, I’ll briefly turn the pages of history before returning to the topic in hand – blockchain.

The Gap in Economic Thoughts Coase Filled

Take this hypothetical example. Linda pays $10 to a retail store in New York, USA to buy one kilogram of an Indian variety of mango. Farmer Suresh receives 20 cents for selling the same mangoes. As absurd as it may sound, this is a close depiction of the amount lost as transaction costs. The difference between the two prices goes to middlemen, legal formalities, currency exchange, banking, and so on. In an ideal world with zero transaction costs, Suresh would receive what Linda pays and the deal would happen at a price within the spread of 20 cents to 10 dollars. Both Suresh and Linda would gain, rather than lose.

Economists before Coase ignored transaction costs in economic analyses. They believed forces of supply and demand were enough to determine prices. More importantly, they ignored another important feature of an economy – the internal working of firms or management. Coase elaborated the role of management and institutions in the functioning of the economy as opposed to the view that price could be determined just by competition between the market players.

Ronald H. Coase, “The Institutional Structure of Production,” University of Chicago Law Occasional Paper, No. 28 (1992).

A firm itself is a feature that reduces transaction costs. For example, a multinational company operating the entire supply chain may be able to offer Linda the mangoes at a much lower price than $10 because they internalize the steps that otherwise would require negotiations between different parties and leakages. Hence, how efficiently the firms function plays a crucial role in the overall output of the economy.

Let us take two more examples of major advances in transaction cost reduction – one ancient and one contemporary.

Currency Replacing the Barter System

Let us simplify the above example. Linda and Suresh live in the same village. Linda is a potter and Suresh is a farmer. Linda has a craving for mangoes. There are only three sellers of mangoes in the village. She approaches all three sellers. Two of them have no interest in exchanging pots for mangoes. They have better offers for exchange such as goat, wheat, and cloth. 

Suresh is the third seller. Most of his mangoes are not ripe yet. Linda has to settle for inferior qualities of mangoes. Suresh does need a pot, but he doesn’t like the quality of Linda’s pots. He prefers Jacob’s pots. He doesn’t know if Jacob would be willing to take mangoes for a pot. He talks to him which delays answering Linda. Jacob rejects Suresh’s offer. So, Suresh approaches Linda with an offer of three mangoes for one of Linda’s inferior pots two days after Linda first thought of eating mangoes. Linda doesn’t like Suresh’s offer and no longer craves mangoes. The trade doesn’t take place and the economy doesn’t grow.

You can see that the costs of making the trade were more than the gains it would bring. So, the trade didn’t take place. Now, let’s introduce a currency to this economy. Linda can now buy mangoes from any seller any time she likes. Suresh can sell his mangoes when they are ripe for a higher price and use that money to buy pots from Jacob who won’t mind taking money instead of mangoes for his pots.

However, Linda could still not dream of purchasing fresh apples despite currencies in circulation. Such a transaction was impossible as no one produced apples in the village.

Fast forward a few thousand years, modern Linda has the option to buy any fruit she wants any time of the year from thousands of possible sellers. In addition to many other advances, the biggest reason why that is possible – the Internet.

The Internet Revolution

Hopefully, David Letterman is convinced now of the power of the internet. He doesn’t have to go back in time or buy bulky records to relieve an iconic baseball moment. He can simply search for one on YouTube.

Talking about Linda, she gets more than 8,000 options on Amazon when she has a mango craving. The prices are clear, contents are standard, quality is reviewed by other buyers, she has many payment options, and she will probably start getting good offers on all things mangoes even before she knows she has a craving. 

With the internet, the size of the market within our reach increased manifolds. The physical limits did not stop us from doing business. Sellers could now easily reach out to the consumers to advertise what they are producing, and buyers could easily make purchase decisions by comparing products online.

So, now we know that, 

1. Introduction of currency reduced transaction costs
2. The existence of firms reduced transaction costs
3. Internet reduced transaction costs
4. Other institutions like banking, sound legal system, etc. reduced transaction costs.

And in the times ahead:

5. Decentralization and blockchain are further reducing transaction costs. Let’s see how.

How Blockchain is Changing How We Do Business

The key technologies in the blockchain ecosystem are smart contracts, decentralized applications (or dApps), and asset tokenization. All three have the potential to revolutionize our business processes, daily lives, and how government agencies work.

With these technologies, blockchain can replace all the intermediaries such as banks, insurers, notaries, brokers, realtors, accountants, auditors, and lawyers. It will eliminate the need for excessive paperwork and accelerate transactions. Algorithms take care of the role of intermediaries. Let us look at some examples to understand it better:

Example 1

You could buy a house as quickly and easily as a stock. Let’s say Suresh uploads the deed of his house on the blockchain. Linda sees the deed and sends an offer. Her payment gets locked in. Within minutes, Suresh could either accept or reject the offer. If he accepts, Linda immediately owns the deed and Suresh gets the payment. If he refuses, Linda’s money returns to her wallet. This process completely bypasses the need for payment of high-brokerage fees.

Example 2

Several investors started an insurance dApp on the blockchain. If farmer Robe pays 1,000 rupees on the dApp, he immediately enters into a smart contract. If the annual rainfall is less than 100 cm in Bardhaman district, West Bengal in 2022, farmer Robe would receive 10,000 rupees. Oracles supply the environmental data from sensor readings, satellite imagery, and advanced ML computation to smart contracts. Investors starting the company would have to pool the funds and lock it up in the smart contract until the end of the year. If the annual rainfall exceeds 100 cm, the initial investment of 10,000 rupees plus the premium of 1,000 rupees gets paid back to the investors. Automation at its best!

Example 3

Suresh may start selling NFTs around his farm project. Holders of the NFT may get two nights of free farm-stay option every month on Suresh’s farm. The NFT holder gets to eat all the farm’s produce for free for those days. Additionally, whenever someone sells the NFT, Suresh makes money as creator royalty. Not to mention, he is also getting publicity for his produce and hospitality. An example of the power of the smart contract behind the artworks sold as NFTs.

I have intentionally looked at examples around agriculture because it is kept at the lower end of the blockchain application feasibility spectrum.

This article is a brief overview of how we have progressed in reducing transaction costs throughout history. I’d love to know other major advances you can think of. 

To view the full project I did on blockchain in January 2022, visit this page.