Economy of Scale – a myth?

The mantra of “economy of scale” is one that is brought up as the justification for centralization and merging of business functions in many private and public sector organizations. For example, the UK Department of Health’s 2010 report “Liberating the NHS: Report on the arm’s length bodies review” states this reason nine times. Yet there is very little evidence that organizational merging of functions yields the savings that were expected.

The term “economy of scale” is one grown out of the 1920’s manufacturing boom. It is defined as a lowering of unit cost as a result of increased production realized from operational efficiencies. This term was mainly used for factory production models. To use a modern day example, you may have two photocopiers that can copy at 50 pages per minute each. The total capacity is 100 pages per minute. You may be able to get a copier at 135 pages per minute that costs less than the aggregate cost of the two 50 page per minute copiers. Therefore the 135 page per minute copier is a rational choice because of the economy of scale.

This manufacturing terminology has been extended to the provision of public services. The thought is that consolidation into a bigger organization will result in a more efficient and cost effective government thereby gaining “economy of scale”. There is little evidence that this occurs. For example an excellent study on the consolidation of several small municipalities into one larger one concluded that there was “no support for the hypothesis that large government takes advantage of economies of scale and avoids wasteful duplication”.

The reason is that economies of scale is difficult to reach in the provision of services or with knowledge workers. In other words, when people are needed to provide the output, economies of scale is a myth. An illustration may help. Let us imagine that you offer a driver service. You have two cars that bring four people each to two destinations across town. The economy of scale thinking would suggest that you could purchase an eight seater van for less than two cars. Thus you have decreased your unit cost. However, the delivery time of the people would increase disportionately. You would now have a diseconomy of scale.

There may be good reasons to centralize functions . However, the reasons for this need to be well understood. Using the mantra of “economy of scale” is unsupported.

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