Monday, February 1, 2010

Economies of Scale: Sweet Music or Sour Notes?

A couple of news stories in the last two weeks vividly contrasted the chasm between the questions the government is trying to answer and the questions the government should be asking.

The first story relates to President Obama proposing legislation to Congress that would keep banks from becoming "too big to fail." I can partially see the logic in this. The FDIC guarantees consumers' deposits; the failure of a large bank would bankrupt this program. Before regional banks were approved in the 1980s and interstate banking approved in 1995, this wasn't an issue.

But on the other side, what if this trend doesn't stop with banks? What if Congress decides that an airline shouldn't be too big to fail, because it has too many employees that would be out of work, or its loss would limit competition at certain airports?

The second story relates to an article in Parade about cities and counties considering consolidation in order to make municipal services — police, fire, garbage, utilities, animal control — more efficient. It identified Buffalo, Natchez, and Pittsburgh as cities pondering the possibility.

The trend is nothing new. The city and county of San Francisco have been coterminous since 1850; the city and county of Philadelphia since 1854. New York City's boroughs used to be separate cities until a vote in 1898 consolidated them. The logic was the same in 1898 as it is today: achieving economies of scale and thus lowering administrative costs.

This is why entities, whether they’re in the public or private sector, merge. It's not a question of cheap money or bad management; it's a question of economies of scale. I admit to seeing this through the prism of technology: the costs of developing or deploying efficient software and hardware are lower when you spread them over a greater number of employees, branches, or offices. If you write software to manage your automatic-teller network, is it more efficient to write it for 100 branches, or for 1,000 branches? Ask Bill Gates, who made his fortune off of writing something once and selling it a gazillion times. (In this regard, economies of scale relate more to white-collar than blue-collar work.)

As much as I respect President Obama, I think that worrying about entities becoming too big to fail is exactly the wrong tack. If government is to become more efficient, we should start thinking not about too big or too small, but the right size to begin with.

This was hammered home to me by an opinion column commentator Tom Brokaw wrote for the New York Times last year, in which he asked why the Dakotas needed 17 educational institutions:
In my native Great Plains, North and South Dakota have a combined population of just under 1.5 million people, and in each state the rural areas are being depopulated at a rapid rate. Yet between them the two Dakotas support 17 colleges and universities. They are a carry-over from the early 20th century when travel was more difficult and farm families wanted their children close by during harvest season.

I know this is heresy, but couldn't the two states get a bigger bang for their higher education buck if they consolidated their smaller institutions into, say, the Dakota Territory College System, with satellite campuses but a common administration and shared standards?

In California, we have the University of California (10 campuses); the California State University (23 campuses); and California Community Colleges (110 campuses within 72 districts). That may not seem like a lot for a state the size of California, but within a 15-minute drive north or south, I can choose from three community colleges. Is that financially prudent?

This is the 21st century. We have a global economy. We have created technology that makes economies of scale scale even larger that ever before. We should stop living with 20th century (or worse, 19th century) perspectives and start thinking creatively about how we can be more efficient, how we can adapt quickly to the way the world is changing.

Cities that are considering consolidation shouldn't be anomalies — they should be the norm. Yet because of political will (or more likely, lack of it), no one wants to consolidate the fiefdoms that they've built. Worse, the government is telling us that big is bad.

That's not true. Big badly run — whether in the public sector or the private sector — is bad. The Titanic didn’t sink because of its size; it sank because of its design and how it was run. Big run well could be the best use of our increasingly limited financial resources.


  1. I believe that you need to differentiate consolidation of government entities and consolidation of (allegedly) free-market entities that are supposed to be free to succeed or fail. Free market capitalism doesn't work if (a) there aren't enough entities to compete or (b) the incumbents have such a grip on an essential market that government/society can't afford to let them fail.

  2. I agree completely. The problem is not size, but management. Unfortunately, bad management in the private sector begets bad management in the public sector, as the latter tries to reform the former.