Economic over-centralization driven by tactics and weak executives!

A fundamental trend in business and government is to centralize; to evolve from a market or political system with a multitude of small players into one that is dominated by one or more large players, each of which is lead by a single, central authority. A centralizing force of the industrial revolution and our modern society— acting like the centralizing force of gravity which builds planets and stars out of clouds of dust— is the economy of scale: as the amount of a product supplied by a single organization increases, the unit cost to produce it decreases (up to some limit beyond which it increases thereafter… but that’s another essay). Therefore, a single supplier with a large market share has an intrinsic cost advantage over competitors with much smaller market shares and will use this advantage to grow even larger by driving its competitors out of business or by buying them up.

The advantage of scale has nothing to do with the relative management competence of larger and smaller players; incompetent, overpaid executives of large companies still have an intrinsic cost advantage over more competent managers of smaller competitors. Nearly all executives of major banks and corporations inherited their positions by patiently navigating through middle management; since they didn’t establish the competitive advantages they enjoy, there is precious little experimental evidence that they are even average in competence. Their compensation policies suggest that they are well below average in spite of mythology to the contrary.

However, the benefits of centralization do not come for nothing, they require tradeoffs. Without exception, the tradeoffs of centralization are to develop tactical advantages in exchange for greater strategic liabilities. (If you think you’ve found an exception in business or anywhere else, please comment, the ensuing discussion will be interesting and perhaps mutually educational.)

That is, centralization is always driven by short term gains and paid for with long term risks. The tradeoffs may or may not be worthwhile, but to judge their worth simply from initial results is a bit foolish; as we are rediscovering with our current financial crisis, in part the consequence of enabling a gross over-centralization of financial management led by a weak “inheritocracy”.

The strategic liabilities of any market dominated by a few players include these: a) they are too big to fail without bringing the whole system down, b) leadership is inherited and not based on proven merits in a competitive marketplace, c) the system develops too few qualified leaders and workers for the next generation, and too many qualified middle-managers who advance by taking no risks, d) the strategy of big players is not to adapt to changing needs but to control their environments (tell customers what they need, buy politicians with political donations, etc.), e) there is no “free-market” way to test the validity of the products nor the quality of leadership by successes and failures…. One needs at least twelve relatively equal competitors for success/failure results to be statistically valid with a reasonable level of confidence!

Centralization is a powerful tool that should be used sparingly in business and in government. Because the natural forces and tactical benefits will push centralization all the way to “eternal monopolies”, we need to provide multiple layers of inhibiting social forces that limit any centralization both in size and duration (thus, for example my earlier hint that we limit corporate charters to 60 years). Businesses that monopolize or simply become too large to fail destroy free markets and democratic societies as surely as political dictators.

In subsequent commentaries I will show how natural systems use centralization to enhance life on earth, but simultaneously limit centralization to sustain life on earth, and how we might emulate nature to get the benefits of centralization in a healthy and enjoyable economic and social system.