Too Many Alternatives
Mitchell Petersen of Northwestern University and I were interested in uncovering the effects of the greater availability of potential financial partners on the strength of relationships.19 We examined the relationships between small firms and their banks. Small firms typically find it hard to get finance, and young small firms especially so. Most economic theories would suggest that in areas with greater bank competition, young small firms would be better off.
Interestingly, we did not find this. Instead, in areas in the United States served by fewer banks, and hence with a less competitive banking market, we found small young firms got more bank loans, and at lower interest rates than similar small young firms in areas with many more banks. Importantly, they also seemed to pay back for this help. As the young firms aged, the interest rate they paid on their borrowings moved up faster in areas with few banks, with older firms paying more in such areas than in areas with more competitive banks.
Why were banks more willing to help out young firms in areas where firms had less choice of banking partners? The answer seemed to be that they knew they could build stronger relationships. As in the community relationships described above, a banking relationship is based on give and take over time. Lending to untried young firms is costly because even a small loan requires a fair amount of due diligence by the banker, and the size of the loan does not allow the bank to recoup the cost of the effort invested. Moreover, many small firms fail, adding further to the bank’s costs as such loans have to be written off. A bank therefore takes a chance on an untried young firm only if it is reasonably confident the firm will survive, grow, and give it more profitable business in the future.
In areas with many banks, a successful firm could always renege on its implicit promise to reward the bank that helped it early on, by replacing it with a new banking partner at better terms. In areas with few other banks, however, the successful firm would likely stay with its original banker because of the lack of choice, and thus would compensate the bank with additional profitable business for the risk the bank took when the firm was young. A bank in such an area, being more confident in the (forced) durability of the relationship, would then be more eager to support young firms.
Thus, relationships seem to be stronger when the members of the community have fewer alternatives, for it gives the members confidence that they will stay mutually committed. An interesting corollary is that communities within a larger economy that are partially ostracized by others may flourish because members build stronger ties within the community. For instance, a disproportionate number of entrepreneurs during England’s Industrial Revolution were nonconformists such as Unitarians and Quakers, who were excluded from civil or military office and from Oxford or Cambridge University.20 Entrepreneurship was one of the few attractive career outlets that was not barred to capable Quaker youth. Many a budding entrepreneur got help from others in the community as he started out—given their exclusion from the larger community, nonconformists trusted one another more in business.
In sum, in a small community, not only am I assured that those I help will stay committed to me, but I also know if I don’t help someone in deep trouble, my community may shrink and leave me worse off. In a small community, therefore, everyone has a stake in everyone else’s well-being. We are spoiled for choice as the community grows, which could hurt the community.21
Community relationships are stronger if members interact over multiple activities—if one’s neighbor is not just a source of the odd gardening tool but also helps deliver our child, we are likely to have stronger bonds. This will occur naturally in small communities. There is no point specializing as a midwife if one is to serve a community with only a handful of women of childbearing age, but it makes more sense if there are hundreds—as Adam Smith famously wrote, “the division of labor is limited by the extent of the market.” As the community grows larger, therefore, we can call the professional midwife when a child is being born and the professional fire service when a cat is stuck up a tree, instead of our neighbor. Members have more choice, and the quality of goods and services they have access to increases, but the breadth of interactions that take place between members narrows. This social distancing with specialization once again diminishes the strength of relationships and the value of community.
Members could try to preserve a sense of community as it grows larger and more anonymous, urging everyone to take into account community benefits in deciding whether to transact locally or in the larger marketplace. They then run into the free-rider problem. We may all benefit from having a local bookstore, where we can browse through books before buying, and meet for coffee or for book events. It may well be that the associated benefits of building community through purchases from the local bookstore outweigh the lower price from ordering more cheaply online. However, if everyone else does their purchasing locally, the bookstore survives, leaving me free to cheat and patronize the cheaper online bookseller. The anonymity of a larger community will make individual transactions harder to police. When everyone acts in a rational self-interested way, the neighborhood bookstore closes down, to the detriment of all.
Too Little Incentive to Change
We have just seen that self-interested people do not take into account the loss of benefits to community health when they transact outside the community. Equally problematic is when they rely overly on community support when they make individual decisions, staying too long within the community when the outside makes more sense. One situation where such incentives may be at work is when an important source of livelihood in the community is threatened by technological change or trade. A well-documented tragedy of the Industrial Revolution in England is the fate of the handloom weavers.22
The automation of spinning toward the end of the eighteenth century meant that there was much more yarn available to be woven. As automated power looms were being introduced slowly, there initially was strong demand for the labor of handloom weavers to weave the now abundantly available yarn into cloth. However, the writing was on the wall—these jobs would eventually be automated also. Nevertheless, even as wages in handloom weaving fell as automated power looms spread, the numbers joining the handloom weaving sector continued to increase. Eventually many ended up unemployed and destitute. Why did so many workers continue to stay in, or join, an industry that was so clearly doomed?
We will see such behavior again in modern United States. The explanation cannot be disassociated from community. Handloom weaving meant following the traditional family occupation, staying at home in the village with family and community close by, and enjoying all the benefits of community support. Changing jobs would entail moving to a dirty slum in a town and working in a hot, noisy factory. For the individual household that moved, this would have also meant foregoing the support the community could offer, and essentially tearing up all the implicit claims they had on it. Staying, even if the likelihood of job loss was high, was made less unpleasant by the prospect of community support.
As the entire handloom weaving industry collapsed, though, the weaver communities were severely weakened and unable to provide the support that was expected of them. Destitute unemployed weavers were forced to petition for public support from the government, which never came—in fact, the Poor Act in England was reformed in 1832 to tighten the conditions of eligibility for public relief.23 While it would not be fair to place the entire burden of this tragedy on the community, it is reasonable to conclude that the presence of the community can distort the decisions of its individual members. When trade and technological change affect many members of the community, their suboptimal individual decisions can end up dragging the community down with them as they place too much of a burden on it.
INSULAR COMMUNITIES
Communities through history have understood how detrimental the free and unconstrained choices of their members can be to community survival. For much of history, this did not matter because people had few alternatives, and change was