Whence Scale Diseconomies?

For good or evil, one of our greatest legacies will be global governance:

Our institutions of global governance may grow, follow us as we expand, and entrench themselves forever. On the downside, they might perpetuate themselves even if they hurt our descendants on net. On the upside, we might use them to overcome key coordination failures.

What will determine the breadth and strength of future global governance? Ideology and public opinion will play a part, but more important is probably organizational innovation; we’ll need better mechanisms to make it work.

As I’ve mentioned before, our use today of larger scale government is limited by the fact that local governments are usually more efficient.  The recent failure to create a global climate treaty offers a vivid example; central coordination is typically slow, expensive, and error prone.  So I doubt we’ll use central government to coordinate much more than we do now, until we learn how to do that more effectively.

While ancient empires sometimes covered wide areas, they didn’t get much involved in most activities, as long as tribute was paid.  Similarly, most ancient businesses were small scale.  But organizational innovations over the centuries have enabled both larger firms and larger governments.  Governments today get involved in more areas of life, and do so at larger scales; issues that were once private or municipal are now national or international.  This trend may or may not continue.

To avoid ideological distractions, let’s focus on how this plays out in business.  In particular, consider organizational economies and diseconomies of scale. Economies of scale are ways in which a larger organization are more efficient that smaller ones.  For example, larger organizations can produce using larger plants, share coordinated distribution networks, or share broader reputations.

Diseconomies of scale are ways in which larger organizations are less efficient that smaller ones.  Those not very familiar with large organizations often find it hard to imagine such diseconomies exist, and this failure of public imagination is arguably a big reason governments are often too large.  This review lists Williamson’s four factors hurting larger firms:

  • Employees often have a hard time understanding the purpose of corporate activities, as well as the small contribution each of them makes to the whole. …
  • Senior managers are less accountable to the lower ranks of the organization and to shareholders. …
  • Incentives large firms offer employees is limited by … large bonus payments may threaten senior managers. … [and] performance-related bonuses may encourage less-than-optimal employee behaviour. …
  • It is impossible to expand a firm without adding hierarchical layers. Information passed between layers inevitably becomes distorted.

These have intuitive plausibility, but it is not clear exactly why they occur, nor why they are so hard to overcome.  Compare two scenarios:

  • Firms – Each of a dozen separate public firms has its own CEO, board of directors, and investors.  Each firm regularly publishes accounting data to help investors monitor it, and its CEO has some incentive contract where pay is tied to measures of firm performance.
  • Divisions – These units are now each a division of one large firm.  Folks who would have been CEOs are now division managers.  As far as possible, the same accounting data is collected on each division, and each manager gets the same incentives tied to division performance measures.  Tracking stocks are created to let investors focus on particular divisions.  The top CEO looks for rare chances to gain value by coordinating division activities, but usually leaves them be.

Firm profitability data suggests our largest firms are usually too big, and would be better off split into smaller firms.  But the puzzle is: when firms get large, why can’t they switch more to the divisions scenario; why is the firms scenario required for efficient operation?

After Arnold Kling and I discussed this, he suggested:

  1. CEO’s are biased to think that they can outperform decentralized decisions. …
  2. Large firms … [allow] globally high status positions. … People differ in their tastes for these games, as well as in their tastes for stability and security (large firms) vs. novelty, risk, and opportunity (small firms). …
  3. If a big company decentralizes, there is no effective way to control the risk that an individual unit creates. Look at what happened to AIG.

Thoughtful, but not fully satisfying.  I’ll say possible answers fall into two categories: can’t and won’t.

Can’t answers say “as far as possible” isn’t far enough; divisions just can’t duplicate the accounting stats, investor monitoring, or manager incentives of firms. Maybe division managers can’t get the same respect from outsiders as CEOs, so you can’t attract the same folks to those roles.

Won’t answers admit the division scenario is possible, but say few CEOs will choose it; most prefer less efficient firms over less centrally managed ones.  Most CEOs will just refuse to give division managers the stats, autonomy, investors, or incentives they’d have in separate firms.

Won’t answers sound more plausible to me.  In the divisions scenario, the top CEO has less to do, and plausibly should be paid less than division managers.  But that conflicts with his or her higher status and choice of who should be division managers.  Since firms needing more active CEOs should pay them more, if there is uncertainty about how actively firms should be managed, CEOs have incentives to be more active than is good for the firm, in a bid for more pay.  While these don’t sound like insurmountable problems, they may well not yet have been surmounted.

