Small Is Ugly!

In the 1970s, one of the most popular books about economics and business was Small Is Beautiful by E. F. Schumacher.  The book makes many valid points, but the thesis encapsulated in the title is misleading. It argues that small businesses are best.  In actuality, most of the progress of the past century or two has come from large organizations, not small businesses.  Big organizations were necessary to produce most of the dramatic economic development of the past two centuries and although some of the changes have been bad, the benefits have been bigger.

That used to be obvious to Americans. Robert D. Atkinson and Michael Lind wrote that

One 1950 poll found that 60 percent of Americans had a favorable opinion of large businesses; more than 70 percent had a favorable view of GM. “We believe today, both inside and outside the business world, that the business enterprise, especially the large business enterprise, exists for the sake of the contribution which it makes to the welfare of society as a whole,” the management scholar Peter Drucker wrote in 1952. “There is, in fact, no disagreement, except on the lunatic fringes of the Right and on the Left.” Today, you need not travel to the lunatic fringes to find suspicion of Big Business. A majority of Americans now view large businesses as self-serving and self-dealing. Only 21 percent of respondents to a 2017 Gallup poll said they have a “great deal” or even “quite a lot” of confidence in Big Business.

I suspect that the median American soured on big business for two main reasons.  First, US businesses adopted the Friedman doctrine in which Milton Friedman argued that the ONLY responsibility of business was to maximize profits for shareholders and the shareholder rights movement further pushed big businesses towards higher inequality and short-termism.  Secondly, globalization makes multinationals care less about the local situations because when the going gets rough, they can just move business elsewhere rather than trying to make improvements.

Would it be better for America if average firm size shrank and there were more smaller firms?  Economists and politicians love to lionize small businesses, but countries with more small businesses (and therefore more entrepreneurs) are poorer than countries that are dominated by big businesses. For example, in the OECD (the club of rich nations), bigger business is more beautiful because OECD nations that are more dominated by big businesses tend to be richer. The US is fortunate to be one of the richest OECD nations perhaps because the US economy is by far the most dominated by large businesses.  All nations that are dominated by small businesses are desperately poor.

Eric Nilsson documented how large US corporations have been growing at the expense of small entrepreneurs.

A  relatively  few  giant  firms  dominate  the  US  economy.  These  firms  are surrounded by a large number of smaller firms. This had led some to argue that the US economy has two quite different sectors: the core and the periphery. The core includes the large giant firms. These core firms are typically able to avoid  extreme  competitive  environments  and,  as  a  result,  earn  higher  profit rates than average. The periphery includes the other firms: small and medium sized firms which face high levels of competition and which typically earn fairly modest profits. …For instance, the US beer industry has about 500 firms. But a few firms in the industry are giants, and dominate the industry… The largest four firms in the industry sell about 90% of all beer in the US. The other 10% is sold by the 490 smaller beer firms.

Nilsson goes on to say,

[G]iant firms are the most important economic actors in the U.S. economy.  These relatively few firms gain control of 75% of the profit (that is, surplus) generated  within  the US  economy and the  decisions they  make about how to use this surplus has major consequences for the evolution of the U.S. economy. And …major  power  in  the  political  and cultural  arenas.  Politicians  must  pay  attention  to  the  concerns  of  these  giant firms because the economic health of the US economy depends largely on the decisions made by these few (but giant) firms. Further, part of the surplus going to these firms is used to shape the cultural landscape of the US economy. The decisions made by these giant firms about what advertising campaigns to carry out, what media to support (magazines, websites, TV shows, newspapers, and so on), and what cultural institutions (museums, symphonies, and so on) has a major impact on the evolution of culture within the United States.

Nilsson shows that the largest 0.2% of manufacturing firms in the United States made 61% of sales and 74% of manufacturing profits.  Big firms also dominate global trade.  According to the Richmond Fed, large firms are less than one percent of all American businesses and account for only about 85 percent of exports and 90 percent of imports. Most of those large firms have multinational operations and the BIS reports that about half of America’s foreign trade is done within multinationals.  In other words, half of American imports are things like Ford Motor US importing parts from Ford Motor China.  It is trade done in a supply chain internal to a firm.

