Why Do Large Firms Exist?

Wille Faler has written an interesting post, in which he points to inefficiencies in large firms (and governments), and predicts that the future belongs to smaller players, such as start-ups.

Large corporations as well as public sectors are hugely inefficient, and for good reason.
Both sides are to an alarming extent run by career bureaucrats: peoples incentives are bound to activity based targets rather than value based achievement.

The blog post makes a lot of sense. Given this, one is led to ask: Why do large firms exist? How can these bureaucratized beasts survive in the marketplace? Perhaps their size makes them more powerful rent-seekers, but even I doubt that that is sufficient to keep them afloat. Arnold Kling speculates on the topic, over at EconLog, although he ask the question the other way round. Given that large companies, in theory, could decentralize and let each department be run as a small company, why don’t they? They would have all the advantages of a start-up, plus the benefits that comes with size. In fact, why are there small firms at all? He provides three possible explanations:

  1. CEOs overestimate their ability to run their businesses.
  2. Firms are not primarily about making profit, but rather they are status games where people compete for top spots in the hierarchy.
  3. Risk management.

I think there’s something to all three of those, along with the rent-seeking potential (although decentralized firms would retain that potential). As 1 and 2 does not explain how large firms can survive, the question is if 3 can sufficiently compensate for this.

Ultimately I think there’s a lot to this:

Presumably, large firms will tend to be found in industries where large firms have a comparative advantage. It is not in the interest of managers of large firms to try to run divisions in a way that replicates the behavior of small firms, because that would be throwing away their comparative advantage.

And, with that in mind, I agree with Faler — start-ups will grow in importance in the foreseeable future. In the creative service-industries, responsiveness and communication with one’s customers, are necessary to be successful, and a large organization is not well suited for that. My prediction is that such firms will make up an ever larger share of the economy as technology drives further automation, and globalization means that others can do manufacturing and other large-firm businesses more efficiently.


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