Graham & Coase: when big companies are a good idea

November 26th, 2011

Paul Graham was once asked the following RAQ (rarely asked question):

How can I avoid turning into a pointy-haired boss?

His answer:

The pointy-haired boss is a manager who doesn't program. So the surest way to avoid becoming him is to stay a programmer. What tempts programmers to become managers are companies where the only way to advance is to go into management. So avoid such companies and work for (or start) startups.

Why be a manager when you could be a founder or early employee at a startup?

Why?! Oh wow. I could fill a book explaining why. But many of my reasons are my own, and aren't relevant to you unless you're much like me. So I'll focus on the general answer to the question implied by Paul Graham: Why do large firms exist?

The question was addressed by the economist Ronald Coase in his article "The Nature of the Firm". This article, together with his work on externalities (the Coase Theorem), earned him a Nobel Prize in economics. This is one evidence that the question is interesting and far from trivial.

Suppose there are no good answers to Paul Graham's rhetorical question. That is, it's always objectively better to start or join a small firm than to be a manager in a large one. You'll always get more work done, or will be more satisfied, or both. Well, if so, competition should eventually drive large firms out of business. So why are they still around?

For starters, clearly there are problems best solved by small groups of people armed with off-the-shelf tools. For instance, two iconic YC startups funded by Paul Graham, Reddit and Dropbox, each solve a problem with the help of a few programmers and a bunch of commodity servers running a commodity software stack. A larger company could hardly improve on what they do.

Note that off-the-shelf products are key to being small (or at least starting small). Reddit or Dropbox could never build those servers from scratch. A small group of people can not erect a $5G chip fabrication facility. Building and operating a fab – or a search engine – requires lots of custom development, so you need a lot of people.

Or do you?

Of course the total number of people involved has to be very large. But it doesn't follow that they should be organized as big companies. Instead, the work could be done by many small organizations, each contracting out most of the work to others.

You're big because you hire. Why hire if you can buy, contract out – and stay small?

Indeed, this seems to make perfect sense. To quote Wikipedia's summary of The Nature of the Firm (1937):

The traditional economic theory of the time suggested that, because the market is "efficient" (that is, those who are best at providing each good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire.

Then why do most people prefer employment to self-employment, as evidenced by their actions (and an economist never trusts anything but actions as a tool to reveal someone's preferences)? Why do I hate the idea of running a small firm?

Either the "traditional economic theory" is right – one should run a small firm, and I'm a freak of nature destined to extinction due to economic evolutionary pressure, together with much of the population – or the theory is lacking, and there should be a concept formalizing my aversion to self-employment.

And in fact, at this point, Coase introduces the term – transaction costs:

Coase noted, however, that there are a number of transaction costs to using the market; the cost of obtaining a good or service via the market is actually more than just the price of the good.

Oh, yeah – MUCH more if you ask me.

Other costs, including search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs, can all potentially add to the cost of procuring something via the market.

YES! Here's a Nobel Prize-winning economist from the notoriously "pro-free market" Chicago school that UNDERSTANDS ME. He knows why I hate markets. ("Pro-market" doesn't mean you love markets, just that you think governments are even worse.)

This suggests that firms will arise when they can arrange to produce what they need internally and somehow avoid these costs.

Avoiding these costs can enable work that just can't happen outside the context of a big company.

For instance, I work on chips for embedded computer vision, at a company that's now fairly large. This is an example where a lot of people need to cooperate in a custom development effort (as opposed to fewer people using off-the-shelf products).

In theory, I could start a computer vision hardware startup instead of it being an internal project. In practice, it wouldn't work, because:

Of course, the number one real reason I couldn't run a hardware startup is that I'm no businessman. But the problems above are also very real, and frequently insurmountable for people who can do business. Not all custom development is impossible to successfully outsource, but much is. The problems result from economic fundamentals.

In econ-speak, such problems are collectively known as "search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs". Indeed, all these problems were featured in my example. In plain English, a simple way to sum up all those problems is trust – or more precisely, the lack thereof:

When you work for a big company, you deal with coworkers, and you're all playing for the same team. The smaller the company, the more you deal with customers and vendors, which means playing against them. There's no such word as "co-customer" or "co-vendor" for a good reason.