Most Americans work for someone else because that is where most of the money is.  Entrepreneurship is rare because small businesses are usually inefficient and usually fail.  That is why the census data in Nilsson’s book shows that 64% of Americans work for the biggest 2% of America’s firms.  These are firms with over 99 employees and most of the rest of us work for businesses that have over 20 employees.  The BLS estimated that in 2012, only 6.7% of American workers were self-employed entrepreneurs and their unpaid family member.  The self-employed entrepreneur category is so bad that the numbers include millions of unpaid family members!  Needless to say, all of the 93.3% of American workers who aren’t entrepreneurs get a wage.  Entrepreneurs are already a rare breed in America and the BLS expects their numbers to continue shrinking.

For example, farming is one of the most highly entrepreneurial industries, but entrepreneurialism is a shrinking share as the average farm size rises due to increasing economies of scale.  By 2022, the BLS expects that America will have twice as many hired hands as entrepreneurs who run their own farm.  Even farming is going corporate.

While entrepreneurs are shrinking, bureaucrats have been a growing fraction of the workforce for about as long as we have been keeping statistics, as Roy Radner pointed out in 1992:


It appears that small businesses in the US have been growing at the expense of large ones for a few years.  If that would continue, it would begin to reverse a centuries-long trend.  Is that a good thing?  Matt Yglesias argues that it may be a bad sign because he argues that the existence of large businesses is a sign of trust within an economy. Trust is certainly good for the economy and the fact that Americans are more trusting of each other than people most counties has been a boon for the US economy, but there are many causes of the correlation between firm size and economic prosperity.

Economies of scale create efficiencies AND require bureaucrats

Yglesias also argues that Greece, Italy, Portugal, and Spain have so many small businesses because of corruption and poor regulation. They are unable to achieve economies of scale in business and that keeps them poor:

Politicians often tout the virtues of small firms as a way of signaling support for dynamism and entrepreneurial spirit… But it turns out that some of the most troubled economies of Europe are precisely the ones that are most dominated by small businesses. And this is no coincidence. An economy where a huge share of the population works at small businesses is not one that is friendly to entrepreneurs, but rather one that has widespread corruption and poor regulation. The key to prosperity is not to coddle small firms, but to give people the tools they need to start one and the firms that exist the ability to thrive and compete.

John Schmitt, an economist at the Center for Economic Policy Research in Washington, D.C., pulled together some striking data last fall from an Organization on Economic Cooperation and Development report on entrepreneurship showing that the United States has a strikingly low percentage of its workforce employed by small businesses. The countries at the other end of the spectrum, however, aren’t dynamos—they’re basket cases. If you look at share of the workforce employed by firms with fewer than 10 workers, the leaders among OECD members are Greece, Italy, Portugal, Mexico, and Spain. Only 11 percent of employed Americans work at firms with fewer than 10 employees while 58 percent of Greeks do. Expand it to look at the share of the workforce employed by firms with 50 or fewer workers, and you get Greece, Italy, Portugal, Spain, and Hungary. About one-third of employed Americans work at firms with fewer than 50 employees while 75 percent of employed Greeks do.

What went wrong?  One issue is trust and corruption. One of the most difficult aspects of modern social life is that the world is a big place and cooperating with strangers is difficult. After all, they might rip you off. You could appeal to the authorities, but the authorities are likely to be strangers, too. In societies with poorly functioning institutions, high levels of corruption, and low levels of social trust, it makes sense to try to stick with smaller-scale entities. Business relationships are driven by family and personal ties rather than contracts, and a small scale is used to solve the difficulties of impersonal administration.

It’s not a coincidence that if you look at Transparency International’s Corruption Perceptions Index, the four worst-performing eurozone members are our old friends Greece, Italy, Portugal, and Spain. The converse is that large-firm employment is most common in English-speaking and Nordic countries that have the least corruption.

