Monthly Archive: May 2015

The week’s exploration centers on how a small organization or firm can successfully compete with a larger corporation.  Three substantial advantages associated with economies of scale naturally fall to a large and established firm.  These are ability to amortize sunk costs over a large customer base, the possession of a larger and more specialized workforce, and leverage in buying goods and services.  With all these advantages, how can smaller business ever hope to survive let alone compete?  And, as a corollary question, how come large firms don’t grow unboundedly?

The simple answer is that firms also suffer from a host of disadvantages, called diseconomies of scale, that grow larger as the size of the firm goes.  Initially, these disadvantages are not active in smaller firms.  But at some point, above a critical size, they turn on and begin to offset the economy of scale advantages.

There are two primary areas where diseconomies of scale present themselves: delegation of authority, span of control, and the principal agent problem; and poor communication, coordination, and standardization.

Let’s start with the first broad category which covers problems associated with delegation of authority, span of control, and the principal agent problem.  Collectively, these problems describe the down side of the principle behind comparative advantage.  No matter how talented and dedicated the original founders and staff of a firm are, they are limited in the amount they can do based simply on the number of hours in a day.  For the firm to grow, additional staff needs to be hired to not only perform the basic functions (manufacturing, delivery of services, etc.) but also manage the growth.

In this process, a vast amount of control and authority has to be delegated to new staff and this is always accompanied by growing pains.  Friction between the old guard and the young turks is natural even under the best of circumstances.  When rapid growth occurs in a firm it is usually due to a highly motivated core group (e.g. the owners of the company).  These individuals obviously have strong notions about what works and what doesn’t.  In addition, they want go-getters just like themselves and they tend to hire people who are just as opinionated and strong willed as they are themselves.  I’ve experienced the tremendous clash that happens next.  The new blood yells about micromanagement and rigid and inflexible approaches of the existing management, who can’t delegate and reduce their span of control.  The original staff can’t understand why there is a sudden rush to change the culture that has been so successful.  Harsh words are exchanged, people quit or get fired and, meanwhile, the business of the firm is left fallow.

As bad as this is, an even worse circumstance occurs when the new blood has designs on the existing corporate structure for their own purposes.  They may see a niche area left undeveloped or may want to move the company in a direction more suited to their personal liking.  In some cases, they may even be dishonorable people looking to exploit the existing cash cow with some scheme or another.  This is the principal-agent problem.  Central to this situation is a difference in the amount of knowledge the two parties possess.  The principal is the term used to describe the existing management/ownership.  In hiring the new staff, which are called the agents, the principal must trust the agent and delegate some ability for the agent to make decisions on behalf of the principal.  Both the principal and the agent have their own self-interest, but while the principal has the advantage in authority, the agent has the advantage in terms of information.  In all cases, the agent is required to report back to the principal (even if the reporting is a token report) and all agents filter the information at their disposal before sending it on to the principal.  The larger the firm the more likely it is that at least one of its agents is using this asymmetry for this own ends at the expense of the firm.

The second broad category of diseconomies of scale includes problems with communication, coordination, and standardization.   Overall, I tend to refer to these problems collectively as the Dinosaur Problem.  The organization in question has the same issues that the Jurassic behemoths had.   Small organizations can comfortably handle peer-to-peer interactions since the number of people involved is relatively small.  Once the size exceeds a critical threshold it is more efficient for interactions to happen through a central location, a manager who facilitates the activities of a whole.  As the numbers continue to grow more managers come on board and the interaction between them may be handle by peer-to-peer even though the employee interactions are not.  At some point, however, the number of managers becomes too large and a new layer of management is conceived and implemented.  This layering continues until some point where the right-hand no longer knows what the left hand is doing.

Along the way, such a firm begins to exhibit all the tell-tale signs of being too large.  The implementation of a one-size-fits all strategy to avoid liabilities.  Having meetings about how to have meetings or for the sake of having meetings.  An emphasis on fairness rather than performance and other idiocies to numerous to mention follow.

