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Real World Economics: What Dorian tells us about risk and scale

Public Policy

Countries, states or cities are not “scale-neutral” from many economic aspects. By this we mean that per capita costs of certain government services may either fall or rise as the physical size or population of the jurisdiction increases.

This may make a difference in the best way for governments to cope with risk, whether it be the wall of a burning building crushing a million-dollar firetruck — or a nation being crushed by a hurricane, as happened in the Bahamas last week.

Edward Lotterman

Start with understanding what we call economies of scale. Econ students learn to plot a curve on a graph showing how the average cost of producing something for a business first declines as output grows, often over a long range, but eventually rises again. The same is true for some government services, emergency or otherwise.

A sewage treatment plant to serve a small town of 1,200 does not cost four times as much as one serving a village of 300. One for the county seat of 3,600 does not cost three times as much as the town with 1,200 people. This may continue for a broad range of populations, although at some point in major metro areas, the complexity and cost of getting sewage tens of miles to some treatment plant may push average costs in the other direction.

Similarly, a Minnesota village fire department in the 1950s probably had two firetrucks. The county seat might have had six times as many people, but it did not need 12 trucks.

A hospital for Murray County, population 10,000, in that era needed an ER, operating and delivery rooms, an X-ray machine, a simple lab, kitchen, waiting room with receptionist, and a dozen patient rooms, of which only half might be occupied some days. Nobles County just to the south had the same land area but twice the population. Its hospital was larger, and perhaps better equipped, but a lot of facilities and equipment needed for a population of 10,000 were adequate for one of 20,000. The cost per capita in the larger county was lower.

The same is true for states. In the 1990s, I was a regional economist at the Minneapolis Fed and drafted its portion of the “Beige Book” briefing document prepared for every Fed policy-making meeting. I often had to contact the state offices that tabulated state and local employment indicators or that tracked and forecast state tax revenues. The district included Minnesota, the Dakotas, Montana and parts of Wisconsin and Michigan.

At that time Minnesota’s population was about 4.5 million while the three district states to the west were around 700,000 each. Any state has to collect taxes, make payments from its treasury, register vehicles, keep vital statistics of births and deaths and track employment levels and unemployment rates. Any such department in a state of 700,000 has to be smaller than in one six times more populous. Yet the same tasks must be done and these often don’t reduce in proportion to population.

For a health department statistician tabulating births, deaths and infectious illnesses from 28 counties, it doesn’t matter much if the county populations are 800 or 90,000. So while the people I contacted in Helena, Mont.; Pierre, S.D., or Bismarck, N.D., were capable and dedicated, they were spread thinner than their counterparts in St. Paul and could not do the same sorts of study and analysis.

The same is true for state universities. Early in statehood, each state wanted its own state university and a land-grant university for “agricultural and mechanical arts.” It would be good to have a law school and a medical school. For farm states, a school of veterinary medicine would please farmers. So there is a USD and a SDSU, a UND and a NDSU, a University of Montana in Missoula and a Montana State in Bozeman.

One can get a good education at any of these. There are fine scholars at all of them. But as technology has changed, it is increasingly hard to maintain a good medical school in a low-population state. And it is nearly impossible to accumulate the critical mass of scientists and laboratories needed for a modern research university that can generate technology and spin-off businesses as did the University of Minnesota.

There also are economies of scale in nations. There are certain basic functions any national government must carry out. And the cost per citizen is lower or the services better for larger population countries. Agriculture Canada has fine research stations in a nation with a larger area than ours. But with a tenth of the population, Ag Canada cannot do what USDA can do here. Uruguay has a central bank, army and navy academies, a diplomatic corps with embassies in major countries and so forth. But these are more costly to maintain for a nation of 3.4 million than for Brazil with its 210 million.

Yet Uruguay is well placed compared to Barbados, a wonderful island nation with the area of Ramsey County and a population of 286,000, just under that of St Paul. Or compared to the Bahamas, a nation of 400,000 with the third-highest per capita income in the Western Hemisphere and the highest income black-majority nation in the world. These need at least the minimal agencies of national government with tiny populations.

This brings us to the intersection of economies of scale and the principles of insurance underwriting, recognizing it is easier to spread risk if the population being covered is larger and more heterogeneous.

One of the roots of property insurance was that of late-Middle Ages merchants from Venice who would sail in convoys to Constantinople and who would agree that if one ship from among 12 or 15 sank, all of the ship-owners agreed to share the loss. Later, merchants not directly involved in shipping would agree to underwrite all or part of the loss of a vessel in report for a fee. But these rudimentary insurers learned to not cover more than one vessel in any single convoy, since they might all be subject to the same storm or pirate attack.

Early white settlers in Minnesota needed protection from hail. Immigrants from Scandinavia had experience with small mutual insurance companies. So a system of “township mutuals” sprang up. But these soon learned that it was better to pool risk across township and county lines because, unless it had large reserves built up, a hailstorm might hit most of the farms in one 36-square-mile township while others few miles away were spared.

They also understood that hail and tornadoes were relatively random. But, as every peasant in the Andes knows, frost is not, since cold air funnels into valleys. If frost were covered with no variation in premiums, farmers with frost-vulnerable farms, like ours, would load up and free-ride on members with less-vulnerable topography.

Hurricanes also are relatively random, though we know they tend to hit tropical zones rather than polar. But Barbados and the Bahamas had not seen a bad hurricane in decades. Last week, Hurricane Dorian missed Barbados but devastated the Bahamas. This unfortunate nation is like a farm township with a wide hailstorm. It simply does not have the resources to recover on its own.

Tornadoes can wreak similar devastation, but in smaller areas. A tornado in 1992 wiped away half of my home town of Chandler, including my mother’s house. This was the last F-5 tornado the state has seen. The damage was extreme, but over an area that was tiny relative to the state of Minnesota. National Guard units from nearby country seats was there within hours. The next day bucket trucks from nearby REA Co-ops, Xcel Energy, and municipal power companies converged on our town under the cooperative disaster repair agreements they had in place. A wonderful team of Mennonites came from Mountain Lake with chainsaws and worked for days. Lutheran and Dutch Reformed relief agencies set up operations. And individuals from miles around simply came to help.

This could not happen in the U.S. territory of Puerto Rico when Hurricane Maria hit in 2017. Virtually the whole island was hit. Help could not simply drive in from all directions on roads. This cannot happen in the Bahamas either. Boats or aircraft are needed. Yet both Puerto Rico and the Bahamas suffered damage that was huge relative to existing property, relative to GDP and relative to available resources.

There are national and international aid institutions. The U.S. Coast Guard is helping out a close neighbor. The United Kingdom sent a Landing Ship Dock to a member of its Commonwealth. Other nations will help, but the people of the Bahamas will take years to replace what they lost physically and decades to return to their net worth of only a week ago.

Being a large nation is not all advantage. But in situations like this, there are harsh drawbacks to being a tiny nation.

twin cities



One Comment on "Real World Economics: What Dorian tells us about risk and scale"

  1. Sissyfuss on Mon, 9th Sep 2019 8:31 am 

    An anecdotal mish mash of BAU weather that no longer exists. We have dislocated the Jet Stream, are currently melting both poles, and acidifying the oceans. The northernmost islands of the Bahamas were scraped clean and the infrastructure for those wishing to live normally are gone for now, much like Puerto Rico. More climate refugees added to the growing numbers wandering the globe, looking for a habitable spot of Earth that won’t be destroyed by the coming droughts, floods, and extinctions. We all live in the Bahamas now, checking the sky for the next megastorm to approach. Interesting times indeed.

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