Keeping economic units small is a perfectly reasonable response to a less-than-ideal situation, but it’s very economically limiting. Economies of scale can make larger firms more productive and let medium-skilled workers specialize more and earn higher wages. A bigger issue is that great ideas deserve to start small, prove themselves, and then grow. Not every business owner wants to build a Fortune 500 company, but sticking forever with a staff of fewer than 10 people is very limiting.

…It ought to be the case that the worst-managed shops close and the best-managed shops branch out and prosper. That way more people would end up working for managers who know what they’re doing, rather than managers who happen to have inherited a license. Such competition-stifling rules are not unheard of in the United States. An idiosyncratic regulatory framework explains why you’ve traditionally had to buy a car from a locally owned car dealership rather than from a national retail chain or directly from a manufacturer. But the fact that most Americans work at companies with more than 250 employees while almost 70 percent of Italians work at firms with fewer than 50 highlights the scale of the difference. The strength of the Nordic and Anglophone models, from an entrepreneurial perspective, is that these are the places where it’s easiest to start a business and also the places where it’s easiest for one to grow.

Marijuana is an example of an industry that is ripe for an economy-of-scale revolution.  In 2017 the cost of a 0.5g dose of marijuana was about $2.50-$10.  If marijuana were completely legalized, producers would achieve the same kinds of economies of scale found in the cotton industry (as a comparison for field-grown marijuana) or the tomato industry (as a comparison for capital-intensive greenhouse production) and prices would plummet. Cargill would bred the plants and produce genetically-engineered seeds which would be grown by corporate farms using specialized equipment engineered by John Deere and they would sell the leaves to Phillip Morris (Altria) to manufacture joints who would hire Madison Avenue marketing firms to advertise on the SuperBowl to generate sales. Walmart would retail pot.  All of these corporations have economies of scale that would make them more efficient than the current system run by small businesses.  Mark Kleiman’s analysis suggests that the cost of marijuana would drop by about 99% to just pennies per dose.  High quality pot would be cheaper than the ketchup packets and low-quality pot would be cheaper than salt. Both of those products are given away for free at restaurants to encourage the purchase of dollar burgers.  If the marijuana industry is allowed to maximize its economies of scale and go corporate, it will be the cheapest intoxicant the world has ever known.  It will be so cheap, it will be given away for free by companies like Doritos to stimulate appetite and sell more snacks.

Another key reason  why rich nations are dominated by large companies is that we have institutions that are better at allowing small businesses grow into large ones.  Poor countries have too many entrepreneurs because it is almost impossible to grow a business larger than about 10 employees.  Microfinance has been a big disappointment in economic development because it hasn’t helped small businesses create the economies of scale that they need to become highly productive, and most countries have laws that hinder small businesses from growing.  So microfinance has alleviated extreme poverty, but it has not helped poor people raise their productivity up to middle-class levels because they cannot grow businesses beyond the micro-level.

The few big businesses that do exist in poor countries are run by elites who don’t want competition from upstart new companies and they favor laws that limit competition.  Carlos Slim of Mexico became the richest man in the world by running the biggest company in Mexico, América Móvil, but he only became so rich by having near monopoly control over running Mexican telecommunications.  If the Mexican government were less corrupt it would encourage more competition or otherwise redistribute Carlos Slim’s monopoly profits back to the Mexican people.  Big is only beautiful if the benefits don’t merely trickle down from the billionaires in the commanding heights, but flow among all citizens.  In Mexico, more equality could increase efficiency (productivity).

Another reason why large businesses are less successful in poor countries is that they lack agglomeration economies because they lack a large number of medium-sized businesses that are common in rich countries.  Agglomeration economies are the benefits of the business ecosystem that provide support services and inputs for other businesses.  It is easier for giant banks to locate in New York City than in Des Moines Iowa because New York has specialized accounting firms, legal services, technology support, electronic markets, and amenities like entertainment that attract skilled workers.  Those support services produce a kind of economy of scale that makes New York more productive for banking than most other places on earth.  Similarly, silicon valley has produced an ecosystem of medium-sized businesses that support one another and make each other more innovative and productive through the agglomeration economies that come from their complementary services and products.