I've lived through many of these types of insanities.  One of the firms where I worked had a supply requisition form on which one could order refills for X-Acto knives (this was for the actual paper-and-glue version of cutting and pasting) but not the knives themselves.  I was issued a corporate American Express card with the very explicit admonition to only use it for business travel and not for personal use.  A scant 6 years later I received a letter from legal saying that they were going to revoke my American Express card because I had failed to 'live up to' my promise on the amount of expected use of the card.  All told, I had never wanted the card in the first place and I was sent on only two business trips in those 6 years.  I’ve been required to attend a meeting about how to have meetings.

All of this factors contribute to limiting the practical size of a firm.  In the economic lingo, the economies and diseconomies of scale are best summarized on an average cost diagram.

On the x-axis is the number of units of some good or service produced by the firm, which is taken as a measure of the firm’s size.  On the y-axis is the cost to produce a unit of the good.  The optimum occurs at the place where the benefits from the economies of scale balance the diseconomies.  It is important to note that as business factors change, what once contributed to a cost savings can turn around and cause an increase in cost.

So it isn't remarkable that the small business Davids can take down the big business Goliaths.  It also isn't remarkable that today’s Goliaths were yesterday’s Davids and tomorrow’s has-beens.  That is the nature of the creative destruction of the free market economy. It also isn't remarkable that economies of scale one day can become diseconomies of scale on another as society evolves.  What is remarkable is how many people refuse to accept this dynamic.

There is a curious unasked question that serves as a back drop to much of the media’s reporting on the economy.  If big business is so powerful, why is it that most people in the private sector of the United States work in small and medium businesses?  Surely both the power that big businesses yield (lobbying, political, and resources) and the economy of scale they enjoy would allow them to outperform and outlast their competitors in the smaller firms.  Asked differently, why isn’t the world dominated by huge multinational corporations?

This idea of the dominance of big business is certainly common fare in the daily fiction that passes in movies and TV.  Many tales come out every year featuring the evil, predatory practices and near omnipotent power of big business, and yet the small and medium rebellion continues unabated every year.

Now, to be clear, I am neither suggesting that big business is benevolent nor that it exercises its power gently.  Businesses, large or small, have a right and perhaps an obligation to aggressively protect their market share and to continue to grow.  In addition, crony capitalism and political favoritism tends to give the larger firms political concessions that the smaller firms lack.  What I am suggesting, or at least exploring, is the notion that smaller can be better, and that we tend to remember economies of scale and forget about diseconomies of scale.

To better understand the staying power of small and medium business, consider some elementary statistics.

Small businesses make the bulk of the US economy, both in terms of the number of firms and in terms of the number of employees.  According to statistics provided by the Census Bureau, 61% of the firms in the country are sized between 1-4 employees, and 99.6% of the firms have fewer than 500 employees.  Nearly 50% of the employees in the economy work in this segment.

The wages these employees make, in aggregate, are comparable to the wages earned by their big business counterparts. Although a more detailed analysis by labor segment (e.g. secretary to secretary) in addition to size of firm is needed to make clear conclusions, there doesn’t seem to be obvious evidence that being in a big business significantly increases wages.

The table below, adapted from 2007 data from the Census Bureau, shows the details:

Now let’s talk a little about all the advantages enjoyed by big business (say, more than 1000 employees) that are either available to a lesser degree for smaller firms or unavailable entirely.  This discussion will focus only on the legitimate advantages afforded to these firms from economy of scale effects and will ignore additional, unfair, advantages due to lobbying and crony capitalism.

As a reminder, an economy of scale is the term that is used to describe any effect that allows the cost per unit of production to lower as the number of units produced grows. Large firms generally have three areas that provide them with economy of scale advantages.

