The Downside Of Downsizing

Corporate downsizing is bad for society as a whole, according to new research by Jan Boone, published in the latest issue of the Economic Journal. The costs to the fired employees outweigh the gains for firms. And what is more, downsizing increases unemployment and reduces economywide growth.

Boone notes that in the 1980s and 1990s, firms downsized to such an extent that newspapers cried foul. Business Week described it as ''America''s Economic Anxiety''; the New York Times ran a seven-part series on ''The Downsizing of America''; and Newsweek moaned that ''firing people has gotten to be trendy in corporate America''.

Of course, senior executives of the firms that laid off huge numbers of employees – which included National Westminster bank, IBM, Scott Paper and AT&T – claimed that downsizing was necessary to improve efficiency. And at first sight, it might be thought that the employees'' loss was the firms'' gain so that ultimately your opinion about downsizing depends on your political point of view.

But the main result of Boone''s analysis is that a stronger statement is possible: the workers'' loss exceeds the firms'' gain. Society as a whole would have been better off if the extent of downsizing had been limited. Furthermore, unemployment would have been lower and economic growth higher if downsizing had been stopped.

To get this result, Boone needs three ingredients:

  • First, Adam Smith''s invisible hand must be absent; otherwise, the profit-maximising decisions of firms are beneficial for society.
  • Second, the gains in efficiency are not translated into higher output and employment.
  • Third, downsizing hinders innovation in an organisation.

First, the idea of the invisible hand is that the ''equilibrium'' price of a good – the price at which demand equals supply – equals the social value of a good. So in theory, firms and individuals taking decisions on the basis of the market-clearing price face the correct trade-offs from the point of view of society as a whole. But the 1980s and early 1990s were characterised by high unemployment – that is, the wage rate was above the market-clearing wage. Hence, firms that based their decisions on the market wage overestimated the social gains of firing an employee. In fact, the gains for firms were smaller than workers'' losses: downsizing had gone too far.

Second, a gain in efficiency typically leads to lower prices, higher output levels and hence higher employment. Why did this mechanism not work? The answer lies in the fact that the people fired were mainly middle management. Management costs are fixed costs for firms. In a competitive market, a firm''s fixed costs do not affect its marginal decisions on whether to lower prices and increase output. Hence, the gain in efficiency did not raise output and employment. So downsizing increased unemployment.

Third, because top management''s attention is limited, it is very hard, if not impossible, for a firm to fire employees and at the same time invent new products and improve existing products. If management is busy trying to find out who can be fired, it has no time to consider strategic decisions on product development. Furthermore, the anxiety within the organisation – ''am I going to be fired?'' – kills off any creative and innovative ideas that people may have. Instead, they spend their time keeping their job or finding a new one somewhere else. So the fact that firms put too much emphasis on downsizing reduced economic growth.

''Technological Progress, Downsizing and Unemployment'' by Jan Boone is published in the July 2000 issue of the Economic Journal. Dr Boone is at Tilburg University in the Netherlands.