Beware Centralization

Imagine merging three public firms, by making each firm into a division of a single new firm with one new boss. In principle, this new boss has the option to keep these firms running exactly as before. The prior CEOs could become division heads, with complete freedom to run their divisions as before, and paid the same, such as via options on new assets that track the new profits of each division. Under this arrangement, the profits of the new firm could arguably be the same of the profits of the old firms, minus a little bit for the salary of the new boss.

However, this new boss would also have the option to do other things. Like cutting redundancies between some subdivisions, such as shipping or human resources. Or reviewing the major decisions of division managers. Or sharing technology between firms. Or using the larger size of this new firm to negotiate better deals with unions, suppliers, or politicians.

Arguably the fact that there is the option to get at least the old profit levels, combined with many new options for making and using synergies across these firms, suggests that such merged firms can in general make more profits than they could separately. Which suggests that firms should just keep on merging until they are very large. But in fact firms do not do this, because their investors do not support it. For example, firms with more than 250 employees employed only 55% of the private US work force in 2020.

So why don’t firms merge to achieve these gains? Yes, regulators and tax authorities may treat larger firms less favorably. Yes, maybe customers and employees dislike larger firms and so treat them worse. But the typical scale of most firms seems far smaller than can be explained by these effects. There seem to be much stronger reasons why most firms are not much larger.

One usual story is that the manager of the new merged firm just can’t help interfering with and inter-connecting these divisions. After all, he or she has career ambitions which are poorly served by a complete hands-off management style. But after such manager “help”, it becomes harder to evaluate the performance of each division independently from the rest. And the quality of the people wiling to work as heads of these divisions, instead of as CEOs of them as independent firms, gets lower. These costs of size are said to be larger than the benefits to be found from exploiting synergies, which is why firms are not larger.

A similar thing happens with government agencies assigned to manage sectors of society. Imagine that we created a government agency in charge of food for the whole nation. This agency is given an authorization so broad that it could allow exactly the existing food practice and industries, such as farms, grocery stores, restaurants, and personal kitchens. Or it could completely nationalize all these resources, and use tax revenue to reorganize them as it saw fit. Or it could do anything in between. Imagine that such an agency had been created in the U.S. in 1970.

It seems obvious to me that by now such a food agency would have intervened in food production, processing, and distribution far more extensively that has been the case in our actual history. Large government agencies would have formed with many thousands of employees, many of them directly managing food activities. Everyone would get access to some food, and some government activities would achieve larger scale economies than seen in the private sector. But this would be achieved in part via more uniformity, standardization, and stability of food processes. Government managed food would end up with less variety and adaptation to individual circumstances and preferences, and this food would improve and innovate less over time.

The amazing thing is that all this would happen even with high quality oversight and accountability by agencies to politicians, and politicians to voters. Voters would tell politicians about things they liked more and less, politicians would pass on these messages to agencies, and agencies would often change their policies and strategies in the suggested directions. But even in the absence of much corruption, civil servant selfishness, or partisan rancor, and even with the best political processes that we can imagine, a food industry managed by a government agency with broad powers would still probably end up creating a worse world of food over the long run.

Similarly, a new firm that merged three random prior firms would typically earn less profits, even with the sincere and helpful advice of its investors, boards of advisors, and management consulting firms, and even in the absence of stupid or corrupt firm managers and advisors. Processes of governance and oversight can and do help, but they are generally insufficient to cancel the harms from an overly centralized organization structure.

These patterns, if true, are seem important regarding the ideal scales of both business and government. And I fear the U.S. public is insufficiently aware of them, as we seem to be on the verge of a historic increase in the scale and depth of government management of society.

Added 4Oct: Let me emphasize that what I’m describing is theoretically puzzling, in that it isn’t very directly implied by our standard models of profit maximization or democratic accountability. There is something important that we don’t understand well going on here.