The greatest irony of market economies: they rely on firms that make no profits
In a world of perfect competition, there are no profits, but in a world of monopolies, the capital and labor markets are forever in disequilibrium. Implications for worker democracy?
I knew the families that owned the businesses in my town
I grew up in Jackson, New Jersey, USA.
When I was a child, many of the retail stores were family owned: a hardware store, a hobby shop, an outdoorsman shop that sold guns and fishing gear, and also several restaurants.
None of these firms generated large profits but they provided a good standard of living for the families that owned them. I went to school with some of the children of the owner’s of the stores, and then as we got into our twenties and thirties their parents retired and my friends took over as the owners of the various stores.
Later, the era of Big Box retail arrived, offering ultra low prices and razor thin margins. My friends did their best to keep their family businesses going. Eventually, some went bankrupt. Something was lost when those family firms shut down, something personal and cultural, but also economic. Certainly, the personal level of service disappeared.
In this essay I’m only going to look at the economic aspect of this sad transformation.
It is well known that the USA economy invested far too much in retail, especially during the strange bubble that lasted from 2002 to 2008. Retail in America has been shrinking ever since. The big chains are consolidating, hoping to get back to the kind of limited competition that will allow them to regain strong profitability.
Sadly, nothing will bring back the era of the family stores. Small businesses rely on fat margins. Big businesses enjoy “economies of scale” and can therefore survive on thinner margins. Outside of niches that arise from changes in the culture, it is difficult to imagine there will ever again be a general, widespread environment of fat margins in retail in the USA.
But retail is only one of many industries where family firms are essential to ensure high quality and low prices.
The problem exists in every country and every century
This reality has been true in all countries and for many centuries. The French historian Fernand Braudel mentions a general store in rural Scotland in the mid 1700s, offering every kind of product, but still barely surviving. But the family kept the store going, knowing how essential it was to the community.
Other nations have seen the same pattern, and the same difficulties. The New York Times recently wrote of business owners in Japan giving away their businesses because no one wants them:
Hidekazu Yokoyama has spent three decades building a thriving logistics business on Japan’s snowy northern island of Hokkaido, an area that provides much of the country’s milk.
Last year, he decided to give it all away.
It was a radical solution for a problem that has become increasingly common in Japan, the world’s grayest society. As the country’s birthrate has plummeted and its population has grown older, the average age of business owners has risen to around 62. Nearly 60 percent of the country’s businesses report that they have no plan for what comes next.
While Mr. Yokoyama, 73, felt too old to carry on much longer, quitting wasn’t an option: Too many farmers had come to depend on his company. “I definitely couldn’t abandon the business,” he said. But his children weren’t interested in running it. Neither were his employees. And few potential owners wanted to move to the remote, frozen north.
So he placed a notice with a service that helps small-business owners in far-flung locales find someone to take over. The advertised sale price: zero yen.
…In 2021, government help centers and the top five merger-and-acquisitions services found buyers for only 2,413 businesses, according to Japan’s trade ministry. Another 44,000 were abandoned. Over 55 percent of those were still profitable when they closed.
Anywhere that people share stories about family owned businesses, we hear of the pain and sacrifice and despair of most such businesses:
A friend of mine took over the family business (dry cleaning). Previous to this, he was a "second chef" at a relatively well known restaurant.
He took a ~25% paycut, he works harder and longer than he did before (as a chef, mind you, regularly known for 100+ hour weeks), spends close to half of that time driving, and often sleeps in the office. He went from probably being a few years away from running his own three star restaurant to running an unsalable, shrinking business, owns 400k worth of similarly unsalable equipment, in a slowly dwindling industry.
His marriage has fallen apart (did I mention he moved 3 hours away from his wife + children to run the business), his mental health seems atrocious, and the only thing the future seems to hold for him is a piece of a slowly shrinking pie.
His father built a burgeoning postwar business that gave his family a good life, but markets change, and businesses that once made sense no longer do.
Small businesses demand sacrifices from their owners
And yet, it is this level of the economy (the small family firm) which ensures that labor and capital markets are rational. Without this layer, unemployment will be higher and yet inflation will also be higher: an economy with less competition will have higher prices and worse quality, while at the same time employing less people.
As noted before, there will be occasional moments when an investment bubble forms and a particular sector receives irrational levels of investment, as the USA retail sector did from 2002 to 2008. In such rare cases, even the firms that normally hope for capitalist levels of profits will find themselves without profits, while also providing a very healthy level of competition to the economy. But such bubbles cannot last — as soon as the capital markets see that an industry has too much competition, the capital markets will divert capital to other industries.
Enamored of equilibrium models, someone might say “If competition collapses, and prices spike, then profits will spike, and then investment in that sector will spike, increasing competition, and thus restoring the market to equilibrium.”
