By Satnam Singh
Transaction costs are expenses incurred when buying or selling a good or service. They represent the labour required to bring in a good or service to the market, giving rise to entire industries dedicated to facilitating exchanges. Understanding of transaction cost economics is vital for businesses and governments for effective strategy and policy making.
In light of this, the changing landscape of the industry and the impacts of transaction costs face a need to be examined and suggestions to reduce the transaction cost have to be extrapolated on.
The Indian IT industry & Coase’s transaction cost theory
The Great Indian growth story has been majorly fueled by the rise of Indian Information Technology (IT) firms like Tata Consultancy Services (TCS) and Infosys, which have primarily utilized the wage differences between offshore employees and their onsite counterparts. They sold this wage difference as the value proposition to their western clients. This is in line with the theory of the firm and the transaction costs theory by Ronald Coase. Coase argued that firms exist because they are able to reduce or eliminate the transaction costs of performing an activity in-house. Further work by Ellram, Tate and Billington on offshoring and transaction cost strengthens this argument. It statistically confirms the positive effects of offshoring in reducing transaction costs for an organization.
The innovation in technology has presented a major challenge to the wage arbitrage business model of Indian IT companies in the recent times. The recent times have witnessed a shift in the traditional IT environment with trends such as cloud computing (AWS, Microsoft Azure etc.), automation, artificial intelligence and machine learning. These trends have presented a case for the western clients of these Indian IT companies to lower transaction costs. These transaction costs can be seen in the form of infrastructure management costs, manpower requirement costs, skilling, re-skilling and up-skilling costs , coordination costs (costs to manage such global contracts involves communication and other non-economic factors), costs associated with political risks (to push for policies w.r.t local hiring in USA etc.), operational risks (variability of performance etc.) and trust.
Transaction costs making workforces ‘irrelevant’?
In the context of the Indian IT services industry, these transaction costs have showcased the market inefficiencies with the existing model of service delivery, signalling clients to look for efficient options utilizing the new age technology. This is evident with the rise of job opportunities in new age technologies and from the flat growth numbers for IT service delivery firms as well. The impact seems quite clear in the quarterly results of TCS and Infosys with the companies showing weakness for a 5th consecutive quarter in 2017.
The effect of these transaction costs can be widely seen with these IT companies planning massive layoffs. A report by Mckinsey says that nearly half of the workforce in the Indian IT services firms will be ‘irrelevant’ over the next 34 years. Another study by executive search firm Head HuntersIndia said that there would be around 2 lakh job cuts annually in the Indian IT industry over the next 3 years. As per the Deepdive forecast, the Indian IT sector growth would fall to 5.3% in 2017. Globally, while the new technologies such as automation and artificial intelligence would improve productivity by 0.8 to 1.4 percent annually, they would also alter the labour market situations. Hence, the policy makers would have to rethink job creation and other safety nets, e.g. universal basic income. The current startup policy of the government should also be re-evaluated.
Addressing the problem
These transaction costs can be reduced by addressing the problem at multiple levels. Private firms can adopt a number of ways to reduce the above-mentioned transaction costs, like moving away from resource based outsourcing business model towards highly skilled consultative service model to reduce the manpower costs. This would prove to be a shift from the cost-based offerings to value-based offerings.
Adoption of new age technologies such as cloud computing, artificial intelligence etc. for service delivery which helps reduce the costs related to manpower as well as re-skilling and up-skilling human resources would also help in reducing transaction costs. Other ways include investing in research and innovation (creating intellectual property around new age tech would significantly help, though it does not reduce transaction cost directly) and minimising operational risks by leveraging existing relationships with clients and providing them services with a revenue sharing model.
The government can also take measures in order to reduce transaction costs. Focused skill development programs in line with the new age technologies, diplomatic level talks about the conducive business environment (protectionist policies of some countries) and promoting start-ups with innovative mindset by supportive state policies and environment are some methods that the government can adopt.
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