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  • Carl Shulman

    Even if the supervised division model was superior in profitability, if shareholder value-maximizing CEOs were rare, they might still do better to sell off divisions to be assimilated into the companies of empire-builder CEOs (since historical data suggest that companies overpay for acquisitions).

    And of course antitrust measures restrict acquisition of outside companies (and we do see giant conglomerates in less developed countries).

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  • Bill

    As an antitrust lawyer, issues of scale economies and diseconomies are quit complex and related to the technology and the relationship between fixed and variable costs. There is no one size fits all.

    What is interesting is how economies in the public and private sector may differ.

    In the public sector, voice may be an important value; in the private sector, voice is less important (or is not offered) if there is choice of alternatives. But, making more alternatives available increases costs, limiting choice at the margin. Voice in the public sphere may limit choice but with the offsetting benefit of lower costs.

    Loyalty is related to voice in the public sector but not in the private sector, where choice creates loyalty and not voice.

    The closer you get to a person and their space and identity, the more people want either voice or choice, and these can be limiting factors in achieving economies of scale.

    Good book on this subject is Exit, Voice and Loyalty by Albert Hirschman. Applies to government and to business.

  • Bill

    This is a pretty good post, and appropriate given Williamson’s recent Nobel prize.

    You might be interested in some current recent research being done by a team of economists and sociologists planted in business organizations as “flies on the wall” listening to negotiations between divisions over budgets and between marketing and sales staffs over pricing. UPSHOT: these are social organizations not engaged in economic optimization. It’s all about POWER baby and personal optimization.

  • Robert Koslover

    A division is generally constrained to advance in accordance with the overall vision of the larger company. A truly independent company is not constrained in that manner.

  • Pietro Poggi-Corradini

    Are there tax-advantages to a large firm with subdivision vs. several smaller firms?

  • Valter Sorana

    Another “can’t” explanation (apparently not listed in the review linked in the post) is given in te paper “Bargaining Costs, Influence Costs and the Organization of Economic Activity” by Paul Milgrom and John Roberts in Perspectives on Positive Political Economy (James E. Alt and Kenneth A. Shepsle, eds., Cambridge University Press, 1990, pp.57-89; available here.(http://www.stanford.edu/~milgrom/publishedarticles/BargainingCosts.pdf)

    Roughly speaking, adding an extra top layer to an organization introduces rent-seeking games at that level that may cost more than what can be gained from the “rare chances to gain value by coordinating division activities.”

  • What will determine the breadth and strength of future global governance? Ideology and public opinion will play a part, but more important is probably organizational innovation; we’ll need better mechanisms to make it work.

    First question: people

    I am uncertain what you are referring to when you mention mechanisms. If you are referring to just “mechanisms” then forget about getting it “right”. If you are referring to “complex mechanisms”, you may have a chance of getting it “right”.

    In these posts I have noticed a lack of distinction between metaphor and surreal. Not all abstractions are metaphors. This is a very important distinction because only metaphor contains a mechanism for shaping value.

    Governments and corporations are surreal abstractions, mutating aggregates, which lack the mechanisms to shape value. The mechanisms that are used are there to restrain or constrain the behaviour of people. Ultimately, people as complex mechanisms, shape the value to give rise to the “final” abstraction.

    When we talk of governments or corporations shaping value to give rise to an abstraction, “the future”, we are talking about a cross-hierarchal violation. This refers to fact that we find it efficient to acknowledge surrealism in order to get along with each other. We “sacrifice” our personal freedom for the “greater good”.

    May I suggest a rethink as to efficiency and effectiveness?

  • anon

    What about business conglomerates, i.e. keiretsu and chaebol? These are single firms from an equity perspective (often controlled by banks which have loaned money to the firm) but their divisions seem to be managed independently.

  • Bill, I’d be interested to cites to those “fly on wall” studies.

    Robert, we are asking why divisions are so constrained.

    Pietro, there are liability advantages to having smaller firms.

    Valter, I agree with the reviewer that that paper didn’t add much.

    Anon, keiretsu suggest the division scenario is feasible.

    • Bill

      Some of the papers aren’t out yet, but you can get the drift of sociologist and economists watching negotiation within the organization over pricing and other matters which have conflict dimensions:

      Zbaracki, Mark J., and Mark Bergen. Forthcoming. “When Truces Collapse: A longitudinal study of price adjustment routines,” Organization Science.
      Zbaracki, Mark J., 2007, “A sociological view of costs of price adjustment: Contributions from grounded theory methods.” Managerial and Decision Economics 28: 553-567.
      Zbaracki, Mark J., 2006, “Success, Failure, and ‘The Race of Truth,’” Journal of Management Inquiry 15(3): 336-339.

