Wednesday, August 20, 2008

The Paradox of Economies of Scale and Government Bounties to Big Business

One of the key arguments that economists and historians have traditionally made in favor of big business, and one that the public has generally accepted, is that it is necessary because of economies of scale. This image was exemplified by the Ford production plants of the 1920s, which could produce thousands of cars per week. The reason that economists and the general public have traditionally believed that economies of scale are important is that the fixed costs of production, costs that will be there whether one or a million units are produced such as advertising, rent, and administrative staff costs, when spread over a large number of units of output become lower per unit. The argument for scale amounted to an argument for centrally planned economies. In his book "Managerial Revolution", written in the 1930s before the murderous nature of Nazism had been fully revealed, James Burnham argued that a new managerial class was independent of owners and he cheered the advent of national socialism in Germany because government control and guidance of large industry reflected the realities of the new managerial power. Thirty years later, in the early 1960s, John Kenneth Galbraith described the economy of big business as based on planning by a "technocratic" elite in his book New Industrial State.

But while the public has accepted the argument that big business is necessary for consumerism because only large firms can produce large numbers of outputs, big business has tactically demanded and likely required government subsidies in order to survive. And there is a paradox. For if big business is most efficient, then why does it need subsidies? In his 1977 book Politics and Markets Charles Lindblom argued that business occupies a "privileged position". More fundamentally, ever since the days of Hamilton, and with the exception of some business interests in the late nineteenth century, much of American business has asked for two crucial kinds of subsidies: protectionist tariffs and monetary expansion. When Jackson abolished the Second Bank in the early 1830s he limited the degree of monetary expansion. That period, from the 1830s to 1900, was the period of greatest innovation in technology and strongest gains in real hourly wages of workers of any in American history. It was also a period of uncertainty, volatility and conflict between labor and management. However, even in the nineteenth century monetary expansion associated with the Civil War facilitated expansion of credit and therefore enhanced the size of business. By the late nineteenth century the Mugwumps, traditional, mostly Protestant (there were some Catholics and Jews as well in their ranks) Yankee elites in Boston and New York protested the support to speculators like Jay Gould that the monetary expansion had provided, coupled with erosion of their annuities and bank accounts.

The expansion of the railroads contributed mightily to the expansion of US markets into a single whole, and were the crucial step in making big business economically viable and efficient. But the railroads were largely the product of subsidy, and the canals that preceded them were government public works projects, not private enterprise. Neither the railroads or canals were entirely responses to market demand. Rather, they were made possible by land grants and rights of way granted by often corrupt state and local governments. An example is New York, where Jay Gould was so indebted to Boss Tweed that he paid Tweed's bail when Tweed was arrested for corruption. Thus, the Civil War inflation and government subsidies to railroads made expansion of the railroads possible. In turn, the railroads coupled with high tariffs made expansion of business possible. In turn, business enjoying both these supports and economies of scale, consolidated in the nineteenth century.

Late nineteenth century big business was poorly managed. It is likely that the labor conflicts and inefficiencies of the large firms were due to their too-rapid expansion. In management, experience is the foundation on which expansion depends. In a laissez-faire market, a firm becomes large as its managers gain expertise in one market and then duplicate the success in subsequent markets. An example is McDonald's. The founders of McDonald's, Dick and Mac MacDonald owned a single store in San Beranardino, California. Ray Kroc, a multi-mixer distributor, read about their success and visited the store. Kroc's vision of a national chain of stores led to his agreement with the McDonald brothers. But it took Kroc many years to make McDonald's a success. He had to learn the importance of standardization through multiple false starts in California. He had to learn the importance of professionalization of the franchisee relationship through mismanagement of franchises by his friends from his country club who did not focus on managing the stores. He had to learn how to use real estate investment to help finance store expansion and contribute to profit margins from Harry J. Sonneborn. He had to learn how to standardize equipment and the size of French Fries. Kroc did not conceptualize almost any of the food offerings, most of which were the result of suggestions from franchisees. He did not create the clown, which was the result of a local advertising campaign by one of his large Washington, DC franchisees.

Would any of the steps that McDonald's took have been made had there been a massive tariff on hamburgers or if state governments, in return for bribes, had offered exclusive distributorships to Ray Kroc, or if credit expansion through the Federal Reserve Bank had benefited McDonald's as it does Wall Street today? Would any of the innovation in McDonald's have occurred?

In the early 1960s Ronald Coase wrote about the reason that organizations reach a given scale or size. He argued that, like much else in economics, it is due to an equilibration of costs and benefits. The costs of scale include ability to manage, incentives to top management, conflicts between labor and management, difficulties in obtaining information about operations, inflexibility in changing direction when markets change and office politics. The advantages of scale include economies of scale and economies of scope, i.e., the ability to share information learned in one business to a different business, much as Time Warner's AOL unit was able to share information with Roadrunner (that's a joke; the Time Warner and AOL units were in constant conflict after their ill-advised and incompetently executed merger).

The subsidies to big business have increased, not diminished, over time. The Democrats have inadvertently or not, been big business's best friend by demanding regulation, supposedly in support of big labor, that squelches smaller firms by further increasing the advantages of scale economies. They have also established the Federal Reserve Bank, which once the Republicans realized was actually the most important of all the subsidies to big business went on a binge and nearly doubled the rate at which the money supply grew after 1971. The Democrats have never complained, and have follwed the same course since. Thus, both parties have seen subsidization of Wall Street and big business at public expense as the cornerstone of their economic policies. The Democrats came up with the idea and the Republicans enhanced it. I became a Republican because the Democrats are better at initiating big government programs that subsidize big business. They do it by telling everyone that they support the poor and that the regulation supports the poor. But there were no segregated inner cities before the Democrats began to "support" the poor.

Which will outbalance the other--office politics or economies of scale and scope? Clearly, if government is providing support to big business, the amount of support needs to be subtracted from the gains from economies of scale.

Moreover, time has revealed that scale is not the most important factor in management. The Japanese were able to defeat big American business not because of scale but because of skill. Wal-Mart was able to defeat K-Mart not because of scale (it was a smaller firm until the 1990s) but because of skill. In particular, management of information, incentives, labor relations, inventory, factory management, total quality management, technology, product design and marketing, and similar factors can generate competitive advantages. Large firms like Nike have found it necessary to emulate small firms. They outsource their manufacturing and reserve the product design and marketing for themselves. In effect, they are consultants who control the business. These ideas have been circulating for many years. Yet, they bring into question whether scale provides much of an advantage. Coca Cola has found that local manufacturers can out-think them with respect to understanding local tastes, and has had to scramble to decentralize in order to compete globally. Its original vision of a one-world market drinking trillions of gallons of Coca-Cola was illusory.

Thus, the American idea, rooted in the expansion into the frontier, that scale and the expansion of markets is necessary results in a paradox. If scale is the source of economic gains, then why are such extensive subsidies to big business necessary? And if scale is crucial, why has there been so much volatility in world business?

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