That theoretical model ignores the biological realities of families, and the large sacrifices that members of a family will make to keep a family business going. Venture capital is looking for outsized returns, so venture capital will never go into what seems like a crowded market — it will never provide high levels of competition. Over and over again, it is family businesses that provide the level of competition that drives prices down to the point that profits disappear, while also maximizing the number of people who can be employed (even if that only means employing everyone in the family). It is therefore small family firms that will tend to soak up surplus labor while providing the competition that leads to low prices and high quality. (Again, this general rule will sometimes face anomalous eras when an investment bubble provides over-competition from big firms, but such eras are short.)
And again, this rule applies to more than just retail. It applies to all industries.
The German Mittelstand
In Europe, which country has typically had the lowest unemployment, the lowest inflation, the highest productivity? That would be Germany:
Germany has the second largest exports in the world. They are second only to China. This is remarkable given the fact that Germany is a first world country with very high labor costs. The Chinese pay slave wages to their workers and make them work for longer hours. On the other hand, the Germans pay generous wages to their employees and only make them work for 8 hours a day, 5 days a week!
What’s even more fascinating about this story is the fact that Germany’s exports are not the result of the success of one company or a handful of companies. Instead, there are several small and medium enterprises (SME’s) that are the reason behind this impressive performance. Germany does have its share of brand-name multinationals. However, the real engine behind Germany’s growth is their small and medium enterprises.
The interesting thing about Germany is that most of their exports are generated from their manufacturing sector. This is unusual given the fact that in most advanced economies, the service sector makes up the majority of GDP and exports. Germany exports twice as many manufactured goods as the United States. This is despite the fact that the size of the American economy is larger. This means that on a percentage basis, Germany is way ahead of other countries when it comes to manufacturing. Although only about 1% of the world’s population resides in Germany, close to 50% of the world’s leading SME companies are from Germany. The emphasis on manufacturing can be seen from the fact Germany derives 25% of its GDP from manufacturing. The United States and other developed nations generate only about 10% from manufacturing.
All of this is thanks to the German Mittelstand, the “small and medium sized” businesses that make up more than 99% of the businesses in Germany.
These firms are much bigger than the family firms that I’ve been discussing but a key thing about them is that they are not big in the global capitalist sense:
There is a misconception that in a global economy, you’ve got to be big to make it. The American example of big companies that succeeded are Apple, Amazon, eBay, Microsoft, Google, Facebook. The old ones who have stood strong are Coca-Cola, Disney, Walmart, GM, Exxon and others.
In Germany, the large companies include, Volkswagen, Siemens, Deutsche Telekom, Bosch, Allianz, and Deutsche Bank.
But Germany has something else too. It has companies like Herrenknecht and Faber Castle. One is a leading manufacturer of tunnel drills and other is leader is manufacturing pencils. Both are family owned businesses. Just like Herrenknecht and Faber Castle, there are numerous unknown and hidden world market leaders in Germany that stand out for their high-quality products. Most of these companies are small but they compensate for their lack of scale by being great at quality, efficiency, and innovation. Also, while these companies export their products world over, they often operate from a small village from where they began their journey. The secret to their success is to be a world leader in a niche market.
While much of the world has embraced big corporations as a strategy for dealing with globalization, Germany has embraced a completely opposite strategy. And it is this strategy for nourishing the small that has played a key role to a vibrant economic performance over several years.
Despite the medium size of Mittelstand firms, very few are publicly listed on a stock market. The overwhelming majority of them are owned by a family.
The Mittelstand firms are an important example of the fact that if you want markets to behave in the manner that economic theory predicts, with high levels of innovation and quality combined with low inflation and low unemployment, then you need a very large number of family owned businesses.
(You also need a political system that favors such firms, and a system of laws and tax breaks that allows such firms to thrive, but that is beyond the scope of this essay.)
Most of these firms are profitable, but only a few generate the large amounts of surplus cash that would draw the attention of capitalist investors who are looking for monopoly returns. The Mittelstand is full of successful family firms, and Germany is successful because it has built an economy that allows the success of family firms. Thus Germany’s political system helped create an economy that has unusually efficient labor and capital markets.
Still, Germany has a gifted position in the global economy. It is in the heart of the West, giving it easy access to other high income nations. If a nation such as Argentina tried to follow the same policies that Germany has followed, it would not necessarily have the same success. For a nation out on the periphery of the world economy, structural factors often limit economic success. Among other things, Argentina has historically suffered “inelastic supply” meaning even when there is demand for some good, Argentina cannot necessarily get that good, since it lacks the foreign currency to import the good and it also lacks the domestic pools of capital that might allow it to develop a supply of the good domestically. In Argentina today, just as in Scotland in the 1700s, we see many businesses that are offering something essential, but being forced to offer that essential thing with such razor thin margins that the business can barely survive, despite being urgently needed. Communities in Argentina are lucky when some family is willing to make the sacrifices necessary to keep such a business going.
My point being, the profitability of the German Mittelstand is the exception, whereas the general worldwide rule is that an economy only has sufficient levels of competition when it has many small family firms which are maintained with great sacrifice on the part of the owning family.
