Why companies?

For the past decade or so, there has been increasing debate among academic economists as to the practical limits of economic theory, specifically as to how much people are actually capable of optimizing (the financial crisis and the human element that caused it has in some ways brought this question to the forefront of public debate). I thought it would be interesting to take a look at one area of possible suboptimality that economics and social theorists haven’t come up with much agreement on, firm theory.

About 250 years ago, Adam Smith said that free trade between individuals, without any oversight from government (edit: OK, he talked a lot about lighthouses too, and thought government should step in where companies wouldn’t, but not an important nuance in this case), will lead to optimal allocations of resources and the most productive society. And yet firms don’t fit in well with that theory. Why should managers be any more competent at allocating a worker’s resources than the worker itself? If individuals are such good optimizers, shouldn’t each person in an assembly line buy the widget from the person behind them and sell it to the person in front, rather than pass it from one to the other and collect a wage?

The above example may seem silly to us, but it took until 1937 for Ronald Coase to develop a formal theory that arrives at the same conclusion as our intuition. This was the transaction cost theory, which stated that a firm’s size is determined by the relative levels of internal and external transaction costs that a firm faces. To put into simple English, if it costs more for two people to complete a transaction if they are operating as separate entities than it would if they were part of a firm, they will form a firm. Otherwise, they will remain independent.

This can be applied to the assembly line example: it is simpler to have a line of people controlled by one manager who owns the whole factory than to have each person rent their portion of the factory, negotiate contracts with each of the other workers, not to mention hire accountants, sales reps, etc. Assuming that tangible economic costs existed for each transaction, Coase’s idea reconciled the firm with Adam Smith.

In the end, however, Coase’s theories were grounded in the assumption that people were optimizing – he was merely suggesting that there was an extra variable in the optimization equation. In order for this assumption to be true, it is taken for granted that managers are motivated strictly by maximizing company profit.

Many behavioral scientists, social theorists and journalists have worked to show that this assumption doesn’t hold. The current view is to be that managers will work to increase profit to a certain target, but once that target is met, they tend to focus on maximizing other variables, such as their prestige, total revenues (as opposed to profits), power, security and so on. The bigger the company, the more layers of inefficiency between the actual production and the owners (who presumably have the greatest interest in maximizing profit, though even owners may be negligent or possess other motives for their company).

Much of this is born out anecdotally. One of my favorite examples is a meeting I ran with a company, where I opened with some cliché about how it’s possible to increase profits either by increasing sales or cutting costs, or preferably both, and was cut off by the manager present, who said that they didn’t want to look into cutting costs, just increasing sales. And it makes sense – growing sales numbers look more impressive on a PowerPoint. People are agents of self-preservation – few will sacrifice their own gain for that of distant shareholders.

Not only does everyone who has been in the workforce have their own pet story of corporate inefficiency, but we see plenty of examples for how productive entrepreneurs are. From entrepreneurship mind Paul Graham: “”People are dramatically more productive as founders or early employees of startups—imagine how much less Larry and Sergey [of Google] would have achieved if they’d gone to work for a big company—and that scale of improvement can change social customs.” And yet to date, we have not seen a significant change of social customs outside of a few start-up havens. Firms remain the organizational unit of business. Why?

An idea that I want to put out is that while companies may seem like they are economically inefficient because managers are not maximizing profit all the time, it is precisely their role as a social, rather than purely economic, construct that makes them more efficient than self-employment. Let me explain.

For the past number of months, I’ve been working in a company where I cannot communicate with most of my colleagues, for language reasons. In many ways, I’m not actually part of the company in an organic way – I’m not part of the social fabric. And, not to put too fine a point on it, this makes working really difficult. We have a lot of departments, and outside of the one or two that I deal with on a regular basis, it takes a lot of effort to go and work with one. You run into a lot of resistance, you never know who is in charge, or what they want or what they’re doing. Once you develop a working relationship with that department, it gets a lot easier, but getting to that point takes a lot of inertia.

This is what a lot of entrepreneurship runs into – you have to deal with a lot of other companies, agencies and individuals that you lack any previous connection to, no social context for approaching, and at least my personal experience, there is a huge upfront cost in getting past that. Entrepreneurs thus become like the nerdy kid during a group project in high school – they either have to make an effort to bring the group on the same page with them, or they just suck it up and do the whole project themselves (which is why so many founders of companies manage every part of the company, from the accounts to the graphic design, and have trouble either delegating or outsourcing that work). It is not surprising that so many entrepreneurs are either very social people who enjoy networking and marketing themselves, or else workaholics who are fine with (and good at) executing every step of the business process. Many are both.

