Why are Founder CEO’s so Effective? Arrow and the Behaviour of Firms

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The maxim in Silicon Valley is that founders make the most effective CEOs. Assuming that’s true, can we understand a deeper reason for it? I think we can. To do so, let’s talk about how groups make decisions.

  • Famously, Arrow’s impossibility theorem shows that no voting system will be “rational” in the usual sense.
  • A rational voting system means that:
    • If every individual prefers option A over option B, then A should win over B. (Pareto Condition)
    • If A wins over B, and B wins over C, then A should win over C. (Transitivity)
    • If A wins out of the choice of {A,B}, then B should not win out of the choice of {A,B,C}. Either A wins or C wins. (Independence of Irrelevant Alternatives)
    • All preferences are allowed. There are no restrictions on what any individual can prefer. (Unrestricted Domain)
    • No single voter can choose the election outcome. (No Dictator)
  • Arrow’s theorem says that it is impossible to have a voting system that satisfies all of these conditions all the time.
    • Note: The voting system is abstracted away. Arrow’s theorem applies to any voting system. The only assumption is that individuals vote based on their ordinal (and not cardinal) preference.
  • Another way of describing Arrow’s theorem is: Groups of people cannot reliably make rationally decisions.
    • Or: Groups of rational agents tend to be irrational.
    • Or: A single individual making decisions will always be more consistent than a group.
  • In other words, for a group to always behave rationally, its voters must be irrational or it must be run by a rational dictator.
    • That is: Either the voters are irrational or the voting system is irrational.
  • Why does this relate to firms? Think of a firm as a collection of individuals whose daily actions (i.e. votes) determine the direction of the firm.
    • If this analogy holds, Arrow’s theorem applies: A firm will only reliably behave rationally when it is run by a dictator.
    • More loosely: Firms will behave more rationally when the power of the CEO is more concentrated.
  • This is why large bureaucratic organizations, where power is dispersed throughout the organization, will often seemingly behave irrationally, lacking clear direction and regularly making illogical decisions.
  • And hence the preference for founder CEOs who have the moral authority to wield concentrated power within the organization.

So yes there is a theoretical case to be made for founder CEOs.

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