At least that's how things are framed by the rules. The rules say that all employees are agents acting towards a common goal, "to promote the company's interests" – whereas different companies have different bottom lines and different interests.

Of course, reality is never like the rules – in reality, everyone in the company plays by their own rules, attempting to promote the interest of any of the following – or a combination:

So in reality, of course there's a lot of chaos in a big company. And it doesn't help that the bigger it is, the harder it is to make sense of what's going on:

...There is a natural limit to what can be produced internally, however. Coase notices "decreasing returns to the entrepreneur function", including increasing overhead costs and increasing propensity for an overwhelmed manager to make mistakes in resource allocation. This is a countervailing cost to the use of the firm.

...Which explains why we aren't all employed by a single all-encompassing huge company.

But at least the rules of a large company frame things right – as cooperation more than competition. (Competition generally isn't an end – it's a means to ultimately force people to cooperate, and, as Coase points out, it only gets you this far.)

Of course, corporate rules also create competition – employees compete for raises, etc. But in practice, overall most would agree that it's much safer to trust co-workers than customers or vendors.

Why be a manager when you could be a founder or early employee at a startup? Here's the part of my answer that is based on economic fundamentals.

I specialize in areas requiring custom development by many people. Many people can only tightly cooperate under rules implying trust. Therefore they must not be customers and vendors, but coworkers, which leads to large firms. Such is The Nature of the Firm.

Of course there are problems that can be solved by a small group of people with mutual trust, without tightly-coupled, joint development with others – for example, the problems solved by Reddit and Dropbox. One reason I personally never looked that way is my aversion to business. Such is my own nature.

It just so happens that the nature of the firm suits my nature nicely – because there are situations where big companies are a good idea. When you can't buy and have to build, trust is fundamental to getting the job done.

UPDATE (December 9, 2011): just found an interesting analogy between company size and program size. Doing many things in one big program can be easier than using many small programs because of "transaction costs" – the cost of exchanging data between the programs.

1. Don MoodyNov 26, 2011

I believe I understand the theory of why large corporations exist & of how they can be a great benefit to society as a whole, though, I wonder has the initial idea of the corporation become corrupted in it's evolution and is now a liability?

I have noticed in my own country that many of the politicians "appear" to be lobbying on the side of corporations and against their own populations.

After seeing my own country Prime Minister lobbying on the behalf of the Asbestos industry so that Canada can sell what's known as a deadly material to 3rd world countries and this confuses me. All my life this material has been extracted from homes & buildings as if it where an infectious disease.

I've taken the time to review & absorb as much as my limited education can absorb on this subject, of big business, as I make every effort so sort out what is going on in the world today.

One of the items of study that I have come across is a movie that is marketed as, "the most successful Canadian documentary", I would like to know your thoughts on this movie as it attempts to review the history & evolution of the corporation to it's surmised end.

The corporation documentary can be found on YouTube at as well as the website

Thank you for your time and consideration, as well as, your points on "when big companies are a good idea".


Don Moody


2. SteveNov 26, 2011

"A company can’t trust a vendor, so a vendor can’t know its algorithms." Ever hear of an NDA? Similar in concept to the confidentiality agreements signed by employees who work for a company. Companies collaborate all the time on confidential technology.

What keeps information supplied to employees secret? Nothing, but their continued good behaviour.

The one thing that does run true from your comments above is the personal sentiment that you prefer working for a large firm. That's fine. As you suggest, not everyone can or wants to work for themselves, but your economic argument just sounds like rationalising your own personal preferences.

3. OnymousNov 26, 2011

An NDA is fine but it still presents the problem that the vendor can't trust the company to continue buying, so it has to generalize, and be less efficient.
And the company can't trust the vendor to produce high quality at low prices, so it has to send out those NDAs to multiple vendors, creating a larger number of firms with their top secret but which (being generalized) have no particular stakes in them succeeding.

