The Amazing Shrinking Firm

Get Small

In his seminal paper, The Nature of the Firm, the great Ronald Coase stated that the optimal size of a firm in an industry will decrease as transaction costs in the industry decrease. The Internet has proven to be a singular tool to reduce transaction costs across almost every industry, so according to Coase, the size of the firm will shrink in response. My view is this phenomenon has only begun and will accelerate dramatically over the next decade.

The on-demand economy. The consumerization of enterprise. The bottoms-up economy. Micro-schools. Citizen journalists. Social media. All of these are symptoms of the same phenomena: the decimation of the firm. Transaction costs are being drastically lowered, enabling small companies to do what large companies used to do.

Everyone understands that firms can be smaller. The non-obvious conclusion is that firms should be smaller.

In classical microeconomics, the marginal cost of a regular firm is modeled as a smile shaped curve. As you increase scale, marginal costs decline at first, as you enjoy economies of scale. Past a certain point, though, the costs of organizing, which include upper management, overhead, and communication costs, begin to outweigh the benefits of scale, and so the curve begins to rise again. The optimal size of the firm is at the minimum of the curve.

If you can reduce economies of scale, then the optimal size of the firm shrinks. If you can reduce the costs of organizing, then the firm grows. My contention is that we’re at a point where we’re seeing drastic reductions in marginal costs, whereas we’re only seeing incremental productivity gains in the costs of organizing. The former is subject to exponential returns. The latter is constrained by messy human behavioral factors. The former wins.

Schools

Schools are a great example of how small is starting to win. AltSchool, Khan Laboratory School, and Acton Academy are all examples of a new breed of K-12 micro schools, schools with fewer than 150 students per location. Two decades ago, such schools wouldn’t be able to exist without serious compromises. At that size, you’d only have basic subjects and basic services. You’d have a substandard library, no specialist teachers, and support for only a couple of grade levels. Now, with personalized learning platforms, microschools are able to deliver self-paced, self-directed programs that have kids testing years above grade level, all with fewer administrators and far less real estate than before.

But that’s not where it ends. The agility enabled by this size matters. At 150 students, you only need a team of 3–6 teachers and no on-site administrators. You can fit into commercial space that is far more liquid a market than what is required for a full elementary or secondary school. You can easily spin up or wind down schools to match demand. With smaller but more numerous schools, school choice actually becomes meaningful. Rather than having only one or two neighborhood schools to choose from, parents may have ten or twenty, finally realizing the promise and benefits of school choice.

Lastly, with smaller staffs, you can be much more agile and autonomous in crafting and delivering your programs. Traditional schools are notoriously dysfunctional, whether it be at the teacher, administrator, or district level. Small schools are the antidote to crippling beaurocracy.

Innovation in schools happens in many different dimensions. However, it’s no coincidence that those who are pushing the envelope furthest in all of the dimensions also happen to have small physical footprints. In the future, the optimal size of the school will be smaller. In the future, the best schools in the world will be small schools.

The Splintering of Big Companies

Even concepts like holocracy are results of the decimation of the firm. At Amazon, a behemoth company, they have a famous principle known as the 2-pizza rule. If a team cannot be fed with 2 pizzas, it is too large and must be broken up. It is a recognition that in today’s economy, agility beats scale, and even large companies constrain themselves to look more like an amalgam of splinter cells rather than a monolithic armada. That decentralization of power is only going to continue, whether it be in the form of holocracy, 2-pizza teams, leagues of independent contractors, or simply more decentralized decision-making.

Increasingly, the glue that holds together a large firm will be vision and mission, not formal hierarchy.

Be the Organizing Principle

The only exception to the shrinking of the firm is the natural monopoly, which occurs in an industry in which multi-firm production is more costly than production by a monopoly. The classical example of this is a public utility, like water, which has very high fixed costs relative to its very low and constant marginal costs. The prototypical digital example would be a company with network effects, like Google, Uber, Amazon, or Ebay. Each of these companies, by acting as their industry’s organizing principle, has shrunken the optimal size of the firms it serves (taxi companies are reduced to taxis, for example). But each of these companies is itself a behemoth. If you are the organizing principle in an industry, you will not only continue to scale in the new world, you will also capture the lion’s share of the economic rents within your industry.

The takeaway is this. If you want to run a unicorn, look to be the organizing principle in an industry. As Peter Thiel puts it, aim to be a monopoly, the natural monopoly in your industry. Only there will you capture outsized rents. Alternatively, if you want to operate as a participant within an industry, run lean and agile, and your agility will prove to be more and more of an advantage against the incumbents as time goes on.

What It Means

So what does this mean for entrepreneurs? When considering companies to join or launch, ask whether your products or services help to eradicate economies of scale. Will you empower little companies or giants? Will you shrink firms or grow them? Are you an organizing principle or a fierce competitor? Do you help big teams or small teams? All of these tests are instructive. All of them qualify or disqualify many of the startups currently in market.

As you ponder your next opportunities, remember that the meek shall inherit the earth. Bet small.