Arnold Kling, "Arguing in My Spare Time," No. 17

Larry Downes and Chunka Mui have developed an interesting speculative hypothesis concerning the trend in the relative advantages of large firms and small firms. This hypothesis can be found in their recent book. However, instead of titling their book, "An interesting speculative hypothesis. . .," they called it "Unleashing the Killer App: Digital Strategies for Market Dominance..."

Clearly, spin is everything, which is why this edition of aimst is called "Unleashing the Killer Essay." Otherwise, I was going to call it something like "Thoughts on the issue of firm size."

What Downes and Mui (D-M) suggest is that firms will get smaller as the Internet makes markets more efficient. They base this hypothesis on the theories of Ronald Coase, an economist who wrote "The Nature of the Firm" in 1937.

Their ideas can be applied to my doctor's office. That office can be thought of as three businesses:

1) Medical analysis and advice

2) Front-end laboratory work

3) Bookkeeping, order entry, and production scheduling

At least two of these businesses are guilty of egregious malpractice. What I notice is that I invariably spend 90 percent of my time at the doctor's office dealing with the second and third businesses.

In the Coase/D-M world, these three businesses will be split up. I will get my blood drawn, EKG done, etc. at any of dozens of labs that work seamlessly with the now-separate analysis and advice business. The clerical and administrative functions also will be outsourced, in this case to the customer. I myself will fill out web forms, instead of writing things on a clipboard so that some inexperienced clerk (it is characteristic of mismanaged businesses that turnover is very high) can type them erroneously into a computer.

The idea is that as markets become more efficient, the internal inefficiencies of unnecessarily complex firms will be exposed and eliminated. The internal transactions among the three components of the doctor's office will be replaced by market-mediated transactons. The result, D-M argue, is that firms will get smaller.

There may be something to the D-M hypothesis that firms will get smaller as increased market efficiency enhances the advantages of outsourcing. However, it is interesting that the doctor's office already is a small business, yet it seems to be a good illustration of the potential for outsourcing.

It seems to me that the D-M hypothesis is more about scope than about scale. The unbundling of services will reduce the scope of firms, but it will not necessarily reduce their scale. I imagine that my doctor's office would become larger if it could just get its act together on the administrative side.

I have another hypothesis about the difference between large and small firms. This hypothesis is that large firms and small firms use different approaches for managing risk-taking and innovation.

In the previous essay, I pointed out that if middle managers at a large firm were given the risk-taking authority that their management gurus tell them they ought to have, this could prove to be disastrous. With no personal downside risk and some share in the upside from risk-taking, they would be incented to make very unsound decisions. As a result, I argued, in order to survive a large firm must put in place systems and controls that limit individual risk-taking. Hence, the process by which a large firm evaluates new ideas necessarily involves bureaucratic filtering.

In contrast, in small entrepeneurial firms the decision-makers share the downside risk as well as the upside potential. This creates built-in incentives to evaluate risks carefully. This reduces the need for the degree of checks, balances, and controls that are required to manage risk in large firms.

In my view, the contest between small firms and large firms is a contest between two mechanisms for incorporating innovation. In a small firm, the mechanism will tend to be trial-and-error. In the large firm, the mechanism will be bureaucratic filtering.

If the Internet and other recent technologies are going to give the advantage to small firms, it must be because they give an advantage to trial-and-error learning as compared with bureaucratic filtering. This is what follows from the hypothesis that the differences between large and small firms lie in this realm.

Hal Varian has suggested that two factors that affect the ability of small firms to introduce innovation are the cost of entry and the cost of imitation. If it costs a great deal to enter an industry, then incumbents are at an advantage and small innovators are at a disadvantage. Conversely, if it costs a great deal to imitate, then incumbents are at a disadvantage and small innovators are at an advantage.

It seems plausible that the Internet has reduced the cost of entry. Once you have built a better mousetrap, it costs very little to put up a web site. Granted there is the question of what it costs these days to get people to find your door so that they can beat it down. However, on balance, the total cost of marketing an innovation probably has declined.

If the costs of imitation are the costs of operating bureaucratic filtering systems, these costs probably have declined by less. True, with better communication technology, the same people can be engaged in the decision-making process more quickly; however, they still need time to evaluate, discuss, and negotiate.

Another way of making this point is to return to one of my earlier themes, which is that the economic problem is shifting from one of allocating capital to one of allocating talent. When innovations require large capital investments to be implemented, this necessarily implies that the cost of entry is high, and there may be large advantages to imitation. When innovation requires superior allocation of talent, the cost of entry may be low and the cost of imitation may be high.

To summarize, this essay has strung together the following hypotheses:

1. In small firms, risk-taking incentives are better aligned than they are in large firms. Therefore, smaller firms require fewer controls and bureaucratic processes.

2. Small firms will be advantaged to the extent that entry costs are low and imitation costs are high.

3. The Internet is likely to lower entry costs more than imitation costs.

4. The increased important of talent relative to capital is likely to lower entry costs relative to imitation costs.

If these hypotheses are correct, then they add up to a case for saying that trends favor small firms.