4. Yossi KreininNov 26, 2011

@Don: I don't think big business was ever "non-corrupted" – if you have lots of money, bribing the government in an attempt to make still more money is sort of a natural idea, especially since refraining from that leaves the options open to competitors. One possible remedy, though I'm not sure how successful it is in practice, is to constitutionally limit the power of what governments can do so that it isn't worth bribing them (for instance, AFAIK Switzerland can't legally print money to bail out private firms the way the US did – I'm not sure it's a net gain to set things up this way in the long run, but an interesting idea).

@Steve, Onymous: an NDA isn't that fine, really. Wouldn't bet the future of a company on an NDA. There's a huge difference between trusting an employee, who for various widely known practical reasons is very unlikely to try to compete with you, and trusting a customer, who can very often easily become a competitor or collaborate with a competitor – and as to NDAs, well, good luck, and see you in court. If you bet on legal protection, try patents – not necessarily gonna work out very well, but better than NDA.

@Steve – are you suggesting that corporations would have no chance in a society composed of sufficiently advanced humans or other economic agents that "can and want to work for themselves", invalidating Coase's analysis?

5. FreddeNov 27, 2011

Well, the easy answer is that Paul Graham is stupid. Rich and stupid. The rich part is what makes many people not see the stupid part.

(Seriously. Start reading what he writes instead of relying it like gospel just because he sold a startup and got rich. It's at best trivial but mostly just wrong. Start by reaidng about things you know a thing or two about yourself.)

6. Don MoodyNov 27, 2011

I've recently stumbled onto what I believe may be an interesting concept to setup an organization that has no leaders and all are equal.

This site based on an "Open Source Concept" has some interesting ideas and pretty much is a contradiction to the Coase Theory as related to market efficiency.

I do believe that before I venture towards setting up such a structure that I may want to enlist the minds of some more educated than I, or "social engineers", to determine if & where the concept may become corrupted.

My best guess is that this structure could have issues with human nature such as people tend to prefer good looking folks, tall folks etc. & I wonder what effect that may have on such a structure.

Still they have a very interesting idea at Better Means. I would welcome your thoughts on their concept of a leaderless organization and whether you thought the market would be more or less “efficient”.

Thank you for your time & consideration.

Don Moody

7. Yossi KreininNov 27, 2011

@Don: Well, Coase didn't say anything about "leaders" – only that it's cheaper to produce things "internally" than obtaining them through the market; "internally" is a broad term, and a "firm" can have many structures. So I don't see a contradiction.

That said, "self-organization" is an interesting idea or at least an interesting term, but part of their inspiration is Wikipedia, and I wouldn't like to edit Wikipedia precisely because of the sort of "self-organization" that's going on there, and I sure wouldn't like my daily work to look like editing Wikipedia. Just me, of course – multitudes thoroughly enjoy editing Wikipedia – just saying it's not for everyone.

8. Don MoodyNov 28, 2011

Thank you for your valuable time and consideration.

Yes, you do have me there and are correct that Coarse didn't say anything about leaders.

I can appreciate the reference to Wikipedia and I agree that there are issues with how that organization is run. I have issues with the value of Wikipedia as a reliable reference source.

The one thing my mamma always told me was that "it's not what you do that counts as much as how you do it" and that being said I do not agree that Wikipedia is run the same as this proposed organizational structure.

I feel that many ways of doing things can be greatly improved by the details of how things are done & accomplished. Sometimes that one added line of code makes a project fly versus not.

I'll take no more of your time & I thank you for the conversation.

I will keep looking into this type of organizational structure and I will take your thoughts into consideration by looking deeper into Wikipedia and it's inner workings as a comparison model for this other "self organization" model.

I also plan on investigating the "social engineering" aspect and will welcome the thoughts of others within that specific field.

9. yairchuNov 29, 2011

Surely you mean the "Nobel memorial prize".

For more than a hundred years, the Nobel prizes are given for accomplishments in five fields: Physics, Chemistry, Medicine, Literature, and Peace.

