You can argue that Ronald Coase, who died this week, was a greater economist than Friedrich von Hayek, Milton Friedman or Maynard Keynes (in descending order of competence). The Coase Theorem, propounded in his 1960 “The problem of social cost” is one of the most important rationales for distrusting state regulation, and preferring the tax mechanism when you need to account for externalities. His earlier 1937 paper “The nature of the firm” is even more important, essential to understanding how and why firms agglomerate. However in the world of ever-faster communications and more powerful IT, Coase’s 1937 paper has interesting implications: it suggests that in the next few decades, large firms may disappear altogether.
Coase’s work has been much used in designing the interactions in regulated industries. His 1959 paper on telecoms regulation first led the FCC to auction radio wave bandwidth rather than simply allocating it by regulator fiat, and has thus been responsible for much subsequent development in communications, allowing especially the development of effective cellphone technology.
His social cost paper showed that most externalities could best be dealt with by taxes rather than regulation, since the market would then allocate resources optimally, given the tax as an additional cost. Thus if global warming is real, it is best combated with a carbon tax rather than through regulation or by means of state investment in green technology, both of which allocate resources sub-optimally. Coase’s work is especially important in the regulatory area, since it shows that even apparently innocuous regulations, by blocking economic activity that would otherwise have taken place, may have unexpectedly onerous costs.
Coase’s “The Nature of the Firm” looks at the economics of corporate formation, balancing the costs of transactions between very small economic entities against the dis-economies of scale inherent in large agglomerations of labor and capital. Within a firm, resources are allocated by direction from the top down, and so do not necessarily follow the directions of the price mechanism – a workman changes departments, not because he will be paid more in the new department, but because his boss tells him to change.
According to Coase’s paper, under pure capitalism an individual workman, perhaps the man who puts the heads on the pins in Adam Smith’s pin factory, would buy un-headed pins from a colleague, would put heads on them, and would sell the headed pins to another colleague for finishing. Coase points out that such a workman would suffer unduly high transaction and negotiation costs, bargaining for his supply of un-headed pins each day, financing the inventory of pins on which he was working, and marketing the headed pins to his next colleague, finding an alternative buyer of headed pins if his next colleague was sick or wanted to take a holiday. Thus the worker finds his income is maximized by working within a pin enterprise, including other colleagues who buy raw materials, sell only finished pins, arrange financing and pay the workers regularly.
Coase’s paper thus satisfactorily explains the rise of General Motors and the like. An automobile is a large, complex object; it is thus most efficient to collect all the activities required to assemble and market such a product within one entity, with only peripheral activities such as parts manufacture, tire manufacture and retail dealerships separate. With the technology of 1937, or indeed of 1970, large vertically integrated companies seeking to establish global market dominance in a sector were inevitable. Indeed, at that time improved communications fostered the development of global titans, because they made it more efficient to organize a business spanning the globe and made that business more cost effective against local competitors.
In Coase’s paper, the limitations on a firm’s size are overhead costs and the tendency of the manager to make mistakes in resource allocation. It’s easy to see that in very large firms, these costs increase exponentially. For one thing, instead of a single manager, very large firms have a hierarchy of managers, and resource allocation becomes political, with committees overseeing all substantial decisions, and managers competing internally for a greater share of the firm’s staff and capital resources. These costs are very real; they explain the failure of the 1960s conglomerates, in which diverse businesses proved to be more efficient as independent entities, and not when saddled with layer upon layer of overhead-adding office politicians.
The interesting question is thus the effect of technological development on firm size, assuming Coase’s paradigm of how optimal firm size is determined. Improved communications make it technologically easier to manage operations that are very geographically diverse, but on the other hand automation reduces the optimal number of employees by increasing the size and complexity of operations that can be undertaken by a single human employee. Thus General Motors’ employment peaked at 600,000 in 1979 and has since declined to 212,000; that’s not just a function of the company’s decline in market share since Toyota, the world’s #1 manufacturer making more vehicles (9.9 million) in 2012 than GM manufactured in 1979 (about 7.8 million), has only 326,000 employees. Thus some Coaseists claim that improved communications, by making it easier to manage a larger agglomeration of business, facilitate consolidation.
