The Seeds of Corporate Failure

Over recent decades, there has been an explosion in business knowledge.  Furthermore, pervasive networks facilitate the dissemination of such knowledge.  Nevertheless, businesses - even very large, formerly very successful businesses - fail at a consistent rate.  Conventional thinking suggests that the causes of failure are largely extrinsic - unexpected shocks.  In such cases, one might expect that a company's size might insulate it from failure.  Contrary to such thinking is evidence that the primary cause of failure is intrinsic, and large companies may bear the seeds of their own destruction.

As Paul Ormerod, author of Why Most Things Fail, notes:

More than 10 per cent of all economically active firms in the US become extinct each year.  It is a distinctive feature of firms, and any economic theory of the firm should attempt to explain it.  Conventional economic theory can only do so by positing an endless supply of completely unexpected shocks, for otherwise the perfectly informed, rational decision-making firm should never die.

In other words, conventional thinking assumes that a key cause of failure is extrinsic.  If extrinsic shocks were the key driver of failure, one would expect that large firms would have a better chance of survival.  After all, large firms can benefit from economies of scale and scope.  Furthermore, their characteristics accumulations of resources can serve as buffers.  Nevertheless, size is no guarantee of longevity:

Very basic mistakes...weed out very quickly those least adapted to survive...surprisingly, there seems to be very little connection between the size of a firm, once the first few fraught years of existence have passed, and its probability of surviving any given period.

Philip Ball, author of Critical Mass, makes a similar observation:

Of the largest five thousand U.S. firms operating in 1982...only 35 percent still existed as independent entities in 1996.

Robert Axtell, a sociologist, found a typical pattern in the lifecyle of large firms: a period of exponential growth is followed by a sudden decline and gradual dwindling.  He was able to simulate the pattern using an agent-based computer model that demonstrates that the rise and rapid decline of firms can be explained intrinsically.  Mark Buchanan, author of The Social Atom, offers this explanation:

In a small firm, each person's effort has a large impact on the total output, so what a worker gets out depends on what he or she puts in.  In small firms, therefore, no one has the incentive to free ride; all have the incentive to work hard.  In a large firm, however, any one person's contribution to the overall effort becomes much smaller.  So if someone doesn't really put in much effort, but only pretends to work hard, he or she will still get just as much because the overall productivity of the company will barely suffer...

Ball elaborates:

...collapse is a consequence of the firm's own success.  Once it grows big enough, it comes a haven for free riders who capitalize on the efforts of others.  So the firm gradually becomes riddled with slackers, until suddenly the other workers decide they have had enough and jump ship...longevity in a company stems from being able to attract and retain productive workers.  A firm fails not when its profit margins are eroded but when it is infiltrated by slackers.

Buchanan makes a similar conclusion:

In short, firms grow out of cooperation and the benefits it brings, but their success sets the stage for later cheating, which undermines the cooperation on which the firm depends.

Here is my interpretation of the dynamics described by Axtell, Ormerod, Ball, and Buchanan (please refer to the diagram at left):  A firm's capacity for success and growth is a function of its resources and capability (intrinsic) as well as good fortune (extrinsic).  Over time, capacity depends upon the interaction of two feedback loops.  The first, which I've labeled the "Rich Get Richer", is a reinforcing loop that describes how success and growth increases a firm's access to resources.  Capacity for future success, for a given level of capability, increases with an increase in resources.  The second feedback loop, which I've labeled the "Free Rider Problem", is a balancing loop.  It describes how accumulated success increases the chances of attracting free riders - slackers and kleptocrats - who drag down a firm's average capability over time.  For a constant level of resources, a decline in capability reduces the capacity for future success.

A thought experiment shows that even this simple model can simulate the patterns of growth and decline observed in the real world.  Consider the following narrative:

• A start-up typically has few resources.  Its workers tend to by highly motivated, but as researchers such as Amar Bhide have discussed, are not, on average, particularly skilled.  Consequently, a start-up's capability is usually modest.  Modest capability and low resources suggest a humble capacity to succeed.  Most don't, as reflected in the power law distribution of market outcomes and data that suggests that at least 75% of business initiatives fail to survive longer than two years.
• Sometimes, however, good fortune strikes, and humble capacity is sufficient.  Growth happens, and success accumulates.  During this phase, the Rich Get Richer feedback loop is virtuous: success improves access to resources and, thus, the capacity for future success.  In my experience, the relationship between accumulated success and capability may even be virtuous: capable people like to attach themselves to a rising star.  If so, the firm benefits from rising capability as well as increasing resources.  The rocket roars from the launching pad.
• Over time, though, the Free Rider Problem emerges.  In spite of careful (and rather expensive) efforts to mitigate agency risk through careful board supervision and measures to improve accountability, average capability diminishes over time (notwithstanding the possibility that a very large company may still have a large number of extraordinarily capable workers).
• At some critical point, success and growth stalls, and the benefit of incremental access to resources is offset by the Free Rider Problem.  At this point, the firm's best (and most mobile) workers start to hit the exit door.  At some threshold, the outflow becomes a stampede, and average capability starts to plummet.
• As capacity falls with the drop in capability, the reinforcing Rich Get Richer loop turns into a viscious cycle, in which a drop in success results in a withdrawal of resources and a further diminishment of the firm's capacity to succeed (absent miraculous good fortune).

Most new firms don't benefit from enough good fortune to ensure that their modest endowments of capability and resources translate into sufficient capacity for success.  So, small firms die.

Of the minority of firms that do benefit from a surge of success and exponential growth in capacity, few are able to recognize the true extent of their growing Free Rider Problem.  That may because we tend to internalize success, believe that we are better than average, and are convinced that we work hard.  Some (many?) large companies may even foster an environment that is corrosive to cooperation, which seems to accelerate the demise of firms.  So, big firms die.

Growing wisely would seem to be much more challenging than growing rapidly.

Comments

[Open Quest]

Have you read WIKINOMICS? After reading your blog, I think tha tyou will greatly enjoy it, and I can't wait to read your synthesis of it like you did with Beinhocker's stuff.

Love your Blog!!!!!

[Dave Bayless]

I have not read Wikinomics, but I appreciate the recommendation. I'll add it to my book pile today.