There is no Nobel prize for economics. There is however the "Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel", or "Nobel Memorial Prize in economics", which was founded 40 years ago and is not endorsed by the late Alfred Nobel.

10. Amit PatelNov 29, 2011

A lot of the excitement around certain kinds of small companies is because they previously weren't feasible.

Consider for example what internet sales have done for specialty t-shirt shops. If you have a niche product that appeals to 10,000 people worldwide, there's hardly any place in the world where it makes sense to build a physical shop, but now you can sell them on the web. That's enabled not only by internet sales but also by low volume custom fabrication/manufacturing/printing companies.

Or consider the YC style of company. Long ago they'd need to run a datacenter. Not that long ago they'd still need to buy and set up 1000 machines in a rented space. Now they can get started with Amazon EC2 and other low cost services. Reducing the infrastructure up-front investment allows lots more ideas to be tried out in small companies, whereas before that friction meant you'd only want to try those ideas out in large companies.

Open source projects and Wikipedia are also examples of things that were previously infeasible.

Despite this, most products and services that were previously provided by large companies are still going to be provided by large companies, and those provided by small companies are still going to be provided by small companies. You just don't hear people *talking* about that because people talk about what's changing, not what's steady.

11. Yossi KreininNov 29, 2011

@Amit – my point was mainly about the trade-off between small and large companies, from the general economics angle as well as from a career choice angle; this is somewhat unrelated to these changes because the choice is always there (I remember alternating between a preference for larger companies and a preference for smaller ones regardless, in my case, of any shifts in the business landscape).

12. SBDec 6, 2011

Interesting analysis with which I mostly agree. I think one reason why small companies still work well in many industries are the invisible ties which often make different entrepreneurs seem more like co-workers than as enemies.

Say, our business interests are not exactly aligned, but I keep buying from you because: "we have the same investor and he tells us to", "we went through the same incubator program", "we used to work together at Google", "we play soccer in the same team on weekends", "our children go to the same school". I guess these ties are stronger in a place with high startup activity like SV, but I am just speculating.

Keep up the diverse writing.

13. Yossi KreininDec 6, 2011

@SB: well, if it actually works the way you describe it, it's fascinating. I can tell, perhaps as a counter-example and perhaps actually as a way to support the view that departments and companies are not much different, that, in my experience, just becoming a part of different departments within the same company with the resulting interest misalignment can spoil cooperation between people that previously worked together just fine.

14. BryceDec 8, 2011

I think you focus too much on the functional reasons and ignore the obvious. Capital is advantage, whether it's money or IP or land or a factory or a trade secret. It's much easier to compete by creating an advantageous market position than to provide service to a customer.

Right now your industry is new, but eventually it will become established. Right now most of that race is to create that advantage and secure a place as the big noise in a budding industry, but once things settle down it makes much more sense to buy out upstarts and minimize your risks and costs as much as possible.

Most of the ballooning in company size is for these reasons. It's a lot more efficient to have a walmart than 20 five and dime stores, or to have a few gigantic farming concerns instead of millions of family farms. Of course that doesn't say the customer gets better sercive or products this way, generally quite the opposite.

So right now they might pay top dollar to talented people but later on they will undoubtedly care much more about cutting costs even if it means the results are poorer, something to keep in mind as this takes many people by surprise. In short, get yours while you can and keep your eye open for the next big thing just in case – and yes, ultimately this means as much as us nerds hate going into business for ourselves or doing the work needed to build contracting clientele up this is always the safest way to ensure you make money.

15. Yossi KreininDec 9, 2011


How is one's market position advantageous if one doesn't provide service to customers?

Or, "if the customer doesn't get better service or products this way", in what sense is Walmart "more efficient" than many small stores – according to what definition of "efficiency"?

Also, why is Walmart successful while A&P is bankrupt (after a lot of acquisitions that were supposed to be advantageous uses of its capital, I guess)?

16. RyanRDec 11, 2011

@Amit: "A lot of the excitement around certain kinds of small companies is because they previously weren’t feasible."

