November 13, 2008 12:47PM

Diseconomies of Scale vs. Network Effects

I was very interested to read Roderick Long's opening essay for this month's Cato Unbound. Long draws a distinction between genuine free markets and policies such as corporate welfare and protectionism that favor the interests of incumbent businesses at the expense of the general public. Almost all libertarians draw this distinction, of course, but Long suggests that many libertarians too readily classify as "free market" policies that are more properly regarded as corporate welfare.

What caught my eye about Long's article was his claim that in a genuinely free market, businesses would be significantly smaller than they are today. He points out that large, hierarchical businesses are subject to many of the same inefficiencies that plague government bureaucracies. The executives of the largest corporations cannot possibly have enough knowledge to make good decisions about the thousands of different projects various parts of their companies are undertaking, and so it's inevitable that large companies will suffer from inefficiencies greater than those that afflict smaller firms.

I think this is an important point, and indeed is a theme that runs through my own work. For example, one of the key arguments of my Policy Analysis on network neutrality, which Cato released on Wednesday, is that the Internet's success depends on the fact that it isn't owned or managed by any single entity. Back in the 1990s, when the Internet was competing with proprietary online services like AOL and Compuserve, the Internet's lack of centralized control turned out to be its most important strength. The hierarchical decision-making processes of the AOL and Compuserve companies simply couldn't keep up with the spontaneous order of millions of Internet users acting without central direction.

Indeed, one of the fun things about writing about technology is that thanks to the rapid pace of change, Silicon Valley is one of the few places where very large and very small companies compete on a roughly equal footing. And I think the experience of Silicon Valley bears out Long's observations. The most innovative ideas almost never come from large, established firms. Silicon Valley is full of firms like HP, Digital (now part of HP), Microsoft, AOL (now part of Time Warner), Yahoo!, Netscape (now part of Time Warner) that began their lives as nimble startups selling highly innovative, disruptive technologies and wound up as large, bureaucratic companies struggling to keep up with the efforts of smaller competitors with a tiny fraction of their R&D budgets.

Central planning doesn't work very well. And Long is right to point out that this is true of large companies as much as it is of the federal government. But having found a theoretical hammer he likes, Long seems to see public policy nails everywhere he looks. He puts forward the even stronger claim that large firms are so inefficient that only government interference in the economy could explain their existence. Not only does this conclusion not follow from his premises, it's not difficult to come up with counterexamples.

Google, for example. Google's success certainly can't be attributed to a sweetheart deal from the city of Mountain View. Nor does Google particularly benefit from low wages or government-funded roads. Even if we grant Long's premise that copyright and patent law are unjustified interference with the free market, these can't explain Google's wealth either. Google's products are available for free, and Google has yet to assert any of its patents against competitors.

The reason Google is so profitable, in a nutshell, is network effects. Google sits at the center of a vast network of users, website operators, and advertisers who are locked in a virtuous circle. More advertisers prompt the creation of new websites, which attracts more users, which in turn attracts more advertisers. As the matchmaker between these parties, Google is able to capture a small fraction of the social surplus created by the virtuous circle.

Now over time, Google will succumb to the same diseconomies of scale that have been dragging Yahoo!, Microsoft, and other companies down. Already, if you talk to people who have worked at Google, they will tell you that the company is slowly losing the freewheeling spirit of its early days. It's gradually becoming more bureaucratic, risk-averse, and strategically incoherent. But it will take a long, long time for Google's bureaucracy to become so inefficient that it will cease to be a profitable company in the absence of government favors. If Google simply rests on its laurels, its existing customer base will continue generating a healthy revenue stream for the foreseeable future.

I think the same thing is true in other sectors of the economy. The choice of Wal-Mart as a poster boy strikes me as particularly ill-considered. To be sure, Wal-Mart is far from a paragon of libertarian virtue. I will be (and have been) the first to condemn them for their abuse of protectionist policies such as eminent domain at the local level. But blaming Wal-Mart for policies such as publicly-funded roads and labor market regulations that have nothing in particular to do with it strikes me as grasping at straws. Wal-Mart happens to be extremely good at logistics, and have managed to wring larger economies of scale out of the retail industry than anyone had previously been able to do. Wal-Mart, like Google, benefits from the network effects that come from bringing together tens of millions of consumers with hundreds of manufacturers.

Of course, we don't know precisely how much of Sam Walton's profits are attributable to these economic forces and how much are attributable to government favoritism. No doubt, Wal-Mart would be a somewhat less profitable company in a world without eminent domain abuse. But it's simply not plausible that none of Walton's profits were attributable to his savvy business decisions. And it's certainly overstating the case that Hayekian considerations dictate that Walton's profits must be attributable to government favoritism because a company of Wal-Mart's size could not exist in a free market.