The first is in the form of non-reoccurring costs or what is sometimes known as sunk costs.  This category covers all the initial investment in the production capital, such as factories and specialized machinery.  A milling machine comes with a fixed price tag whether it is used to produce 1 unit of goods or 100.  In the latter case, the initial outlay for the machine can be recouped over a large customer base and so allows the cost per unit to be reduced.  Similar advantages occur for advertising and marketing, where the price passed onto consumers is smaller per good the larger the number of consumers, and for shipping, where it is cheaper to have a truck that ships 200 goods than to have two smaller trucks that ship 100 goods each.  Finally, a large firm typically has greater financial resources and can bear the risk associated with research and development of new goods and services more easily than smaller ones.

The second advantage of larger firms comes in the form of the workforce.  Employees at larger firms can more easily specialize, leading to production.  The prototypical example of this is given in Adam Smiths ‘The Wealth of Nations’.  Smith examined how straight pins were made, and identified 18 distinct tasks.  A single worker performing each of these 18 tasks might be able to produce 20 pins in a day.  By dividing up the tasks amongst several workers so that one worker performed only 1 or 2 of them, Smith estimated that a group of 10 workers could produce 48,000 pieces in the same time.  Division of labor and specialization enabled each worker to increase his output by over a factor of 200.  Large-firm employees also enjoy a larger community from which to learn, and an environment filled with greater intellectual capital and corporate knowledge.

The third advantage is the leverage that big businesses have in procuring goods and services.  They can bulk-buy from suppliers and vendors and receive a discount that is out of reach for the smaller firms.  They can also command better terms and concessions on loans and related financial instruments that can be used to increase their production.

So, having enumerated all these great advantages, how can small firms ever compete?  And yet, they not only compete; they also dethrone the giants of yesterday.  Not so long ago, IBM was the unassailable provider of computers and business machines.  Within two or three decades, Microsoft had supplanted IBM.  As time progresses there is mounting evidence of Microsoft losing ground to both Apple and Google.  Other examples from every enterprise and industry can be found where yesterday’s giants are today’s has-beens; simply look at Abercrombie & Fitch, or Nokia, or Borders, or… well, you get the picture.

In next week’s column, I’ll discuss how the Davids of the economy can defeat the Goliaths.  Stay tuned.

As I geared up for this week’s column, a variety of forces interfered with my peace of mind.  I found myself perpetually starting on an idea only to find that another idea shot in from an unseen direction to wreak havoc on my concentration.  I pondered this state of affairs for a while and realized that my mental state was in some sense reflecting the state of country and the economy as a whole.  It was at this point that it seemed most prudent to take up blog space this week to rant about the many little things weighing on my mind and on the nation’s recovery.

Since this is going to be a rant, I’ll excuse myself from the usual rule of trying to produce a logical flow and a clean narrative.  Who knows perhaps it will work better.  It may even make me feel better, but I doubt it.

First let me point out that the state of the economy is hardly in recovery mode.  A recent trip to a nearby mall left me feeling depressed and deeply concerned.  The mall in question contains about 200 separate slots for storefronts.  Despite being relatively upscale, it was, in my estimation, doing quite poorly.  As I walked up and down in front of the various shops I noticed that a large number of storefronts were vacant. By the time this observation had wormed its way into my conscious mind I was conveniently at one end of the building.  I decided to turn around and make a careful count of the vacancies.  When I reached the other end, my tally was 18 store fronts boarded up and idle, corresponding to about a 9 percent vacancy.

A short trip later found me at a strip mall a notch or two down the glamor ladder from my previous visit.  Even this bastion of thriftiness was not left unmolested by this so-called recovery.  Of the 30 storefronts, about 4 were vacant and the local RadioShack was sporting banners reading “Store Closing!” and “Everything Must Go!”, all in an attempt to lure shoppers in to take advantage of the liquidation.

The next set of ‘good news’ came in the form of a seemingly never-ending set of statistics being pushed at my face, some correctly interpreted and worrisome, some poorly interpreted and annoying.

On the worrisome front, all indications on the horizon showed that the April jobs numbers were going to be disappointing.  This news comes hard on the heels of a March report that showed that job growth failed to match population growth.  It seems that period of time in which job creation was out-pacing population growth in the fall and early winter has evaporated and the new trend is the same old jobless recovery we've seen for the prior 5 years.