This is perfectly in line with the theory of Transaction Cost Economics: higher transaction costs increase the boundaries of the firm (meaning we get bigger firms).

The Internet, highway, Visa, FedEx, globalization, etc era has decreased transaction costs of search and communicating, clearing transactions, manufacturing and distribution to the point many activities can effectively be conducted in the market instead of inside the firm.

Of course many transaction costs still exist, and Milgrom & Roberts style "complementarities" are a classic example of costly-to-outsource concerns, perhaps unknowingly spelled out beautifully in this article (interaction of hardware/software/marketing design in this case), that will never go away and will always ensure some place in the economy for large firms.

Another commenter mentioned essentially "increasing returns to scale" which is just a special case of decreasing transaction costs with increasing scale.

Transaction Cost Economics will often be the best way to model and design the boundaries of the firm; those interested should see Williamson's "The Economic Institutions of Capitalism" as an update to Coase's much earlier work. TCE is hot sh!t in economics these days ;-)

17. Yossi KreininDec 11, 2011

@RyanR: I guess I didn't think of complementary goods – rather, I just thought of something requiring a lot of work on custom stuff. Complementaries are perhaps the more interesting subset of these cases – "perfect complementaries" are the boring subset: one thing that can't be consumed/is totally useless without the other, so someone has to make the same amount of both, and the question is whether it's done by one or two firms. I guess you could say that perfect complementaries are rare, so that angle captures much of what's actually happening.

18. LehahahahaDec 13, 2011

All those talks about coding standards... I just don’t get it. From my experience (which is not so solid at this point), coding standards are important on a much higher level – on the level of loose coupling/high cohesion, design patterns, etc. Vars and class and method names – this is from another opera.

All homes in Jerusalem and in Tel Aviv are designed with loose coupling/high cohesion in mind, they are separate and have well-defined simple interfaces (doors, windows, address (which is not a completely unique id but still..)). Anyone from another country can use those simple interfaces very well. So why bother with roofs color?..

If you arrive in a city and you see that (its written in perl hahaha) it has actually one big house instead of separate houses, and you cant get inside, cause it does not implement EnterenceAndWindows interface, or the door is 7 kilometers above the sea level... Would you be much concerned about the fact that this houses walls are painted with green?

Coding standards can somehow help you program faster, or to keep in mind more things relevant to your project or manipulate them with more ease? I don’t think so.

I think its more like the real world – first you know what you are going to do, then you’ll get the details on how you will do that (intention first). For example you want to get drunk with Dave – you surf the documentation on how to, then youll use IDE with autocomlition to quickly make it happen. Would it be
Humans.CurrentLocation.Dave.Deeds.getReallyDrunk(Me, Today, true);
or it would be more like
humans.current_location.dave.deeds.get_really_drunk(me, today, true);
or even
thingsToDoNow.getDrunk(Dave, extremely, yes_i_mean_extremely);

Who cares? I surf documentation, use autocomplition and not storing in my mind method names (even if i did, it would be too easy to mix things up independently of using coding standards (is it getDrunk(Dave) or Dave.getDrunk(true) ? I don’t have to know!))

19. LehahahahaDec 13, 2011

oops, i missposted this, sorry :)

20. Nick ZivkovicFeb 22, 2012

Becoming a big firm doesn't necessarily decrease transaction costs. Take Microsoft, for example. They are a huge firm, and have to interact with many customers (HP, Dell, Toshiba, etc). The only reason they don't vertically integrate (like Apple did), is because they have the deep pockets to cover these transaction costs. They also have enough money to sue their customers, when trust is violated.

I find that the big firms you are referring to (i.e. Vertically Integrated firms), do save on transaction costs, but _more importantly_ they get to avoid the hold-up problem. Which, fundamentally, is the inability to objectively trust a company/vendor, unless the interests are aligned.

It seems that vertical integration is ideal if there is only one supplier of $RESOURCE. Even if there are multiple suppliers, they could still conspire to simultaneously raise prices. (Kind of like what OPEC did in the 70's).

Thus, vertical integration can be thought of as minimizing dependence on foreign elements.

