Why Your Business Might Be More Like a Jigsaw Puzzle Than a Pyramid
"New research challenges traditional firm growth models, suggesting diversification and unexpected volatility play a bigger role than previously thought."
The question of what governs the statistical laws of firm growth has intrigued economists for decades. While a purely statistical approach might seem insufficient given the myriad factors influencing a company's trajectory, research has revealed surprising regularities. Understanding firm-level dynamics has become increasingly crucial, as they underpin changes in macroeconomic aggregates like GDP and offer insights into individual wealth creation and the growth of city sizes.
Despite the diverse nature of statistical samples, certain robust patterns persist in firm growth across countries, time periods, and size proxies. Two prominent observations stand out: both the firm size distribution and the distribution of firm growth rates exhibit non-Gaussian characteristics and heavy tails. The heavy tails are particularly striking, indicating frequent episodes of extreme growth or decline. This challenges the intuitive notion of gradual, predictable expansion.
However, pooling growth rates from various firms to characterize a single distribution requires careful consideration. It implicitly assumes that all firms operate under the same firm-independent and time-independent distribution, which is clearly unrealistic. A key factor complicating this picture is the well-established inverse relationship between firm size and growth volatility. Larger firms tend to exhibit less volatile growth rates, seemingly due to diversification. But the observed decay in volatility with size is slower than what a simple diversification argument would predict, suggesting a more complex interplay of factors.
Beyond the Island: Why Granularity Matters
To reconcile these observations, researchers have explored models that go beyond the simplified "island model," where firms operate in isolation. These models incorporate two key elements: firms operating in multiple markets and the unequal distribution of sizes among a firm's constituent sub-units. This means a firm can be seen as an ensemble of interconnected sub-units, each functioning in a distinct and independent market. These sub-units aren't necessarily equal in size, leading to a situation where a firm's aggregate size might be concentrated in just a few key areas.
- Well-diversified firms: These firms have sizes evenly distributed across many sub-units, indicating a broad range of revenue streams.
- Concentrated Sub-unit Firms: Display many sub-units but with concentrated size in just a few, relying on a narrow set of revenue centers.
- Poorly diversified firms: Consist of only a small number of sub-units, making them vulnerable to market shifts.
The Unsolved Puzzle: Where Do the Shocks Come From?
While these models offer valuable insights, they don't fully capture the complexity of real-world firm growth. Key inconsistencies remain, particularly in the distribution of growth volatility and the scaling of higher-order moments. This suggests that the mechanisms driving firm evolution are more intricate than previously thought. A crucial next step is to explore how shocks impacting a firm's sub-units become correlated as a firm grows. Factors like supply chain dependencies, shared customer bases, and reputation effects could amplify these correlations, leading to larger and more volatile swings in overall firm performance.