Large Corporations Will Not Come to Dominate the Economy
Giant corporations controlling national governments. Corporate behemoths regimenting their workers, controlling their customers, and obliterating their smaller competitors. The rich get richer and the large get larger until a small handful of megacorporations rule the planet.
We have heard this warning about King Kong capitalism from Marxists and other statists for decades. The future is always about to bring about the death of small companies and individual initiatives. Since the 1980s a new, popular form of science fiction known as “cyberpunk” has reinforced this view in the popular imagination. Books such as William Gibson’s Neuromancer suggest that our economic system will become utterly dominated by a few faceless bureaucratic megacorporations. One of the great appeals of a free-market economy is precisely that it promises to distribute power widely. But the image of the future being pushed at us will undermine that appeal if it goes unchallenged. Ironically, the result will be a call for more intervention by the state—the most monolithic, bureaucratic institution imaginable.
Those who understand how free markets really work have long responded to these dire predictions with economic theory and history. We know that harmful monopolies have little chance of forming and surviving without government intervention, whether in the form of direct government ownership, subsidies, legal privileges, trade protection, and so on. Contemporary enemies of the market may suggest that advanced technology has changed the rules, making megacorporations and monopoly inevitable.
On the contrary, an analysis of what makes firms a certain size, combined with an understanding of technological change, reveals a far different and more exciting picture.
Over 500 million years ago, sparked by the introduction of sexual reproduction, the Cambrian Explosion brought a massive proliferation of new life forms. Multicelled organisms appeared (jellyfish, sponges, and worms) along with the first shelled creatures. As we enter the 21st century, technological changes will have a similar effect on another kind of ecosystem: the economy. Contrary to the expectation of highly concentrated corporations, we will see the proliferation of new organizational forms. The keys to success will not be overwhelming size but flexibility, agility, rapidity of response, and the ability to reform, spin off, dissolve, and recombine into new business structures. These changes are already underway.
To understand what kind of corporate environment will emerge in the markets of the next century, we need to answer two questions:
- What economic forces determine the size of firms?
- How will information technology affect those forces?
The answer to the first question lies in economist Ronald Coase’s theory of transaction costs. The answer to the second lies in the Internet and a powerful new form of business software called enterprise resource planning software.
The Size of the Firm
Why do firms exist in the first place? And why do they grow to a particular size? Ronald Coase won a Nobel prize for being the first to seriously tackle these questions. His answer involves the concept of “transaction costs.” We might wonder why, for any production job, individuals do not simply make contracts with each other on the market instead of forming a firm. Why not carry out production in a completely decentralized manner rather than centralizing activity within a firm?
The problem is that negotiating and settling contracts for every exchange transaction consumes time and energy. Every time something new is to be done, contracts have to be renegotiated. These transaction costs often make it difficult and expensive to be productive. If you simply want someone to paint your garage, an individual agreement with the painter makes sense. It would be pointless to form a corporation with the painter. But if you wanted to work with the painter and 20 of his buddies to paint a variety of buildings over a long period of time, forming a corporation and hiring them as employees might make sense.
Carl Dahlman has identified several kinds of transaction costs. Search and information costs involve the difficulty in finding the right people with whom to make a contract for each task. Bargaining and decision costs involve the time and energy used to reach agreement on the terms for each task. Policing and enforcement costs involve the expense in ensuring compliance with each individual contract. When individuals form a firm, a single employment contract replaces this complex series of contracts. The contract states that the person agrees to do what the employer or entrepreneur says within certain limits in exchange for specified compensation. Direction by the entrepreneur replaces numerous contracts made in the market.
Firms will continue to grow so long as the cost of adding activities by organizing labor and resources within the firm is less than the cost of contracting for those factors on the market. The firm will stop growing at the point where the costs of organizing a transaction internally equals the cost of carrying it out through market transactions.
Firms will tend to grow under several conditions. If workers are closer together, it becomes easier to organize them. The movement of people to cities in the Industrial Revolution helped companies to get bigger. Government policy can also alter transaction costs to favor growing firms. For example, sales tax is imposed on market transactions but not on activities within the firm. The higher the sales tax the more the cost advantage to corporate organization of economic activity.
Technology and Transaction Costs
Technological change can strongly alter transaction costs and so affect the size of firms. Coase himself noted that an invention like the telephone may tend to increase the size of the firm. It does this by making it easier to organize widely dispersed individuals. Yet as Coase also noted, every invention will change not only the costs of internal organization but also the costs of using the price mechanism. Whether firms get larger or smaller depends on which effect is greater. In today’s world of a rapidly evolving Internet and increasingly powerful business software, technology is already changing the optimal size of the firm and the look of the business ecosystem.
We don’t need to look to the future to see the effect of technology on the size of firms. Twenty-five years ago Fortune 500 companies employed 20 percent of workers. Now it’s only 10 percent. Many observers have noted that the widespread use of e-mail has flattened corporate hierarchies. These companies may be larger than ever in terms of money flows, but the number of layers of communication between top executives and lower-level operatives has shrunk. Some fast-paced technology companies actively encourage their employees to communicate directly with high-level planners. The popularity of software such as Lotus Notes and “groupware” is enabling groups of employees to communicate with less managerial mediation.
Two areas of technology will have the most profound impact on business organization, flattening hierarchies, enabling innovative business structures, and fostering temporary, flexible work teams in place of fixed giant corporations. These areas—computer networks and enterprise systems—work together to alter the incentives of business.