Here's another software analogy:

Open Source is a form of vertical integration, that minimized dependence on distributors of binary software. Even if the binary software is good, the vendors, holding a monopoly on the source code, hold a monopoly on improvements and enhancements. It is very easy for a binary software vendor to discontinue improvements and support for code that a dependent party may use for core functionality, thus putting a major speed-bump in the dependent party's growth path.

Open source solves this problem, by commoditizing things like OS's and compilers, and preventing any vendor from monopolizing improvements/enhancements. By using certain open source components, companies can vertically integrate fixes to these systems into their corporate structure (like Google with Linux, Joyent with Illumos, Apple with FreeBSD and Darwin [and Microsoft with Windows, because they have access to the code]).

So, to summarize, I wouldn't say that "big firms" are solutions to the trust problem, as much as "vertically integrated firms" are. It's just that such firms _tend_ to be big but they probably don't have to be. Oh, and open source _is a form of_ vertical integration.

21. AlpheusJun 2, 2012

I think you give a little too much value to the effects of patents and trade secrets–it is my understanding that ideas need to flow to people who are interested in them, for them to thrive–but even so, I think the rest of your blogpost is probably spot on.

Ideas are harder to implement than many patent proponents make it out to be. If your company were to publish all your algorithms, and even the information for creating your chips, would just anyone be able to take that information, and suddenly become a competitor with you? No, they cannot. Your competitors *might* be able to absorb that information, but they also have their own goals and ambitions, and trying to use that information might be as much a hinderance to those ambitions, as it would be a help.

Having said that, for a couple of decades, at least, I've been wanting a little device, the size of a laser printer, that would allow me to build, if not any silicon device I wanted, at least simple ones that I can experiment with. Op amps and small processors and so forth. Even though I was in Junior High at the time I started having this desire, even then I knew how much of a pipe dream it was: how the heck am I going to dampen the vibrations of the Earth, which are known to adversely affect chip manufacturing? How am I going to keep that device stocked up with highly caustic chemicals?

As much as I'm attracted to small businesses, I am like you: I have no interest in *being* a business person–I just want to experiment with ideas, and to try to develop new ones. Thus, it probably isn't a good idea for me to found a startup; the best that I can hope for is to join one early on.

A previous commenter said Graham is "rich and stupid". I don't think that's the case at all. Graham is someone who desires freedom, and sees oppression in large organisations–and he is correct, as far as that goes–but there are a lot of people who don't mind giving up a certain degree of freedom, to be a part of something that is likely impossible to do on a tiny scale! Thus, Graham's words are best applicable to those who desire freedom.

On the other hand, I've often wondered if something like Microsoft can be duplicated by dozens of small companies, each paying each other for their services...

I apologize for my somewhat rambling comment. It could probably be best summarized as "You're right, and Paul's right, all because the Market is 'flexible enough' to accommodate the best solution for a given problem, whether the solution be small or big!'".

22. AlpheusJun 2, 2012

Come to think of it, my last sentence reminded me of an essay I read a few months ago, called "I, Pencil". You mentioned that Reddit and Dropbox benefit from thousands, perhaps hundreds of thousands of people, all doing things to support their work. In this essay, the author is writing from the point of view of a standard #2 yellow pencil with a pink rubber eraser at the end; making that one pencil, and bringing it to market, may very well be as complex as putting together a microchip, or supporting a service like Dropbox.

Whether the solution is found in bringing together a lot of small solutions (as in Dropbox) or integrating a lot of people together in a large solution (as in your company), the order in the complexity, even chaos, is amazing to behold!

23. Yossi KreininJun 2, 2012

Regarding patents (not that I particularly like the idea of patents, mind you): I can tell you with certainty that it is patents that sustain the businesses of IP companies like ARM and MIPS (otherwise people could legally clone them without paying for an "architecture license"). In fact, CPU instruction sets are pretty much guaranteed to accumulate (barely needed) new fancy instructions so that when older patents expire, new patents can prevent legal cloning of newer CPUs.

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