Indispensable Economics Size Matters

Jul 17, 2009

Yesterday I had a conversation with a gentleman who argued that large corporations and “Wall Street,” whatever he meant by that phrase, worked to the detriment of small business. He complained that large corporations and “Wall Street” put small businesses out of existence.

 

While this conversation was too short because we both had to leave, I tried to point out that the facts do not bear out this theory. Small business employs two-thirds of all employees in the United States, and since Reagan was president, small business has flourished.

 

In his theory I detected the distributist, “big is bad, small is good” theory pursued also by Thorstein Veblen. I have argued before, and this kicked off our conversation, that the distributists have absolutely no serious economic theory to back up their assertions. I am waiting for a distributist to claim that he read one of the most important scholarly articles ever written which increased the understanding of economists regarding the nature and size of corporations. The article was by Nobel Prize–winning economist Ronald Coase in 1937. All persons who have pursued graduate study in economics have read this article. Up to my present experience, no distributist has even heard of it.

 

The article is entitled “The Nature of the Firm,” and it demonstrates that no one really examined this subject before. Why do firms exist, what do they do and how large should they be? We are here concerned with the answer to the last question. Firms are as large as they have to be in order to effectively and efficiently produce and market the product or service to the consumers.

 

This is so obvious, you’d have to have blinders of ideology on not to see it. Suppose I want to start a photocopying store. I see a need in a neighborhood where there is inconvenience in doing the specialized jobs that I would do; I rent my facility and I hire persons who have specialized training in these copying jobs. (I am simplifying just to show my point.) In terms of size of the firm, there may be three employees and myself, who directs the firm and assigns the work. Suppose I now see a niche market in auto manufacturing, now that the government is forcing General Motors to make “green” cars that few want to buy. I want to start a firm that will actually cater to consumers with large families who really want large cars, and for tall people who find it hard to fit comfortably into “smart” cars.

 

In this latter case, there will be a massive investment in time, technology, and specialized hiring, such as engineers, machinists and designers. And this is just getting starting. I need metal used to make parts, railroads to transport the product, dealers to distribute the “Luckeymobile,” and a lot of people to make it. I need a marketing staff and a large office staff to manage the whole affair. This is truly a gigantic project. Where will I get the money? In the copying business I could get a second mortgage on my house and then hit up my relatives. For the car project I need to go to the dreaded “Wall Street”! Investment banks and the stock and bond markets are the only places likely to be able to pool the enormous funds needed for my task, and I will have to demonstrate the market need for such vehicles by first paying for a market survey. (I have gotten tired just thinking about it.) My business will be as large as it needs to be to make “Luckeymobiles.” If it is any smaller, the car will not be properly made and marketed. Any larger, and I am wasting money. Why should I borrow money to get more than I need, seeing that the sales of the cars must be enough to pay that money back? If I want to stay competitive with the other car companies, I need to sell at a lower price than they. Extra, unnecessary expenses may force the price up and make me less competitive. If I do not get enough employees, equipment, etc., the car will not be made, or sales properly accounted for, or properly marketed, designed or engineered. In addition to this, I must show a decent profit, because the “evil” “Wall Street” folks did not lend me all those millions of dollars because I was handsome, but because they could get a return on that loan sufficient to give me the money rather than some alternative project. This forces me to be efficient, even if my company is large, meaning I need to keep expenses down so that I can clear a decent profit, to give a decent return to my investors.

 

Frankly, I see no problem in this at all, and if I was running a car company, I would do it this way. What the man I was speaking with meant about big corporations and Wall Street attacking small business, I do not know, but I think I have the scenario that many anti-free market folks bring up. The devil in this case is John D. Rockefeller. The story, once presented to me at a cocktail party, goes like this: John D. Rockefeller was able to force small oil producers out of business, and then he aggrandized his empire and raised prices to abominable levels, because there was no place else to go. I told the man at the party that this was not true. Did you ever run into people that are so sure and forceful in their arguments, you start to doubt your own facts and arguments? This was that kind of person. Afterwards, I went and looked up the facts. I was right all along. (I always am.) John D. Rockefeller was a very religious man. He wrote in his diary that his purpose in life was to enable every family to have oil to light their lamps in the evening so that they could read! In those days, oil lamps created the only serious demand for oil, and only the rich could afford them, because most of the oil came from whales; difficult to catch and squeeze the meager amount of oil from. So the cost of oil was so high, only the rich could afford it and the rest had to live in the dark. The truth is that Rockefeller bought out inefficient petroleum producers, whose oil was way too expensive because of their inefficiency, and then produced oil more efficiently, lowering the cost so much that actually everyone could light their lamps in the evening to read.

 

This is true of buyouts. The capital markets, i.e., Wall Street, search for inefficient firms to buy out and make more efficient, thus turning a larger profit than the old owners and operators. The very threat of a buyout is a disincentive to x-inefficiency, which is where a company settles for a lower profit because their expenses are built up from junkets for the executives and the purchase of extra Lear jets. So the dreaded Wall Street does us all a service because inefficiency of any kind wastes resources, and causes prices to be higher than they ordinarily would be.