Small Business Doctor

Company size is a strategic decision. This decision, like all corporate strategy decision, is made by examining a company or nonprofit organization’s external environment.

Coase’s theory of the firm tells us that big companies are big because they have decided to take in-house tasks that could otherwise have been performed out in the marketplace. Company decision makers make this decision because they think these tasks can be performed at less cost by their own employees than by external vendors even though adding tasks and employees increases the company’s management load and there are diminishing returns to management.

In order for that strategic decision to make economic sense, the transaction costs in the marketplace must be higher than the extra management costs from adding these tasks and employees. If those transaction costs decrease, meaning that it now becomes less costly to pay for whatever product or service out in the market, then the company is strategically misaligned. The company, structured in this way with higher internal managerial costs than the market will bear, can no longer produce its own product or service at a competitive price. Unless it changes its own management structure, the company will eventually decline.

Business writers use the term downsize to refer to this change in a company’s management structure. Most often so-called “middle management” jobs are eliminated when this occurs. This is painful and costly both for the employees of course but also for the company itself.

That’s why it is in the best interest of a big company for those transaction costs inherent in market transactions to remain high. That enables the company’s expensive management costs to continue being justified.

The primary reason for transaction costs to be high is low social trust. Low social trust environments require more lawyers, inspectors, guards, auditors, insurance, and so forth. High social trust environments like Amish communities have very low to no need for any of those services and therefore have very low to nonexistent transaction costs. That is also why companies in these high social trust economic environments do not tend to employ many if any managers or human relations staff to provide these services internally.

High trust social networks favor many small companies along the supply chain. Low trust social networks favor a few big companies along the supply chain. Therefore, a big company is incentivized to do what it can to keep social trust in the marketplace low. Big companies and big organizations have an incentive to keep the social networks in which they operate at low levels of social trust.