In addition, both IMF Chairman Christine Lagarde and Federal Reserve Chairman Janet Yellen and spoke at length of the risks that still face the economy in this post fiscal-crisis world at a joint conference at the Institute for New Economic Thinking on May 6, 2015.  Lagarde warned of continued distortions in the incentives for the financial markets that focus on short-term profits over sustainable gains. A few rays of sunshine did poke through from this discussion, including Yellen’s assertion that improvements in the financial markets, mostly occurring before the start of the financial crisis in 2008, were mostly aimed at helping the poor.  But mostly it was the same type of ‘doom and gloom’ about stability, liquidity, and ‘too big to fail’ that we’ve been hearing over the past 6 years.

On the poorly interpreted and annoying statistics front, society, as a whole, and journalists, in particular, can’t seem to get over the hump in their understanding to realize that correlations in data don’t imply causation – no matter how fervently they want it to.  Just to frame the frustration I feel on this point consider the following two statistical statements.

First is a statistic about America’s energy usage, courtesy of Washington State University, that states:

The message being conveyed is that American’s consume profligately and waste so many resources that could be used by the poor.  However, this message is only supported by the statistic itself and not with any of the usual machinery by which we make inferences.  That is not to say that America doesn’t ‘waste’ energy – if by waste we mean that we leave lights on when they could be turned off, that we are casual with our energy consumption because the cost of energy is relatively cheap.  But it also needs to be recognized that we consume more energy than the rest of the planet because we are more productive.  On the same page, the anonymous compiler of statistics points out that each American uses the same energy as two Japanese.  But Japan has about 1/3 the population of the United States, implying that the per capita usage of the average Japanese citizen is about 1.25 times more energy than the average US citizen.  So much for this statistic.

Equally interesting, is what is missing from the WSU statistical diatribe against the very country this so-called academic calls home.  In his audio lectures entitled ‘The History of Moral Thought’, theologian Peter Kreeft notes the following statistic.

This per capita wealth of lawyers doesn't seem to even raise an eyebrow in the academic circles.  But if the common belief that the economy is a zero-sum game is true, then surely we in the United States have taken lawyers from other, less fortunate people.  I say, let’s give them back.

Sigh…

In a column some months back, I presented the basic concept behind the Prisoner’s Dilemma and talked about some of the most common applications in economic circles.  In this column I will discuss a somewhat discouraging application of these concepts to the relationship between business and workers (or firm and employee or management and labor, etc., as you prefer).

The particular type of business I will be talking about is a government contractor in the technical sector.  Businesses like these depend on a highly-trained and technically savvy work force to be able to bid on and win new work.  Central to the ability to credibly bid on new work is the idea that the firm and/or its workforce can set itself apart from its competitors in one or more of three distinct ways: 1) offering equal technical competency for a lower cost, 2) offering structured processes that lower risk and ensure delivery on cost and schedule, or 3) offering innovative solutions that enable new technology or a new opportunities.  The application I will deal with is the last case, but the attentive reader can adapt this example to the other two.

Typically the ability to innovate new technology on government contracts is limited by two factors.  The first is that government contracts with a specific research and development (R&D) focus are rare and becoming even rarer as federal spending on basic research drops.  Second, unless otherwise negotiated, the intellectual property for any research done on a federal contract is typically owned by the government.  Even in those cases where rights are granted for commercialization, the government retains limited ownership and exercising the ability to commercialize may be hard to do.

As a result, the general idea is to own the intellectual property itself and to leverage the intellectual property into increased profits.  And therein lies the rub – who owns the intellectual property and who benefits from the increased profits?

From management’s point-of-view, the firm wants to produce a body of intellectual property by engaging the employees’ talents in creating innovative technologies for the good of the firm.  The business: 1) provides the work environment in which the employee can tackle interesting problems, 2) actively pursues new business, 3) insulates the employee from the day-to-day hassle of running an enterprise, and 4) maintains the employee’s wage level even when profits decrease or disappear (‘sticky wages’).