A functioning company, on the other hand, essentially gives people an excuse and a social context for working together and asking each other for things. Managers enforce that social context (whenever I have trouble talking to one department, I ask whoever is in charge of both that department and my department to mediate). In some way, a company is for doing business what a shared-interest community is to making friends. A company is still a group of individuals doing business with each other, it just normalizes the process by giving people an excuse to feel comfortable working together, much in the way that joining a community gives people an excuse to meet people and make friends.

This is at least to some extent why start-ups tend to be clustered in geographic areas. These areas have whole social structures that support their start-up scene. It is easier to marshal the resources you need for a start-up because people expect you to be doing that – there is much less of that initial inertia that I mentioned. Silicon Valley is more than just a high concentration of entrepreneurs – it is an entrepreneurship community.

There are two unrelated ideas I would like to draw from this. One is more about economic theory, and the other about the future of firms. One of the apparent shortcomings in economics, if what I’m saying is true, is that it does not account for this inertia. In many ways, this inertia is like a social fixed cost: we have to invest some larger-than-normal amount of effort to start doing business with an independent unit that we have no connection with (much in the way it takes a lot more effort to approach an attractive guy or girl without any introduction).

The main problem is that while non-fixed social costs are easy to incorporate into traditional economic models, fixed social costs are hard. Fixed monetary costs are solved by efficient credit markets, but there is no such thing as social credit markets. As such, people can presumably be constantly stuck in a sub-optimal economic position, like working in firms, just because it is the only way to get rid of these social fixed costs. I’m not sure what all of the implications would be, but it’s an interesting point to consider.

In terms of the future of firms, I think there may be some big changes in the air. Economists like to say that the advent of the internet, while significant, pales in comparison to the advances in shipping technology, starting with the steam engine. And in some sense, this is true – the economic savings from falling shipping costs are much larger than the economic savings gained from falling information transfer costs (after all, the value of physical goods consumed dwarfs the value of information consumed).

What economists rarely consider, however, is the impact of the internet on social costs. For whatever reasons, social fixed costs seem to be drastically reduced through the anonymity of the internet. People find it easier to make the sort of basic relationships that could be conducive for business through the web. And now, it is possible to do so much business or outsourcing without ever having to talk to anyone. Consider how many social interactions it would take to hire a freelance programmer in India through a site like guru.com, versus trying to do that without the internet. I won’t pretend to understand the actual social underpinnings of this, but most people are probably familiar with this effect.

And of course, information is becoming more centralized, more easy to access and transmit and more global (though to some extent less anonymous). Are we in store for a self-employment revolution? That might be too big a claim, but I certainly think that we will see firms shrink in size, and increase in productivity. I wouldn’t be surprised if when the economy starts picking up, we start noticing a lot of people employing themselves in America, which could catalyze a broader shift in employment trends (and Europe, which is holding up its employment safety as a model for stability, will miss out, as usual).

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5 Responses to “Why companies?”


  1. 1 Momin June 5, 2009 at 10:44 pm

    About the inertia and economic theory… it is indeed an interesting point to consider! But I’m skeptical that what you’re suggesting is hard to incorporate into existing models. It doesn’t seem like the social costs you talk about are fixed; aren’t you saying the cost decreases as time increases (as you network, etc)? So you could have a cost function that takes time and firm size as exogenous and effort as endogenous (I was taught moral hazard from a model that takes ‘effort’ as an endogenous variable so I guess it’s legit). The model would say something about how individuals would maximize over effort while the market optimizes for firm size. Then you might model the role of the internet as a coefficient of effort.

    • 2 JSC7 June 10, 2009 at 11:58 pm

      Well the distinction between fixed and variable costs is a loose one, even in the purely monetary sense. Over the long, pretty much all costs become variable. What I’m saying is that for each additional non-pre-formed social interaction, there is a large upfront cost, which, when paid, gives way to relatively low variable costs. No matter how many social interactions you need to tack on, that fixed cost will always be there for each one, unless you train yourself to reduce it (possible, obviously, but not how most people operate).

      The reason why I think it poses a problem to economics isn’t that it would be difficult to model in a mathematical sense, but because the conclusions wouldn’t be the kind of thing that economics is made to handle well. It would lead to a steady state where if we could get over these fixed costs, we would be more efficient, but no one does get over them, because the standard way over getting over a fixed cost – credit – is of no use to social fixed costs. It becomes a game theory problem where its really hard to move to the optimal allocation.

  2. 3 David(P) June 6, 2009 at 10:07 pm

    This is a very interesting post. It touches on a lot of ideas that I’ve been thinking about for a while.

    I’m sure at some point in college they briefly mentioned that our assumption that firms and markets making optimal choices was over-simplified for the sake of being able to construct coherent economic models.

