Small Is Ugly!

When I was young, 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 basic thesis encapsulated in the title is misleading. It argues that small businesses are best.  In actuality, most of the progress of the past two centuries has come from large organizations, not small businesses.  Big organizations have been necessary to produce most of the dramatic increase in development over the past two centuries and although some of the changes have been bad, the benefits have been bigger.

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. Within the OECD (the club of rich nations), bigger business is more beautiful.  OECD nations that are more dominated by big businesses tend to be richer. The US is fortunately to be one of the richest OECD nations and the US is by far the most dominated by large businesses.  All nations that are dominated by small organizations are desperately poor.

Eric Nilsson wrote a book documenting the rise of large US corporations 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.

Later, 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.  That is only the largest 2/1000!  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.  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 unpaid family member.  The self-employed entrepreneur category is so bad that millions of its workers are unpaid family members!  Needless to say, all of the 93.3% of American workers who work for a bigger company get a wage.

Farming is one of the most highly entrepreneurial industries, but entrepreneurs are also a shrinking part of the farm economy as the average farm size rises.  By 2022, the BLS expects that America will have twice as many hired hands working in agriculture as there are entrepreneurs who run their own farm.  Entrepreneurs are already a rare breed in America and the BLS expects their numbers to continue shrinking.

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.

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.

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.

Big companies are better than small ones because they:

  • Do 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).
  • recent paper found that big established companies account for 2/3 of innovation.  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.  Brianna Cardiff-Hicks, Francine Lafontaine, and Kathryn Shaw looked at retail businesses and found that the big-box stores paid more than small
  • Create more upward mobility.  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.  This is one finding of the Cardiff-Hicks et al. paper mentioned above.  mom-and-pops stores.  Workers with some college education earned 36% more at big stores.
  • 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.
  • 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.

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.
  • Entrepreneurial freedom.  Wannabe entrepreneurs have little chance of competing due to barriers to entry.
  • Monopolistic rents.  It is not clear how much of the stability and higher profit at large businesses is due to their greater efficiency and how much is due to competitive barriers that give big firms an unfair advantage at the expense of the rest of society.  Big pharmaceutical companies clearly have some of both reasons for their high profits.
  • 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 produce inequality and corporate money that corrupts the political process.

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.

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 and management is the key skill.  But most entrepreneurs don’t become successful managers and most of our successful managers didn’t start out as entrepreneurs.  Of course we also need entrepreneurs, markets, and governments, but bureaucrats are under appreciated.  They are the central planners of the organizations where most Americans work and without good managers in big organizations, this country would be a much poorer place.

 

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Posted in Development, Globalization

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