Nigeria has big businesses in its capital city of 21m people, but they lack the medium-sized companies that produce quality support services and other inputs to help small businesses grow.   Nigeria has too many entrepreneurs working as sole-proprietors and too little competition for the giant companies.  China has mastered agglomeration economies because it is good at producing medium-sized companies and clustering industries so that complementary firms are located near one another.  Different Chinese towns develop clusters of firms that specialize in producing the same kinds of things like motorcycles (Bishan), fireworks (Changsha), or undwerwear (Shantou).  60% of the world’s buttons and 80% of zippers are produced in Qiaotou and over a fifth of the world’s violins are produced in Beijing.  China is successful because it has fewer independent entrepreneurs than most developing nations.  More of China’s workforce are working together in bigger teams that can grow as they develop synergies together rather than remaining in tiny, unproductive businesses.

Small towns are ‘ugly’ too

Although rural areas are quaint, their economics are ugly.  Perhaps the most important kind of agglomeration economy happens when people agglomerate in cities which are more productive than rural areas.  You can tell by looking at wages which are higher in cities.  Big is beautiful for wages and the bigger the better because bigger cities are more efficient.  Geoffrey West found that when cities double, wages, per capita innovation, and energy efficiency increase by about 15%.  Similarly, countries that are more urbanized have higher incomes:


The two most important events in economic history were the agricultural revolution and the industrial revolution.  The latter saw the first sustained increase in median income in all of human history.  And it was dependent upon urbanization.  Without cities, we couldn’t have much industrialization and vice versa.  If you plot median income AND urbanization rates over all of the millennia of history the two graphs look almost identical except that urbanization started to grow very slowly during the two millennia before the industrial revolution when median income, population and urbanization all suddenly skyrocketed:


Big companies are better than small

Big companies have better statistics for almost everything.  They:

  • Do almost all of the research that increases productivity and living standards.  The 700 largest multinationals firms account for close to 70% of world business R&D spending (UN World Investment Report, 2005).  Large firms also get more results per dollar of R&D spending.  By comparison, big government also accounts for roughly a third of total global R&D, so big business is the big kahuna.
  • Account for 2/3 of innovation according to a recent paper.   Smaller challengers are important though because challengers give the big incumbents more incentive to innovate.  For example, Goettler and Gordon argued that copycat chip maker AMD forced Intel to innovate to keep ahead.
  • Pay higher wages than small businesses and they offer more benefits like health insurance because they are more productive.  A  Kauffman Foundation study showed that large businesses paid 50% more than small businesses in 2011.  Workers with some college education earned 36% more at big stores.  Brianna Cardiff-Hicks, Francine Lafontaine, and Kathryn Shaw looked at retail businesses and found that the big-box stores paid more than small.  Part of the reasons may be that larger firms are more likely to be unionized.
  • Create more upward mobility.  The Cardiff-Hicks et al. paper mentioned above found that small, family-owned firms typically privilege family members for promotion even if they are not quite as capable as other workers.  Big, impersonal corporations give a better chance to people who were not born into privilege.
  • BLS data shows that firms employing more than 500 people give 2.5 times more insurance benefits and paid leave and offer 3.9 times more retirement benefits than workers at firms with 99 employees or less.
  • May be more friendly towards women and minorities.  For example, Goldin and Katz (2012) found that as the pharmacy industry consolidated into large chains, more women entered the field in part because larger pharmacy chains have better human resource policies that made the field better for women.
  • Are more reliable for employees because they are more financially stable and less likely to go bankrupt. Robert D. Atkinson and Michael Lind wrote that, “In 2015, small enterprises were four times more likely to lay off their workers than large ones.”
  • Pay a higher tax rate.  The aforementioned authors also wrote that “the tax code favors small firms to such a degree that, in 2013, federal income tax paid, as a share of total net income, was 18.2 percent for firms with more than $250 million in sales and just 4.6 percent for firms with less than $5 million in sales.”
  • Are easier to regulate.  As long as they don’t corrupt the government through regulatory capture, it is easier to regulate a dozen large businesses than a thousand small ones.  That may be one reason big companies have better safety records.

