The Shrinking Hand: Why Information Technology Leads to Smaller Firms

We explain the firm downsizing trend of the recent decades by the new abundance of information – the ICT revolution. Production processes differ in their information requirements: while decentralized production by means of market exchanges is information intensive, less information per unit of output is needed in the hierarchically integrated production of firms, and the information/output ratio is decreasing firm size.

We formulate a quantity of information theory of the firm embodying these differences and derive a Coase–Rybczinski effect for the aggregate economy, which predicts a decreasing employment share of large firms and an increasing share of small ones when the aggregate quantity of information increases Panel data regressions and other evidence provide support for this hypothesis.