by Megan E. Hansen, Research Director
Posted March 13, 2019 In Scholar Commentary

This article was originally posted on the Medium publication The Benchmark

A few decades ago, renting your home to a complete stranger for the weekend seemed crazy. How will you know whether you should trust the person not to ransack your home, throw a huge party, and leave the mess for you to clean up when you return? Getting into a stranger’s car 20 years ago? No way. Putting your kids in a stranger’s car? Not a chance.

Today, all of this seems completely normal; what’s more, it seems strange not to use the apps and platforms that have become so central to our lives. Airbnb and other platforms in the sharing economy have convinced us to trust complete strangers with our most valuable possessions and, in some cases, our loved ones. And we are doing it at an astonishing scale. Over 2 million people stay in an Airbnb rental every night.

It may not feel like it, but we are witnessing an amazing feat of coordination that is worth reflecting on. But first, let’s reimagine the not so distant past. Let’s imagine you’re considering buying a used car from a complete stranger. Before you can feel confident making this transaction, you’ll need to gather a lot of information. You’ll want to make sure you understand the terms of the agreement and have good information about the reputation of the seller and the quality and condition of the car. Has the car received regular maintenance? Has it ever been in a car accident? Even if the seller will provide this information, how can you know if he is telling the truth?

Now what kind of information would you need before getting into a stranger’s car? What would you want to know before agreeing to stay in a stranger’s home? What about renting a room from a homeowner who will also be staying there? Acquiring and using this information are what economists refer to as transaction costs. These costs include all of the time and effort (and possibly financial costs as well) that we must undertake to gather information before we can feel confident that a transaction we’re about to make is legitimate. The economist Ronald Coase described transaction costs in his Nobel lecture:

What the prices are has to be discovered. There are negotiations to be undertaken, contracts have to be drawn up, inspections have to be made, arrangements have to be made to settle disputes, and so on.

In an interaction where you know little about the person you’re working with, transaction costs can be high. A decade ago, the transaction costs were prohibitively high. We didn’t spend the night in the homes of complete strangers, put our kids in their cars, or get in them ourselves because we didn’t have enough information to feel safe doing so.

The sharing economy is reducing transaction costs

In today’s digital economy, platforms have reduced transaction costs by providing consumers with greater access to information about who they’re interacting with and what the terms of the transaction will be. And the two-way rating systems provide even more information by allowing both sides of every transaction to continually provide instant feedback about their interactions. For example, when you call a Lyft to meet up with your friends, you are prompted to rate your driver at the end of your ride, but your driver also gives you a rating as a passenger. Just as passengers can request a driver with a minimum rating, drivers don’t have to accept requests from passengers who have low ratings either.

Forquet, Larson, and Cowan at the University of Waterloo have written about how reputational mechanisms like two-way reviews can help establish trust by reducing uncertainty:

Feedback systems, or reputation mechanisms, increase trust and trustworthiness among strangers engaging in commercial transactions. They provide summarized histories of past behaviour, increasing the opportunities of well-behaved participants, and decreasing those of poorly-behaved ones. They thus improve trust by rewarding cooperation

In addition to sharing information and allowing for two-way ratings, businesses operating within the sharing economy have realized they can increase the number of transactions taking place by providing additional assurances about how transactions will be monitored and enforced. For example, in case a rental doesn’t go as planned, Airbnb now provides all hosts with $1 million in free liability insurance for every listing. The company also monitors risk by conducting background checks on hosts and guests and by scoring every reservation for potential risk using predictive analytics and machine learning.

Services like these further reduce transaction costs and encourage participants to trust in the strangers they are interacting with online through services like Turo and Airbnb. In their 2016 paper, Adam Thierer, Christopher Koopman, Anne Hobson, and Chris Kuiper described this development:

While eBay and Airbnb started primarily as a simple service-listing platform, it soon became evident to both that adding services and mechanisms to enhance trust in the transaction would be valuable to both parties. This frees people from having to critically evaluate each individual with whom they interact, thus lowering transaction costs. What these systems have in common is that they radically lower transaction costs by making hassle-free cooperation among diverse parties easier than ever.

