Covid-19: Ending the tyranny of scale?

Whereas China’s other exports had kept the global economy running for two decades, the virus it exported last December has stopped it dead in its tracks. Such a “sudden stop” has never happened before on such a scale, if ever.

Usually, it is either agg­regate demand or aggregate supply that fall off the cliff. This time, thanks to China, both have.

Of the many views that have emerged about the post-China-virus global economy, two deserve attention. This is because they have a special bearing on the way economic theory has evolved over the last 200 years.

One view says this is the end of globalisation. The other says it is not. There is a lot of evidence to suggest that the former group could well be right because of the supply chains argument. But there is an equally compelling case to suggest the opposite also.
 

I suspect, though, that technology will play a huge role in determining the final outcome. What could happen is the death of scale. Let me explain.

The technology-driven industrial revolution started in the mid-18th century. After that, scale became pretty much both the necessary and the sufficient condition for economic success. The yardstick has been steady annual increases in industrial output and employment.

Scale became critical because of steadily increasing capital intensity that the new technologies engendered. Technology led to scale, which led to search for bigger markets, which eventually led to globalisation as we know it.

So economic theories of the last 200 years — classical, neo-classical and Marxist — have analysed economic outcomes by simply assuming scale. No one has ever questioned it, and with good reason: So far, it has always delivered economic success by lowering the unit cost of production.

Indeed, Karl Marx wrote his three volumes of Das Kapital based on this. Joseph Schumpeter wrote one equally influential book arguing the opposite.

Marx said constant technological progress would eventually leave everyone worse off. Schumpeter said everyone would be better off. Both turned out to be somewhat right.
 

But in the case of economic theories, unlike in the case of the physical sciences, much depends on the length of time a theory approximates reality. This, in turn, depends on whether new technologies make the current reality obsolete.

Is scale invertible?

Hence my question: Does there, or could there, exist a new technology that makes scale obsolete? Or, can increasing returns to scale be reversed so that we get increasing returns to de-scaling?

Increasing returns to scale means that if all inputs are increased in the same proportion, output increases by more than that proportion. Put simply, if all factors of production are doubled, output will more than double.

The key lies in what happens to the marginal cost of production, which declines if you have increasing returns to scale. This means that every additional unit of output costs less to produce than the previous one. But can new technology change this 250-year old paradigm?

Or, if you like, think of inverses in mathematics. Very crudely stated, an inverse reverses something that’s already there, like X and -X.

However, not everything can be inversed. But things that can be, are called invertible. The issue is: Is scale invertible?

Let me ask this differently. Can local, national or small regional markets — think South Asia, Europe, the Americas, Australasia — have increasing returns without global scale?
 

I know it sounds very counter-intuitive but if it can be made to happen, it will yield huge positive externalities. One of the main beneficiaries will be the environment, not to mention teaching China a lesson.

Not quite old wine

It is tempting to think of this as the old small-is-beautiful, appropriate-technologies argument and, in some ways, it is indeed that. But one reason why that argument didn’t capture the imagination was that it regarded modern technology as inherently undesirable and even attributed an implicit, ethical dimension to it and scale.

Leaving ethics aside, we still need to know if scale is intrinsic to declining marginal cost. Perhaps it is not, because if you look around, most of the new businesses in the services industry tend to be scale-neutral which, I should add straightaway, is not the same as the concept of “constant returns to scale”.

Can such scale neutrality happen in manufacturing also? If so, what would make it happen?

To find out, read my next column in this space.