The dead layers of a coral reef enable the higher levels to thrive
The French historian Fernand Braudel said that civilization is like a coral reef, with each era adding another layer upon which future layers will eventually be built. Even the dead ruins can offer spaces where future life can thrive. (I'm drawing from The Perspective Of the World.)
Following the Continental tradition (different from Britain or America) Braudel suggested that the economies that existed in the civilizations of the world, during the centuries he covers (1500-1800) had 3 layers, that had built up over time:
1.) Barter, the non-monetary economy, exchange based on personal relationships, mutual gift-giving. This part of the economy goes back thousands of years, to long before the first civilization.
2.) The market, where money is used to exchange goods and services.
3.) Capitalism, the super-structure of civilizations, the world of monopoly powers, the handful of national champions, advancing across the world with the help of their nation's armies.
The point is, the top layers rest on the lower levels, and are dependent upon them. The world of the monopoly firms, accumulating capitalist profits, rests on the lower levels, the less profitable (and often non-profitable) layer of small businesses.
Is worker democracy possible among small firms?
Why am I going over this subject, the importance of firms that generate almost no profits?
All of my adult life I’ve been hoping to see the success of worker democracy. So I’ve spent a lot of time thinking about why it is so rare.
One obvious problem is that it takes some money to set up a business, but if the business never generates a profit than there is no way to repay whoever put up the initial money. For example, suppose it takes $500,000 to set up a grocery store that will be run as a worker’s democracy. Let’s also suppose that the workers run this company the same way a family might run a business, as a lifestyle business that aims to provide a good life for the workers, but without generating large profits. In that case, the original $500,000 is never repaid, so whoever put up the initial capital never gets repaid. So setting up the business has to be an act of charity.
In Europe and the USA there are several examples of successful worker democracies. For instance, in the USA there is the commune known as Twin Oaks which was established in the 1960s. It is an intentional community that produces hammocks and tofu and honey and yogurt and a few other products. It’s made enough money that it has thrived for 60 years. But it hasn’t generated the kinds of profits that would pay off the people who set it up, at least not at the usual capitalist rates. So setting it up was therefore an act of charity, and such acts of charity are less common than investments made with the hope of profits. Thus worker democracy remains rare.
There are other problems. In 2018, when I was in Charlottesville, Virginia, there was a man who had recently inherited 40 hectares of land just outside of town, and he wanted to set up a commune there. But he also had a reputation for having sex with a large number of women, and some of the women who might have otherwise been interested in his project were made wary by his reputation. This is one example of what is a general problem: whoever puts up the money to get a new venture launched, they often want to keep control of it, and therefore they keep it from becoming a true democracy. Even when they themselves think they want to establish a true democracy, they sometimes don’t realize how much weight their opinion carries as the person who is putting up the money. Real democracy means that decision making becomes free of whoever starts the organization.
There are also complex emotional issues that need to be addressed, which we’ve discussed before.
So we face another paradox. What would cause capitalists (or the government) to want to invest in large numbers of worker democracies? Only this: if those worker democracies wanted to generate huge profits. Some may regard this as deeply ironic. Many of the people who are the most interested in worker democracy are also anti-capitalist and anti-hierarchy, so they are anti the things that might allow worker democracy to establish itself as the new normal. But a group of ambitious workers who want to create vast wealth are the most likely workers to get the resources needed to build an organization that they control.
In a very small way, one could argue that the tech industry took some small steps towards worker democracy by making it normal to give stock options to workers at startups. One can imagine this trend expanding to something that starts to resemble actual worker democracy, if it were to become normal for workers to be vested with actual stock that holds significant amounts of voting weight.
It’s possible the culture will evolve in a direction that makes worker democracies more common. Perhaps there will come a generation of workers who are both comfortable building huge capitalist enterprises, but want to do so while running the enterprise as a worker democracy. Such organizations might be better run than the traditional, hierarchical organizations. I make this point implicitly in my book How To Destroy A Tech Startup In Three Easy Steps. That startup (described in the book) would have done much better if us workers had been in charge.
Still, if we want to establish a pragmatic, efficient Communist society, in which everything is owned by the government, then we continue to face the problem that to get low prices with high quality we need to ensure high levels of competition, and to get the highest levels of competition means having firms that generate no profits, and if these no-profit firms are owned by workers, then setting up the firm has to be an act of charity (by either private sector actors or the government). In other words, it is difficult to imagine how any society can survive without family owned businesses.
Is it possible to establish a worker democracy where the workers make huge sacrifices for society, in the same way that parents make sacrifices for their children? This is difficult to imagine.
So we are left with these conclusions:
to get enough competition to ensure low prices with high quality, society needs a large number of small firms, and these firms will be barely profitable, save for certain exceptional circumstances.
if we want to see private sector actors investing large amounts in worker democracies, then the workers will have to be committed to building huge companies generating vast profits.
If we want to see worker democracies run small firms that fill the market segments that are normally filled by small family firms, then society will have to find non-monetary ways to incentivize such activity. Towards that end, see what I wrote in How would brilliant, creative, visionary entrepreneurs be paid in a Communist society?