Since the continued existence of the worker’s job is predicated on the health of the business, it is natural for management to expect that the worker will contribute to the overall health of the firm by shouldering some of the burden of making the company competitive.  How then does the business encourage the worker to apply his talent to creating intellectual property that the business can own?

Likewise, an employee wants to produce his own intellectual property for continued advancement and increasing wages and compensation.  The two main components of this capital are the technical skills required to perform the jobs in his sector and the external recognition that he can muster these skills to bring a complicated piece of work to fruition.  The employee provides: 1) the technical expertise and education need to be able to innovate, 2) the dedicated time needed to concentrate on a problem and deliver solutions and 3) the perseverance and intellectual fortitude to find these solutions.

Since the continued health of the business depends on the condition of its workforce, it is natural for the worker to expect that the business will provide opportunities for the employee to develop innovative solutions to complicated and challenging technical assignments and will support and assist the employee in generating tangible proof that he actually developed intellectual property rather than just use the fruits of someone else’s labor (e.g. patents or papers).  How then does the worker encourage the business to provide the infrastructure that benefits him?

If both sides could trust that the other will cooperate and compromise, then they each would get an attractive payoff.  The problem is that the business worries that, after all their investment in securing interesting work, the employee will either shirk his responsibilities and just collect a paycheck or that he will take all the credit and then head off to greener pastures.  Likewise the employee worries the business will keep all the intellectual property for itself and take credit for the hard work and talent that he mustered.  The situation abounds with questions of trust and with structured payoffs that are directly related to the Prisoner’s Dilemma.

Consider first the payoff matrix from the perspective of the business.  Its choices are either to trust the employee and invest in increased wages and/or improved infrastructure (e.g send the employee to a conference) or to safeguard against the employee shirking his responsibilities by keeping wages static and by avoiding infrastructure investments that benefit the employee, until the employee delivers.   The payoffs are then described by the company as:

Next consider the payoff matrix from the perspective of the employee.  His choices are to invest extra hours of his own time to develop intellectual property that he then turns over to the firm in the hopes of a reward or to perform the minimal amount of work to meet expectations, until such time as the company begins to show concern for his needs.  The payoffs are then described by the workers as:

Both of these perspectives can be combined into one common payoff matrix where, for consistency with the original language of the Prisoner’s dilemma, the word ‘cooperate’ will mean either ‘trusts’ or ‘rewards’ for business and ‘delivers’ or ‘invests’ for the employee, depending on context.  Similarly, the word ‘betray’ will mean either ‘safeguards’ or ‘ignores’ for business and ‘shirks’ or ‘meets expectations’ for the employee.  Also the payoffs will simply be given a single letter value ‘C’, ‘L’, ‘S’, and ‘M’ with the relative ranking between these of the largest payoff  (L) > cooperative payoff (C) > mutually-betrayed payoff (M) > sap payoff (S).  The payoff matrix now looks like:

Ordinarily, if the employee and the business were engaged in a one-time only deal, the equilibrium solution of this game is for both sides to betray leading to lousy payoffs (M) for both sides.  This is a well-known feature of the strategies for both players in the Prisoner’s Dilemma.

But the usual relationship between a business and an employee is one of repeatedly playing this game.  This is the iterated version of the Prisoner’s Dilemma (with no known limit of turns) and the best strategy that has been currently discovered is the tit-for-tat approach.  In this strategy, each player’s optimal response for the current turn is to perform the same action as the opposing player performed in the previous turn.

This observation then provides some insight into the employee/management scenario.  It is obvious that once one side betrays, it starts a long line of subsequent betrayals by the other side unless one side decides to unilaterally cooperate.  Thus once a business had been burned by a few bad employees it will have a tendency to not meet the goals of its employees.  They, in turn, will be less willing to innovate and both sides suffer.

There is no easy way to extricate both sides from this vicious circle without one side risking a substantial loss.  That said, there is an asymmetry between the two sides as management in these types of business are more consolidated and organized than the work force.  So it is up to management to offer the first olive branch (and perhaps many more) when the situation gets into one of these downward spirals.