Big business is a myth

Many policy discussions, from antitrust to telecom policy, focus on how large businesses should be. Almost no one asks the big questions. Why are businesses created in the first place? Wouldn’t an economy comprised of independent individuals yield greater productivity? Or would a society organized as one large corporation be more efficient? At first glance, a production process where every worker is an independent contractor might seem most efficient.

In reality, businesses range in size from corner stores to multinational corporations. Why are there differences in sizes? Some claim that certain businesses are simply greedier or more adept at growing. In his famous article “The Nature of the Firm,” economist Ronald Coase had a deeper answer: transaction costs.

Take the automobile-making process as an example. Auto companies tend to be very large. It takes thousands of engineers, designers, safety experts, and truckers to successfully design, build, and transport a single car. A decentralized body of independent contractors would have trouble managing the endless contracts, interviews, and logistics needed to coordinate the whole process. Hence, companies consolidate individuals and resources to reduce transaction costs. In other words, companies greatly reduce friction.

Transaction costs explain why businesses are formed: to decrease the producer’s total cost. High production costs make a firm uncompetitive and force higher prices, which are often incurred by the buyer. The structure a business provides helps producers to avoid this problem by consolidating capital to one location with long-term contracts and aligned goals.

But not every industry is the same. In some industries, like autos, bigger firms have the lowest transaction costs. In other industries, like corner stores or boutique crafts, smaller producers have lower transaction costs. That explains the wide variation in business sizes.

Nonetheless, transaction costs alone do not explain all growth. Many businesses have advantages of scale. As a business produces more goods, the marginal cost (the cost per producing one additional unit) often decreases. This increases the good’s average profit through lowering the average total cost of production.

In layman’s terms, the cost of producing the next unit differs at every quantity produced. Typically, this marginal cost decreases as the quantity increases. However, this process is not unlimited, due to transaction costs. Coordination problems, including layers of management, paperwork, and other frictions, increase with the size of the firm. This leads to diminishing marginal returns. A company stops production when the cost of producing additional goods exceeds the profits it generates. This self-regulating mechanism prevents endless growth. Ironically, the search for a profit is the same factor that grows and limits a business.

In short, transaction costs and diminishing marginal returns show us that companies have a natural upper limit on corporate size. If a company becomes too big and bureaucratic, a smaller and nimbler competitor with lower transaction costs can gain ground in the market. Just as FedEx’s market entry in the 1970s caused a bulky and inefficient US Postal Service to improve its service for customers, transaction costs naturally regulate the size of big companies.

Ronald Coase’s idea of natural limits on corporate size has been under attack. Economic populists on both sides of the aisle have criticized large corporations, without economic grounding, for being too big. “Big business” has become a politicized, arbitrary term used by elected officials to signal their solidarity with American consumers. The first step to overcoming populist anger is understanding that companies cannot endlessly expand, particularly due to transaction costs and diminishing returns.