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Central planning and diseconomies of scale

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Central planning and diseconomies of scale

Oliver Williamson was the co-winner of this year’s Nobel Prize in Economics. Among his many contributions is his excellent work on hierarchies. His insights provide a sound basis for what economists call diseconomies of scale; that is, the tendency for a firm’s average costs to increase once it surpasses a certain size.

Williamson explained that as a firm, or any organization expands in scale, it becomes much more complex and costly to manage. As a result of what Williamson described as bounded rationality and span of control, hierarchies develop in order to manage increasing numbers of employees. Harvard Professor Richard Freemen wrote a book entitled “Guard Labor”, where he expounded, in part, on Williamson’s work. Professor Freeman’s basic argument was that more and more Americans were working at jobs that required them to supervise others. They did little productive work themselves, and their jobs shared some characteristics with those of prison guards.

The gist of this is that there are limits to the optimal size of any decision-making organization. Complexity, weak accountability, ineffective controls, and distorted information flows throughout an organization eventually make it unmanageable. These are very profound insights, especially for structuring and managing organizations.

Tom Friedman, one of the New York Times best known journalists, has written a number of columns where he appears to be envious of the ability of the communist structure of government in China to make and implement decisions. I suspect that part of his fascination stems from what  seems to be a U.S. system of government and policy making which is increasingly dysfunctional. But he also is quite impressed with the economic outcomes in China. And finally, he believes that government must play the central role in moving the economy forward.

If Friedman is familiar with the work of Williamson, he does not see its applicability to central planning. Just as a firm becomes too cumbersome, so too does government, particularly one that dictates every part of what happens in the economy and society. Just as firms which are too large might have a good run before they collapse, so too can governments, communist or otherwise, which try to plan the economy. The collapse of the USSR is an obvious example. Hugo Chavez can make all types of decisions and implement them quickly. Yet I doubt that anyone would point to Venezuela as an example of the superiority of centralized decision-making. President Carter was dreadful because he tried to micro-manage everything. And the flat line economy of Japan for the past 20 years also demonstrates the eventual failure of concentrating more economic powers and decisions making at the center in a small number of hands.

Can China’s system of government continue to succeed? Undoubtedly, it can, but not indefinitely. Eventually, it will become too cumbersome, if it has not reached that stage already, and the failures of centralization will become increasingly more obvious.

Decentralization works. Simplicity works. Give people the freedom and opportunity, and their ingenuity will move us forward. China did not create Avatar, a global cultural phenomenon and a multi-billion dollar enterprise. China did not invent the iPhone, or Google or countless other important breakthroughs. China has the talent. But creativity is not a strength of central planning.

Government does play a very critical role in creating and maintaining the foundation for innovation and prosperity. But government rarely has succeeded, for any lengthy period of time, in driving an economy forward.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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