Our current economic structures were built on the premise of economies of scale, and that in turn relies on cheap, readily available energy to move goods from large-scale farms and factories to end users. Do rising energy costs mean we need to rethink and recalculate economies of scale? And if we're nearing a point where decentralized production nearer the end users is cheaper than large-scale farms and factories, how will that change our lives?
This week, Morning Feature focused on change. Tuesday we explored why we're often so resistant to change. Wednesday we looked at risk and how it shapes our society. Thursday we considered how the institution of law functions as a "common wealth," and who relies on and benefits most from that institution. Today we apply those ideas to a real-world change that may soon touch all of us.
Will Energy Force Localized Economies?
Many of us have grown tired of the phrase "too big to fail." We studied history and learned that the Sherman Antitrust Act busted the Gilded Age monopolies. Some of us are old enough to remember the government-ordered breakups of Bell Telephone and the oil giants. Yet most of those massive corporations are back, and some are bigger than ever. From banking to publishing, from agriculture to airlines, more of us have fewer choices in where to sell our labor or ideas, or what to buy and from whom to buy it.
Thus, when a massive corporation teeters on collapse, we're told it's "too big to fail," and that government must intervene to keep it solvent. If not, tens or hundreds of thousands of jobs will vanish and/or the absence of its goods and services will collapse our entire economy. It sometimes seems as if government is too sensitive to "too big to fail" corporations, and too blind of the plight of ordinary Americans. Vermont Senator Bernie Sanders wrote last fall, "If a company is too big to fail, it is too big to exist."
But why do these massive corporations exist? And are they, like massive dinosaurs, keenly dependent on an economic environment that is inexorably changing to one in which they cannot survive?
Size does matter.
The revival of near monopolistic corporations is not just a function of wealth and greed. It also reflects a basic principle of micro economics: economies of scale. That means simply that as the size of an operation increases, the per-unit cost of goods and services decreases. You can see a similar effect in your kitchen: it takes a few minutes to hard-boil a single egg, but only a few seconds longer to hard-boil a half-dozen eggs at once. It does take a few seconds longer, because putting several cold eggs in the boiling water lowers its temperature more than would one cold egg. But it takes the same amount of time to bring the water to a boil before you put the eggs in, and only a few seconds longer to cook the half-dozen eggs. So the per-egg cooking time decreases if you cook a half-dozen at once versus cooking each egg separately.
The same basic principle applies in business. The larger the operation, the lower the per-unit costs. It can purchase raw materials in larger lots and thus often a better price. With a larger cash flow and a wider market, a big business has a lower risk of ruin and thus can get better interest rates when it borrows money. A larger business is often better able to optimize the use of its infrastructure by running multiple shifts. And with more employees, more of them can specialize and be more efficient. All of those factors reduce its operating costs, and thus the per-unit cost of its goods and services.
Of course, that's only relevant if the business still has competitors. If it becomes a monopoly (sole supplier) or a monopsony (sole buyer), it can charge or pay whatever price it chooses. That was the reason for the Sherman Antitrust Act was passed in 1890.
Former Federal Reserve Chairman Alan Greenspan famously criticized the Sherman Antitrust Act, saying that by limiting economies of scale it had deprived Americans of "untold new products and ideas." He's hardly the only economist to have criticized trust-busting, and almost all of those criticisms focus on economy of scale arguments. But is the conventional wisdom on economies of scale - that bigger is better - an immutable fact, or merely a byproduct of a transient economic condition?
Energy Costs and Economies of Scale.
Last May in the Canadian economic journal StrategEcon, economists Jeff Rubin and Benjamin Tal asked a pointed question: Will Soaring Transport Costs Reverse Globalization? (Note: this is a pdf file.) Fuel accounts for nearly 50% of a business' operating costs, and with the world's oil supply diminishing, that percentage is likely to rise in the future.
While alternative energy sources may be available at the factory or farm, transportation requires portable energy, and fossil fuels remain the only currently practicable source of portable energy. All else being equal, the farther a business has to transport its products, the more transportation costs will drive the price of that product, regardless of economies of scale at the factory or farm.
So yes, the conventional wisdom on economies of scale is a byproduct of a transient economic condition: the ready availability of cheap, portable energy by which to transport goods from large, scale-efficient factories and farms to end users around the world. Change that condition - and it is inexorably changing - and you change the calculations on economies of scale. It's becoming cheaper to decentralize production, to manufacture and grow things nearer to the end users and minimize the single largest operating cost item: portable energy for transportation.
Surprisingly, that holds true even if the localized plants have to import raw materials. The ton-mile cost of raw materials is often less than the ton-mile cost of finished products, for three reasons: (a) raw materials are more often transported by rail or ship, which are much less expensive per ton-mile than other transport methods; (b) raw materials can often be shipped in bulk, without the specialized packaging and handling required to avoid damage to finished products; and, (c) risk-in-transit costs are lower as raw materials have less added value than the finished products.
A Change to Localized Economies?
Last June, the Wall Street Journal reported that soaring transport costs are indeed forcing companies to rethink the economies of scale, and even the lower cost of foreign labor may be more than offset by the greater cost of transporting the finished products. If the cost of portable energy continues to rise - and it seems unlikely to do anything else - that may not only force production back to our own continent, but back to our own regions and thus nearer to our homes. It may be more cost-effective to run small factories and farms, with each serving an individual city or metropolitan area, than to ship goods from huge, centralized factories to end users around the country.
Ironically, the rise of the internet may make that more practicable, as the cost of shipping information is becoming almost negligible. And many of those economy of scale calculations are information-based: from cash flow to specialized production methods and training. We may be entering an era where we "ship recipes" globally, but "cook" locally.
And that change would affect our lives in profound ways. More cities and metropolitan areas would have a wider range of local job offerings, and thus there would be a local demand for a wider range of interests and job skills. More of those jobs would be in smaller firms, with less need for and benefit from rigid, hierarchical organizations. Cheap, easy, global "recipe shipping" would give firms a wider menu of choices for how best to do business in their locale. The "best" idea for a firm in St. Louis might come not from Kansas City, but from Kathmandu. And with more food grown locally, industrial agriculture and homogenized crops might give way to family farms and greater biodiversity, as farmers (re)learn what varieties of foods grow best in that particular soil and climate.
These changes might in turn revive local cultures, albeit not the same as those that existed before the One Size Fits All cultural homogenization born of centralized mass production and the mass media. While localized economies will not be entirely self-sufficient, they can still afford to be more different and more fitted to local people. That would, in turn, revive more "local" governance, where the city's or region's leaders can optimize solutions for their problems, but again choosing from a menu of solutions in practice anywhere in the world. The "best" city transit plan for Worcester may come not from Boston, but from Budapest.
Would this be "better?"
That will, of course, depend on whom you ask. As we discussed this week, different people respond to change differently, and often for very sound and rational reasons. A shift to localized economies would force us to learn some new frames, or at least to learn new strategies in the frames we already use. And because all change is risky, it at least temporarily push up the risk of ruin for those whose lives aren't well situated to adapt to change. The institution of law can socialize some of the risks, and government must be a responsible participant in those transitions. But there will still be those who can't or don't want to adapt, however much the changes might benefit their and their children's lives.
Would you welcome some of these changes? Which ones, and why?
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Tomorrow is Sunday, and that means our Ask Ms. Crissie Morning Feature. If you'd like to offer a question, your own or "from" a public figure who's been in the news this week, please post your question in response to this comment. Thank you!
Happy Saturday!