When you consider the effect of the Internet and computing power revolution of the last 20 years, however, it becomes obvious that Coaseist principles should lead us to expect the opposite effect. Computing power, which in 1980 was concentrated in mainframes controlled by large corporations, has been devolved to the individual level, and information can now be disseminated instantly to individuals all over the globe.
As for Coase’s transaction costs, if Adam Smith’s pin manufacturers had access to modern IT, it is not fanciful to suppose that they would have been able to devolve the task of negotiating for headless pins and selling headed pins to their cellphones, which would be able to use standardized algorithms to find the best price available at each stage of the production process and arrange the logistics of delivery and payment. Thus the new technology reduces transaction costs to zero, potentially enabling much smaller production units to operate independently.
Conversely, however, the new technology does nothing to reduce the bureaucracy and office politics costs of large organizations; indeed it potentially increases them. Bureaucracies are able to demand ever more onerous reporting from their members, and indeed to control their members’ Internet usage and monitor their communications and minute by minute activity in a way unthinkable 30 years ago. By destroying privacy, the new communications facilitate bureaucratic intrusion and disruption of the employees’ activities. Meanwhile devious back-channel interactions undermining organizational rivals become much easier in a world where physical presence is no longer required to communicate a subversive message.
Given human nature, the new communications methods will be used to facilitate the negative interactions of large organizations at least as much as they facilitate business-assisting interactions. In large organizations, the dysfunctionality of the new technology, its potential for harassment, is far more important than its functionality, lowering barriers between business units separated by mere distance.
Since the new technology facilitates communication between individuals, and negotiation between them, it greatly reduces Coase’s costs of isolation, making small organizations more competitive with large ones. It thus shifts the size break-even sharply to the left. The extra costs and inefficiencies of organizations with 10,000 or 100,000 employees will no longer be so fully offset by their economies of scale and business units will become atomized.
Is this actually happening? There are some signs of it. In the Old Economy, one of General Motors’ advantages was its more efficient access to capital. However recent legislation and monetary policies have greatly reduced the capital cost differentials between large and small companies. On September 23, the SEC, under the provisions of last year’s JOBS Act, will lift the prohibitions on direct solicitation of small investors, thus allowing “crowd-funding” of start-ups and small companies.
Of course, the initial effect of this liberalization, in a bull market with easy money such as today’s, will be to spawn an immense flood of crooked schemes whose sole purpose is to relieve retail investors of their money. Initially, the new rules will spawn a million mini-Madoffs. In the longer term however, once a recession and a period of tight money have driven the crooks out of the crowd-funding business, the differential between funds availability and cost for small and large companies will be much less than has traditionally been the case. After all, the problem for small business has always been that funds availability has tended to dry up altogether except in bull markets, thus leaving small companies forced to overfund new projects and maintain costly cash reserves in order to survive a credit crunch.
Manufacturing and marketing are also much easier for small companies than they used to be. It is no longer necessary to maintain a nationwide presence and launch a massive ad campaign to market a new product; the Internet, Amazon and social media will do just fine. Similarly, many of the economies of scale have gone out of manufacturing and design; if General Motors is trying to tailor each car sale to individual customers’ requirements, it becomes much easier for a small competitor with an arrangement with a manufacturing facility to produce to the customer’s order at a competitive cost.
Coase’s work on firm structure, when analyzed in conjunction with modern communications and IT capabilities, thus suggests that large companies will over the next generation disappear, as small ones, without their costs of bureaucracy and politics, come close to their financing costs and undercut them in manufacturing, marketing and overhead. Not only are we looking today at General Motors-saurus, therefore, but also at Citi-saurus and even Apple-saurus. Only the government will remain, providing suitably slow-moving and bureaucratically complex drudge-work for those not capable of independent or small-group existence, or who find office politics endlessly fascinating.
Downsizing the government will also eventually happen – but will take at least another generation.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)