Computer networks include the rapidly growing Internet. The utility of the Internet grows as the number of computers and users on it grows and as bandwidth expands. Fax machines were not terribly useful when only a handful of people had them. Once they became almost ubiquitous, their utility improved drastically. Similarly, when only a few physicists in Switzerland used the World Wide Web, its utility was severely limited. As millions of individuals and tens of thousands of businesses go online, more and more of us find the Internet indispensable. As bandwidth improves, its utility will grow further as we move to real-time video and interactive virtual environments.
Along with the Internet, businesses are developing “intranets” and “extranets.” Intranets are computer networks accessible only within the corporation. They allow the easy and efficient sharing of corporate information, tracking of activities, and communication of ideas. Extranets extend a company’s networks over the Internet to its suppliers, customers, and partners. Intranets reduce transaction costs within the firm, while extranets and the Internet itself also reduce costs in the market.
Dramatic Productivity Gains
Enterprise systems add to the business transformations being wrought by computer networks. Enterprise systems take the form of enterprise resource planning (ERP) software (and related packages such as supply-chain management and sales-force automation software). When a company installs ERP software it is not simply running another piece of business software. It is installing a business model—a way of doing business embodied in the structure of the program. Enterprise systems organize and integrate a company’s reporting, sales and delivery, financials, manufacturing, service, inventory and supply, and human resources. More and more businesses are installing these programs in pursuit of enormous productivity gains. A company might reduce the time it takes to re-price all its products from five days to five minutes, reduce credit checks from 20 minutes to three seconds, and ship products within 24 hours instead of two weeks.
The development and convergence of computer networks and enterprise systems are changing the shape of corporations by reducing transaction costs. Even when companies appear very large, as measured in terms of their revenues, they employ relatively few people. They are becoming increasingly “hollow.” Dell Computer, for example, differs greatly from traditional manufacturers. It not only does not make computer parts, it does not even buy the low-level components. Instead it buys subsystems and assembles them into a range of computers. Since Dell does no manufacturing, it can fulfill orders rapidly. Thanks to its enterprise system, it carries an incredibly low eight days of inventory (compared to two months for competitors).
Some companies are so decentralized that they never even handle their products at any point. One fashion accessories company with $80 million in revenues has only three employees. It contracts with other companies and individuals to make its products, design its packaging, and distribute and sell its products. The automobile industry is experiencing similar changes. A modern factory will simply fit together pre-assembled parts.
Companies are not only hollowing out; they are becoming more fluid in organizational structure. I have already noted that e-mail and intranets allow employees to communicate directly and easily. Intranets also give everyone ready access to corporate information without having to go through management. As the flow of information has improved, it has become easier to loosen the corporate structure while continuing to track activity. Largely autonomous temporary work teams have been one result. Traditional companies maintain a strict organizational hierarchy. Each employee has a superior, and that superior has a higher level superior. Increasingly, employees are forming independent work teams with no fixed boss. Business units within corporations even deal with one another as if they were independent companies, having to make competitive offers for their services. This is sometimes called “intrapreneurship.”
Hollow corporations, outsourcing, independent business units, and intrapreneurs join other trends to transform the corporate landscape. Temporary workers and freelancers add to organizational flexibility. The temporary agency, Manpower Services, now employs more people than any other private company. As Internet access improves and bandwidth expands, telecommuting becomes an option for more and more people. As these new options proliferate, bigness often becomes less appealing. More companies spin off operations into new corporations, adding to their flexibility and focus.
Computer networks continue to spread and to expand in capacity. We find sound and video appearing all over the Web. Full motion teleconferencing is becoming feasible. Before long we will see virtual reality technology reach a point where virtual meetings can take place, making physical proximity unnecessary. Individuals will search for one another over the Net, set up businesses using off-the-shelf enterprise systems, then dissolve their team when the job is done, perhaps never having physically met at any time.
Large, stable, enduring corporations will not disappear. But they will cease to dominate the corporate ecosystem. The new face of business will look far more diverse. We will see constellations of activity, including large corporations, corporations with vast revenues but few employees or production facilities, temporary firms formed for a single project (which might be hugely complex), and semi-independent work teams. The existing large companies may perform the valuable role of creating the cultures and standards that allow these corporate mutations to emerge and flourish.
Government: Stay Out of the Way
Governments may slow down this process, but cannot stop the forces of technological change. The best way to help is to stay out of the way as new business structures form. They can also help by cutting sales taxes. Sales tax is paid on exchanges between companies but not within a company. This makes it more economic to organize activity internally rather than contracting for it on the market, making companies bigger.
We will not become citizens of Microsoft or General Electric. While large corporations will probably continue to exist in the future, they will not dominate the economy. On the contrary, the continuing reduction in transaction costs, the expansion in computer network bandwidth, and the ability to quickly create a business using off-the-shelf processes will accelerate today’s trends toward a more diverse and flexible business environment. Free markets will bring not King Kong capitalism but a network of dynamically changing organizations. Permanent corporations will be only one of many species in the business ecology of the 21st century.
The market is vastly smarter than any individual, so we cannot predict exact or complete details of the emerging economy. Yet the trend clearly favors flexibility over rigidity, responsiveness over resistance, and speed over size.
Ronald H. Coase, “The Nature of the Firm,” in The Firm, The Market, and the Law (Chicago: University of Chicago Press, 1988).
Carl Dahlman, “The Problem of Externality,” The Journal of Law and Economics, April 1979.
Thomas W. Malone and Robert J. Laubacher, “The Dawn of the E-Lance Economy,” Harvard Business Review, September-October 1998.