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What economists can teach us about cloud computing

Bernard Golden | July 9, 2013
William Stanley Jevons was a Victorian-era economist who explained why Britain used more coal, not less, as the resource dropped in price. Ronald Coase wrote his seminal work on why people use firms to conduct transactions back in 1937. Both help explain why this is the era of cloud computing.

Jevons Paradox is widely discussed, with respect to cloud computing, thanks primarily to Simon Wardley. While the "true" cost of cloud computing vs. on-premises IT infrastructure is quite controversial, there's no question that, for short-term resource use, on-demand pricing is far cheaper than the traditional IT cost associated with upfront capital expenditure.

Just as Jevons would have predicted, users who found traditional IT pricing burdensome and cloud computing on-demand pricing congenial have begun finding vast new uses for computing, based on the cloud's lower costs. Applications that could never have been cost-justified under traditional IT economics suddenly become affordable.

Particularly relevant here are the type of applications that in the past could never have been cost-justified-the so-called "systems of engagement" such as company-based social media campaigns that, since they are not tied to economic transactions, struggle to be justified. With the cost of putting these types of applications in the cloud plummeting, there has been an explosion of system of engagement applications.

Firms Exist to Reduce Costs, But This Only Goes So Far
Jevons isn't the only economist who has something to teach us about why cloud adoption is so massive. A second economist is even more important to the adoption explosion: Ronald Coase, whose relevant work, The Nature of the Firm, was published in 1937. (Remarkably, Coase is still alive and kicking at 102 and, one hopes, basking in the renown his work quite rightly deserves.)

In his article, Coase asked a question that hadn't been examined before: Why do business organizations exist? Why don't individual actors buy and sell among themselves, using the market to set prices, thereby ensuring prime economic efficiency?

His answer? Transaction costs. The cost of using an external resource includes not only the price of the resource, but also associated costs: Searching (seeking and identifying the right resource), bargaining, protecting trade secrets and so on. It can be more efficient to employ people to provide resources, as the associated costs are avoided and the total resource cost is lower.

However, there are natural limits to this centralizing advantage. Coase notices that "decreasing returns to the entrepreneur function, including increasing overhead costs and increasing propensity for an overwhelmed manager to make mistakes in resource allocation."

Here's a vivid example of how these overhead costs play out in IT. A friend recounted that gaining access to a server required eight separate emails, spread across five days. This for a high-priority project. Set against this, the attractiveness of immediate availability of resources from a CSP is easily comprehensible.

In essence, shadow IT represents the struggle created when a high-transaction cost environment (manual IT processes) confronts a low-transaction cost environment (self-service cloud computing). Application groups are choosing cloud computing in hurricane proportions. The choice-even if the low-transaction cost environment ultimately costs more money-is understandable when examining the full transaction costs of the internal alternative.


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