The ugliness of big

Unfortunately there are also a few drawbacks to having an economy dominated by large companies.  Concentrated business power is bad for

  • Equality of incomes.  Larger organizations create larger incomes for top managers.  A nation of shopkeepers is relatively equal compared to a nation where Walmart is the biggest employer.  But I still prefer a world with more efficient stores and higher incomes.  Eventually, I hope to get Walmart to act like a good citizen like it is in China.  The Chinese government requires that Walmart share more profits by paying relatively high wages to unionized workers in China where Walmart is the 3rd biggest retailer.
  • Political corruption.  Half of the top 100 donors to political campaigns in 2004 were private corporations and much of the rest of the list were organizations or individuals that represent corporate interests.  Big companies are the source most of the money that corrupts the political process.  Of course, small businesses have tremendous clout as well.  Five of the twelve biggest business PACs in 2016 were representing associations of small businesses like the National Association of Realtors, and the National Automobile Dealers Association.
  • Entrepreneurial freedom.  Wannabe entrepreneurs have little chance of competing due to the barriers to entry that economies of scale create.
  • Monopolistic rents.  It is not clear how much of the higher stability and profit at large businesses is due to greater efficiency and how much is due to competitive barriers that give them an unfair advantage at the expense of the rest of society.  Big pharmaceutical companies clearly have some of both reasons for high profits. Governments can reduce monopoly rents by breaking up companies, progressively taxing more dominant companies (as with the too-big-to-fail banks), or by encouraging globalization which allows for greater competition from foreign behemoths.  To take advantage of economies of scale requires good management by governments too.

Much of the resource curse is due to the problems of concentrated economic power.  Natural resource abundance leads to a concentration of power in a few large companies that corrupt politics and stifle opportunities for other kinds of businesses. The good news is that these problems can all be managed if there is good democratic governance.   Economies like Norway, Australia, and Canada are dependent upon their abundant natural resource wealth, but they don’t suffer from the resource curse because they developed efficient democratic institutions before they developed the technologies to create the economies of scale that concentrate economic power.  Their governments use policies like public education to give the median person a greater ability to contribute to the national wealth, and progressive taxation to give the median a greater stake in the national wealth.

Entrepreneurs vs. bureaucrats

The cult of entrepreneurship has led some textbook authors to elevate the status of entrepreneurship to the most important level.  They list entrepreneurship as being one of the four fundamental economic resources (along with land, labor, & capital).  This is wrong.  Entrepreneurship is important, but it isn’t nearly as important as other factors of production like efficient bureaucracy (management) or technology.  If entrepreneurship were a more important factor of production than bureaucracy, then poor countries should be rich because they have a very high ratio of entrepreneurs to bureaucrats, but in fact, richer countries have lower entrepreneur/bureaucrat ratios.

One of the most influential business thinker of the 20th century, Peter Drucker, said, “It is only managers–not nature or laws of economics or governments–that make resources productive.”  Notice that he said managers, not entrepreneurs.  Drucker was talking about how we need good managers to achieve the economies of scale that makes society productive and wealthy.   Entrepreneurs mostly do very low productivity work except for the very tiny fraction who successfully grow their businesses and become managers.

The two concepts are very different.  Very few entrepreneurs develop into great managers and very few of our great managers have ever been entrepreneurs.  Of course we also need entrepreneurs, markets, and governments too, but they are all greatly appreciated by at least one side of the political spectrum or the other.  Bureaucrats are under appreciated by everyone.  They are the central planners of the organizations where most Americans work and without skilled managers in big organizations, this world would be a very poor place.

Posted in Development, Globalization & International

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