Lowering transaction costs benefits gig workers, too

While much of the literature has focused on how reducing transaction costs benefits consumers, the growing number of workers in the gig economy also benefit from technological advances that provide more information than ever about a particular person’s skills and abilities to potential employers. Employers benefit too, as they can use this information to decide which freelancers would make the best partner for a particular project.

Ronald Coase, in his famous article titled “The Nature of the Firm,” explored how transaction costs impact a company’s staffing decisions. Coase explained that firms bring in traditional employees (W-2 workers) because there are often high transaction costs to simply interacting with separate contractors (1099 workers) in an open market. These include the time and effort needed to evaluate potential contractors for each project to see if they will be a good fit. They also include effort spent negotiating with that particular person and coming to an agreement about the terms of employment. Finally, the transaction costs of working with contractors also include any efforts needed to monitor and ensure the work is being done properly.

Firms respond to high transaction costs by bringing in full-time employees that they can direct without having to create a separate contract for every transaction. Working with full-time employees also helps solve the principal-agent problem that can arise when working with contractors. Contracted employees likely do not have the same interests as a traditional W-2 employee and, as a result, it can be more difficult to align the incentives of the company with those of the contractor. Contractors can also decide which projects they’d like to take on and which do not interest them, whereas traditional employees must take the whole package.

When the transaction costs of working with freelancers are high, it makes sense that companies will tend to prefer bringing on full-time employees. But when transaction costs fall, it becomes much easier (and less expensive) for companies to partner with a contractor on a particular project rather than trying to find a full-time employee that will meet all of their needs.

Thanks to advances in technology, the transaction costs associated with contracting have been falling for some time. Platform sites like Upwork allow companies to post a project and receive proposals from freelancers all over the world. The site also provides reviews and examples of past work to help companies make a decision about which contractor will be the best fit for their project. Finally, just like Airbnb and others, Upwork provides a secure payment platform, further reducing transaction costs of working with a would-be stranger. Freelancers can also use the platform to decide who they’d like to work for and what kind of projects they want to take on, giving them more flexibility to develop their careers in the direction they most value.

It should not come as a surprise that as transaction costs fall, the number of employees per nonemployer firm continues to drop. That is, more and more work is being completed by individuals operating on their own terms rather than within a traditional employment relationship.

What does the future hold?

Consumers, businesses, and gig economy workers all benefit from the increased exchange of information because it reduces transaction costs and increases the potential for mutually beneficial exchange. Platforms in the sharing economy are providing not only online rating systems, but insurance and secure payment systems. The sharing economy is giving us greater reason to trust each other, allowing us to interact in mutually beneficial ways that improve our lives and the lives of those around us.

As Michael Munger, an economist at Duke University points out: The sharing economy is creating two major shifts. We have tended to focus on the first. Instead of purchasing and owning the items we need and want, the trend has been toward renting goods for short-term use. This could have huge benefits in terms of reduced costs for consumers, as we will only have to pay for the use of a particular item during the time when we need it. We also won’t have to pay to store items we don’t use often. In looking toward the future, Munger says:

“If Andy Warhol were alive today, he might describe the new world this way: in the future, people will own stuff for fifteen minutes.”

But the second change is just as important. Perhaps, even, this will be the lasting impact of the growth in the digital economy: Instead of consumers interacting with producers arranged as traditional firms, consumers will increasingly interact directly with other individuals acting as producers. This network is already coming to fruition as individuals can rent vacation homes through Airbnb or buy a ride from their neighbor who has a car and happens to drive for Lyft. We are also seeing it disrupt traditional industries dominated by larger firms.

But these technological advances aren’t inevitable. If we want to enjoy continued improvements in how we interact with one another, we must think carefully about the public policies we put in place to regulate these interactions. If we adopt rules that are flexible and that allow for innovation and experimentation, we are likely to see current trends continue. These reductions in transaction costs will benefit consumers, businesses, and workers alike.

CGO scholars and fellows frequently comment on a variety of topics for the popular press. The views expressed therein are those of the authors and do not necessarily reflect the views of the Center for Growth and Opportunity or the views of Utah State University.