    Going to school in Southern California I came into contact with a lot “business people” that were just mad about real estate. Real estate is what they wanted to do. They felt about it how guys on wall street probably felt about trading equities. That it was the supreme level of business activity that one could conduct. I think we’re seeing a lot of this in Vietnam as well. Building for the sake of building, villas for the sake of villas. These people are not rational optimal economic actors slowly nudging the system towards equilibrium. These are stupid people with too much money. This is the real economy.

    It took a huge market catastrophe to effectively signal that these firms and these folks might be on the wrong track. This system does not have the subtle sensitivity that our calculus curves would imply.

    So yeah, firms are dumb, fuck em. Let’s all work for ourselves.

    This idea has been bouncing around the blogoverse for years now. Guru.com is one of many similar sites (elance, rentacoder, odesk, ifreelance, sologig, bitwine, etc.). This stuff is even discussed in “The World is Flat”, so this idea has been around at least long enough that it slowly managed to burrow it’s way through Thomas Friedmans thick skull. A lot of bloggers, myself included, have carefully built their “personal online brand” in an attempt to support a search for independent work.

    As a worker I hope to do as much work as possible outside of traditional employment relationships. I love the idea of showing up, doing my thing, and getting paid for my work, rather than my time spent sitting in a office looking busy. I don’t trust employers to pay me fairly and support me through retirement. That era seems to be bygone.

    As a (somewhat crappy art licensing) business owner I built my whole business around the idea that we can outsource everything, the design, the printing, the warehousing, the marketing, the credit card processing, the shipping, and the accounting. We originally ran the whole thing out of a single three ring binder.

    (Once for a class we had an employment attorney give us a lecture on all the different things your employees can sue you about, and how impossible it is, even in America, to fire people. It’s terrifying.)

    So while the idea of doing away with traditional firms and employment is nice, much like in the case of the inverse idea of efficient and rational firms, reality hasn’t quite caught up yet. I don’t get a lot of job offers from people who read my blog. Our little business wasn’t able to compete with the big guys doing things the old fashioned way by keeping most of their value chain in-house. I can’t quite imagine an assembly line in a factory being reduced to individual agents communally coordinating their individual economic activity. I doubt they could get themselves up to six sigma, and I’m afraid to think how the porter model would play out along each step of the process. I think our culture is still just too entrenched in the idea of the firm.

    The funny thing about all this is, despite the progressive business culture in Silicon Valley, Vietnam is really the kind of place where I can see this working first. We’ve both had the experience of showing up at some street restaurant, ordering something off the menu, and seeing the waiter bring the dish in 10min later from their friends restaurant across the street. Vietnam has that culture of flexible systems and improvisation. They have whole towns that produce pottery, silkstuff, and or whatever that just consist of individuals sitting around doing their step of the process. All those street vendors are actually freelance sales people. I’ve interviewed a few of them, and they all show up in the morning at some larger distributor of fruit or rubber sandals or whatever, borrow two big baskets worth for the day, and come back with their earnings and extra inventory in the evening.

    So yeah, big firms are dumb, there is a lot of potential for people to take that coordination into their own hands, but I don’t think American culture is ready for that on a large scale. But for programing, graphic design, and a few other types of work it’s already moving in that direction. It might be the developing world that leap frogs us on this, if they ever manage to realize that our ways of doing things actually suck.

  3. 4 David(P) June 6, 2009 at 10:12 pm

    followup: another reason the developing world would be better adapted to flexible employment systems is that they often have a much better ability to absorb an inconsistent income stream.

    Americans have mortgages, insurance, $100 monthly iphone service, kindergardens for the kids, retirement homes for the grandparents. We need our steady wage, and we’re willing to give up a lot for it.

    In Vietnam the kids and the grandparents are at home, the cell phone is $5 a month. If you have a good year you buy a car or build another level on your house, if you have a bad year you eat pho. No big deal.

  4. 5 JSC7 June 11, 2009 at 12:08 am

    Obviously, this change will be a matter of degree (which, granted is a cop out to say, because everything’s a matter of degree, but whatever), and not necessarily spread to all industries with equal speed. With regards to your art licensing example, sure, it may have been hard for you to compete with the established names, and that’s always going to be the case simply because these things are slow to change and poster selling isn’t going to be a hotbed for innovation. I guess my point would be that while not every poster start up that’s small will succeed because it’s small, if a poster start up were to succeed, it would probably because of its small size, which would allow it to push the envelope on efficiency. You need to do a lot of other things right outside of being compact, and that’s maybe where you guys ran into trouble, but you would have had an even tougher time, by this logic, were you to have started a new, large poster company.


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This is a group blog. JSC5 currently writes from the US. JSC7 writes from behind the Great Firewall of China.

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