Large Or Small: Does it Matter?

There is a thriving industry at the moment discussing the importance of size in business. More to the point: it is the relative lack of size that seems, to some, to be the epicenter of competitive failure in Europe’s sickly peripheral economies. The Economist has waded in with its usual straight from the textbook appraisal. There is, so they say, a direct relationship between the small scale of Greek or Portuguese business and the lack of competitiveness that has amplified the disruptive nature of the financial crisis and led to the roiling balance of payments crisis that threatens the Euro.

Quite a few European nations protect, or differentially treat, small businesses. The French, for instance, have a slew of rules that kick in the moment a business employs more that 50 people. Look at the distribution of size, by number of employees, within French industry and you see an enormous skew towards 49 and under.

While it would be nice to pretend that this reflects French entrepreneurial spirit and the constant start-up of new ventures, a more likely interpretation of this distribution is that most French business managers attempt to keep their enterprises small in order to avoid red tape and higher taxes.

This is quaint. It is not sound business. It is a stark reminder of the way in which government policy can shape the business, and hence the economic, landscape. In their eagerness to protect small business the French have erected barriers that prevent the natural development of scale in industry. Instead of producing competitive businesses regardless of scale – which should be a function of basic competitive trends in an industry – French politicians have privileged the small and inhibited the workings of the marketplace. They run the risk of their economy failing to adjust to global conditions.

Is this a bad thing?

That, I think, is the correct question to ask.

‘Small is beautiful’ was a refrain tossed about not long ago as the first signs of globalization washed ashore in Europe and the US. The emergence of large-scale business – back then it was in the form of anonymous conglomerations – stuck in the craw of many analysts who held to a more traditional view of business. The scale of ‘big business’ has always been an anathema to some, despite the obvious efficiencies that scale endows in certain industries, and so resistance to size developed. especially on the left in politics.

The problem is that the economics of business and the politics of business collide. This is a phenomenon oft noted – Adam Smith was famously leery of the moral worth of business people and their likely attempt to skew politics for profit.

The modern business firm exists to fill a gap that the open market fails to cover. It allows for the central control of resources to be dedicated towards a limited set of goals – producing cars for instance. Those resources are usually very specific to the task at hand and so their purchase represents a significant risk. They are also very expensive, which magnifies the risk. Further, the inherent uncertainty of the economy buffets anyone attempting to undertake production tasks that consume large chunks of time – again producing cars is a good example. So there is a very large co-ordination problem to be resolved that an open market fails to deal with precisely because of uncertainty. Lastly such tasks require the ongoing and intricate fitting together of a web of skills, both embedded in technology and in labor. Those skills are often needed in precise order and within tight timeframes. They have to be guaranteed, or the entire production process can either grind to a halt or not even begin.

The business firm solves this challenge. The marketplace fails the same challenge.

It is the emergence of complex production processes that consume time, skill, and dedicated assets in the face of ongoing uncertainty that led to the invention of modern business. Parenthetically it is also this emergence that both classical and Austrian style economics fails to grasp or encapsulate within their respective theoretical constructs. Complex production invalidates the simplified worlds at the chart of both.

Thus modern economics gets to grips with this phenomenon only tangentially. The theory of the firm is often treated lightly or, more often, with laughable disdain in most textbooks. Business, to most economists, is a black box that, at best, is peripheral to economic theory. Despite the fact that an increasing percentage of all economic transactions take place within, and not between, business firms. Certainly the number of transactions that represent final sales to consumers is smaller that accumulated number of transactions that end up as the product being sold. The final sale is just that: an endpoint in a long chain of transactions, most of which are protected from the vicissitudes of the market by being protected within the centralized, hierarchically managed, and authoritarian atmosphere of business. If they were not thus protected they would not take place: the decentralized marketplace has no way of balancing – sufficiently – the information needs of production with the encroachment of uncertainty. At least where production is complex.

It is the necessity of centralized management not complex production, as found in modern business, that is so disruptive to the central claims of orthodox economics. It ought not to be this way. But it is. So most economists simply ignore the problem and carry on as of we live in the late 1700’s.

So size does matter.

Complex production managed in a centralized and authoritarian process reaps great rewards. By creating the illusion of certainty within its boundaries a business firm enables the chain of transactions to exist insulated from the destructive and corrosive forces at work in the open market. It is an illusion – the end product may not feel at the desired price – but at least the product can be re-priced. Or, and here is where scale matters, the cost of production can be managed independently of those external forces. Cost can be adjusted. Expectations can be aligned with outside conditions. More importantly, those expectations can be managed.

One of the most potent – if not the most potent – method for adjusting those costs is the establishment of the boundaries of the firm. Indeed, in my view, the most important single decision a modern business manager faces is in setting those boundaries. Which part of the production chain, how much of that sequence of transactions, or which activities should be enclosed? What can be left out?

This is not simply a question of outsourcing or any other faddish technique. It is a fundamental question of size. How much of the process needs to be centrally managed? How much can be allowed to be tossed into the waves of the open market?

This is a decision that will vary according to industry. Technology, and particularly information technology, alters the exact pitch of the boundaries constantly. The cost of centralized management has to be balanced against the possibility that the open market can manage certain parts of the process more cheaply.

By privileging small business, for whatever reason, politicians prevent businesses from making the boundary decision on purely economic grounds. Other factors are allowed to play a role. These other factors include a cultural or social preference for small business; attempts to preserve traditional production methods; a need to protect a strong political lobby – family owned businesses for instance; an aversion to global competition; and the mistaken notion that small business is the engine of most employment generation.

This latter point is particularly important here in the US.

We hear repeatedly that we ought to protect small business because it is the engine of job creation. This is not entirely true. At any moment small business employs more people than large business. But that is not a measure of vibrancy. It is a measure of volume. Most businesses are small. They start that way. Most die off that way. Jobs are destroyed continually as small businesses fail. There is no rule or iron clad law that tells us small business is better at creating jobs. So entrenching protection of small business is not based on anything inherent in business. It is based on a bias in politics.

The net result of this bias can be that an entire economy is wrongly scaled. Collectively the boundary decisions being made within an economy are at odds with the wider global economy. This results in a endemic or pervasive lack of competitiveness that manifest itself, amongst other things, in a balance of trade imbalance. Greece and Portugal both suffer from this problem, as do other European economies to a lesser degree.

All this is, of course, entirely different from a discussion on the social responsibility of business. For the record I believe that business should be left to make decisions for economic reasons and then coerced to be good citizens. That’s what regulation is for. But the first impulse of business should be to seek profit. Once that impulse crosses socially acceptable lines it ought to be constrained or prohibited. In particular so-called ‘externalities’ should be forced back inwards onto the shoulders of the shareholders.

But that is a different discussion.

This is about size and where the boundaries of a firm are set. The forces at work dictating those boundaries are always in flux. So too then are the boundaries themselves. Arbitrarily limiting them is to deny the existence of change and uncertainty. And the result of such denial can devastate an economy.

In this instance the Economist has a case. It just didn’t argue it well.