  • Incentives large firms offer employees is limited by … large bonus payments may threaten senior managers. … [and] performance-related bonuses may encourage less-than-optimal employee behaviour. …

    Hard Facts, Dangerous Half-Truths And Total Nonsense: Profiting From Evidence-Based Management has it that it’s extremely hard to develop incentive plans which don’t damage cooperation.

    • But that difficulty should apply to both scenarios, firms and divisions.

      • That was my point– incentives shouldn’t be on the list of possible factors.

        Also, Hard Facts may be of interest to any contrarian.

  • Jay

    One other cause of scale diseconomies is macroeconomic factors. A firm that is large relative to its input markets finds that it _is_ the demand curve for its inputs. When its needs increase, unit prices go up. When its needs decrease, unit prices go down. It’s always moving the markets against itself.

    The military sees it all the time. E.g. there are basically two suppliers for military jets, and the government won’t let either go out of business (since that would make the problem worse). They both have to get the same amount of business, year in and year out, just to keep their factories viable. There’s enough knowhow in each that, if one died, replacing it would be practically impossible. And you’ll notice that “how many planes we need” is not a factor in these equations…

    I certainly am not saying that management and institutional factors aren’t serious causes of diseconomy in their own rights, of course.

    • Sorry, that makes little sense. If the many firms together are a large part of the demand for some input, they won’t be worse off buying that input together as a single firm with many divisions.

      • Jay

        They wouldn’t remain a single firm with many self-competing divisions. The company would reorganize into one division with several plants and one overall management.

        It’s easier to analyze a single management making large purchases than it is to analyze a large number of smaller purchasers. If a company is big enough, its customers and speculators can profit at its expense by predicting its actions and their effect on the market.

        As the company gets bigger, this opportunity increases. Its impact on the market is greater, leading to larger profit opportunities. Its size makes in slower to reach a decision. Bigger buyers means less likelihood that a large buy somewhere will be cancelled out by a smaller-than-normal buy somewhere else (or vice versa), raising overall volatility in the market.

        A firm in this position might consider buying one of its suppliers, but that has its own risks.

  • The division model seems stronger in Japan than in the US. Sony would be a particularly interesting example, as their content and electronics divisions are constantly at odds over what capabilities Sony hardware should have when handling Sony intellectual property.

  • ERIC

    Excellent post. This is vastly easier to observe than to explain. If you work in a large organization you will surely notice what Robin (and Williamson) is talking about. This becomes much easier to see if you have any business/management training. Easier still if your company is poorly run.

    To me the reason for the problem is the disconnect between the work and what it is to be human. When you forget that people naturally want to do a good job and feel involved and be a part of something larger then themselves — then you get stuck. Thinking about it in the context of: people are…well…humans, filled with emotions, social desires/aspirations, and other feelings this becomes very easy to see. There are always a few bitter holdouts though!

    Compare what it is like for:
    (A) a creative, artist-type to see their efforts made into something and have a real sense of importance in the world (people love to create and improve things don’t they?) with; (B) a cog who knows they are replaceable, who can’t see the importance of what they do (usually because, let’s be honest, it’s not that important, mostly uncreative and boring, simply pushing paper around).

    Nobody wants to ever be, or feel like, (B).

    You can just ask the (B) people and they are more than willing to tell you once you get them going. Most recognize how they are one technological innovation or policy change away from becoming obsolete. Bad companies do little to actually develop their employees so that they can change with the corporation. Most large corporations though generally do a bad job of changing with the times so this is a near-impossible dream.

    I think this is why CEO’s do so much to entrench themselves; they know how little value they bring to organizations and how much good/bad luck can impact performance and overall survival of their company. They can very easily be replaced – just like their employees — and this is scary.

    This really isn’t anything new and, I agree, quite intuitive. Shame is how long it’s been going on for and how long it will continue. We should all be thankful when companies (are allowed to!) fail, when recessions occur, and small companies can sprout from this creatively destructive process.

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  • Nancy Lebovitz

    “Employees often have a hard time understanding the purpose of corporate activities, as well as the small contribution each of them makes to the whole. ”

    You could pair that with it being too easy for management to make rules that don’t make sense as the organization gets larger.