Saturday, February 19, 2011

Explaining Why Some Firms are Big

The ecology of the business world is a logarithmic landscape of firms with lots of little companies, fewer middle-size companies, and a very few behemoths.

If you recall, over the last two decades, the same decades that glorified the EMH (Efficient Market Hypothesis) and globalization and small nimble firms that outsourced all but their essential operations, the world became a destablized place. I think all three phenomena are related, but I'm not an economics type so I have no evidence or real understanding. But here's my argument...
  • EMH spread the lie that markets were optimal, that prices included all information, and nobody could do better in estimating real value than what the market price indicated. But this is an illusion as the 2008 stock market crash illustrates. A few who understood the enormous scale of fraud underlying the rise in liar loans and the sordid lies behind mortgage securitization foresaw the crash and made a fortune. The market price didn't "foresee" this. It did the famous Wily Coyote moment of going over the cliff, looking down, seeing there was no ground beneath it, and fell.

  • Globalization spread the lie that the best market was an international market that gave everybody a chance to enhance their comparative advantage. But the disorderly collapse of internal labour markets as work was outsourced and the lie of equal and fair access to markets as demonstrated by the continued manipulation of market that exclude third world countries from fair access to developed world markets put the lie to this idealization.

  • Outsourcing is built on the lie that you can spin off the "non-essential" parts of your business and focus on just those key bits where your intellectual property and business prowess are maximized. But as the following post from Krugman shows, that is a lie.
All three are lies based on utopian social thinking. During the revolutionary 19th century so many insurgencies went haywire because of utopian thinking. The utopianism of Communism's central planning was the bane of 20th century economies. The three examples I cite above are examples of late 20th century/early 21st century utopianism that have destabilized the economic future of billions of people.

Here is a post by Paul Krugman looking at the disaster that the Dreamliner has been for Boeing:
Thank You, Boeing

For providing such a clear illustration of the forces driving the theory of the firm.

Oliver Williamson shared the 2009 Nobel mainly because of his work on a question that may seem obvious, but is much less so once you think about it: why are there so many big companies? Why not just rely on markets to coordinate activity among individuals or small firms? Why, in effect, do we have a lot of fairly large command-and-control economies embedded in our market system?

Williamson answered this in terms of the difficulties of writing complete contracts; when the tasks that need to be done are complex, so that you can’t fully specify what people should do in advance, there can be a lot of slippage and strategic behavior if you rely on market incentives; in such cases it can be better to do these things in-house, so that you can simply tell people to do something a particular way or to change their behavior.

In Boeing’s case, they outsourced far too much, only to find that they were getting parts that didn’t do what they were supposed to — and also to find that the subcontractors were seizing a lot of the rents. They discovered, in effect, that there are times when it’s better to rely on central planning than to leave things up to the market.

Obviously this isn’t always true. There’s a tradeoff. But that’s the point — and it’s this tradeoff that determines how big firms should be. Boeing has now provided a clear motivating example. Their loss, the economics profession’s gain.
Go read the original post by Krugman to get the embedded links.

I always enjoy Krugman's ability to clearly get across an insight into economics. Here he points out that Boeing's failure with outsourcing demonstrates why you have big firms. There is a cost to trying to realize the idealization of "efficiencies" like outsourcing (or, as I would claim, the "efficiencies" of EMH or globalization). So for real world reasons, some firms get big so they don't have to deal with the hard reality of writing a contract that can spell out all the expectations of a collaboration between two firms.

Excellent post by Krugman. It makes a person think and understand and connect dots and get a better picture of the world.

And here's a relevant detailed bit on exactly what Boeing did wrong. From an article in the LA times:
787 Dreamliner teaches Boeing costly lesson on outsourcing

The airliner is billions of dollars over budget and about three years late. Much of the blame belongs to the company's farming out work to suppliers around the nation and in foreign countries

The 787 has more foreign-made content — 30% — than any other Boeing plane.... That compares with just over 5% in the company's workhorse 747 airliner. Boeing's goal, it seems, was to convert its storied aircraft factory near Seattle to a mere assembly plant, bolting together modules designed and produced elsewhere as though from kits. The drawbacks of this approach emerged early. Some of the pieces manufactured by far-flung suppliers didn't fit together. Some subcontractors couldn't meet their output quotas, creating huge production logjams when critical parts weren't available in the necessary sequence. Rather than follow its old model of providing parts subcontractors with detailed blueprints created at home, Boeing gave suppliers less detailed specifications and required them to create their own blueprints. Some then farmed out their engineering to their own subcontractors, Mike Bair, the former head of the 787 program, said at a meeting of business leaders in Washington state in 2007. That further reduced Boeing's ability to supervise design and manufacture. At least one major supplier didn't even have an engineering department when it won its contract, according to an analysis of the 787 by the European consortium Airbus, Boeing's top global competitor.

Boeing executives now admit that the company's aggressive outsourcing put it in partnership with suppliers that weren't up to the job. They say Boeing didn't recognize that sending so much work abroad would demand more intensive management from the home plant, not less. "We gave work to people that had never really done this kind of technology before, and then we didn't provide the oversight that was necessary," Jim Albaugh, the company's commercial aviation chief, told business students at Seattle University last month. "In hindsight, we spent a lot more money in trying to recover than we ever would have spent if we tried to keep many of the key technologies closer to Boeing. The pendulum swung too far."...

That's not to say that outsourcing never makes sense — it's a good way to make use of the precision skills of specialty manufacturers, which would be costly to duplicate. But Boeing's experience shows that it's folly to think that every dollar spent on outsourcing means a cost savings on the finished product.Boeing can't say it wasn't warned. As early as 2001, L.J. Hart-Smith, a Boeing senior technical fellow, produced a prescient analysis projecting that excessive outsourcing would raise Boeing's costs and steer profits to its subcontractors. Among the least profitable jobs in aircraft manufacturing, he pointed out, is final assembly — the job Boeing proposed to retain.
Utopian thinking is dangerous. Boeing is an object lesson in extreme optimism born of a utopianism derived from the three points made above.

Extreme pessimism is dangerous, but utopianism is an example of extreme optimism and it too is dangerous. As I watch the spreading demonstrations and revolutions in the Middle East my mind is brought to think about utopianism. These upsurges are based on an optimism that fundamental social change can be achieved quickly and easily. Unfortunately, I don't think so. I'm happy with the revolts and the overthrow of tyrants. But the people are fooling themselves if they think that social revolution is an easy thing.

Already in Egypt it is clear that the military is working from a different "playbook" than the demonstrators. They still haven't released all political prisoners, they are not laying out a path to effective democracy, they have not quickly included civilians in the instutions and created transitional organizations. Instead we are hearing echos of Obamas "security and stability" calls with the military in Egypt calling for an end to all strikes and the people to abandon the only tool they have: demonstrations. The path forward in Egypt is unclear. I remain hopeful, but the number of "worrying signs" increases daily.

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