Economic Calculation and Constraints on Firm Size
Abstract: It is recognized that the need for economic calculation places boundaries on firm size. However, much of the existing work focuses on the costs of market exchange rather than the costs of monitoring internal exchange. In this study, we examine the costs associated with a firm’s internal exchange of capital. We argue that firms dependent upon the financial markets for infusions of capital are likely to curtail sub-optimal investment policies to maintain a positive reputation in the eyes of potential investors. Conversely, firms with the ability to finance their investment with internally generated capital bear the costs of avoiding this external oversight. Larger firms have significantly more cash flow available after investment and are consequently less reliant on the external markets. With high levels of free cash flow, the unconstrained manager can socialistically fund investment projects by choosing to invest both in positive and negative net present value projects. Thus, we anticipate the efficiency of resource allocation within a corporate internal capital market is decreasing with the coincident levels of free cash flow and with firm size. Consistent with this view, we illustrate that the internal dependence on capital (and the associated costs) are indeed increasing in firm size. They are likewise increasing with the level of free cash flow available at the discretion of managers. We illustrate that these increased levels of free cash flow lead to suboptimal resource allocation in the form of cross-subsidizing and value-destroying investment activity, and ultimately to the deterioration of shareholder wealth. However, the free cash flow problem appears to be concentrated in mid-sized and large conglomerates which are less dependent on the external capital market. Smaller conglomerates funding investment with externally generated funds do not experience such deteriorations in wealth.
