With apologies to the long-trunked among us, any large integrated company that supplies water, electricity, heathcare and other essential services might be best described as an elephant.  (AP Photo/Tsvangirayi Mukwazhi)

The proposed merger of Exelon and Pepco is a cautionary reminder of persistent tension between innovation and businesses of scale.

Exelon is a nuclear energy giant. Pepco powers Washington, D.C. and a number of mid-Atlantic states, and has a less-than-stellar reputation for customer service due to its slow response to natural disasters and caller hold times longer than the life spans of certain invertebrates. A merger of these two companies appeared likely as one by one, state power commissions approved the deal until the last of them — the Public Utilities Commission of the District of Columbia — said, at least for now, “no way, no how.”

This difference of opinion reflects the challenge raised by a concentration of economies of scale to deliver important services to customers. Companies that supply water, electricity, media, bandwidth, healthcare and many essential services have evolved into large, integrated businesses of scale best described as elephants. Scale allows these elephants to gain efficiencies of production and allocate costs against a larger customer base — a base effectively “locked in” to receiving the required service or product from the provider. Costs for potential competitors to reach the same customers are effectively raised to an unmanageable level. Meanwhile, the cost for elephants to introduce new products to their existing customers is effectively zero.

(Photo courtesy of Jonathan Aberman) (Photo courtesy of Jonathan Aberman)

Now let’s look at innovation. Innovation describes the process of creating something new to satisfy a customer need. Innovators do not initially achieve business success through economies of scale; they gain customers through novelty and are consistently working to reach customers — often the largest expense new technology businesses have. You can start a software business for $25,000, but it takes tens of millions of dollars to achieve scale. This truism applies to every new business providing an innovation.

In a world of elephants, where access to customers is effectively controlled by a small number of large companies, the ability for innovators to reach these customers is heavily constrained. Therein lies a central challenge of the U.S. economy since its development as an industrial power: balancing the benefits of scale vs. innovation.

Since the late 1800s, regulators kept an eye out for companies achieving business scale through predatory practices and limited unfair concentration of businesses strength. The system was set up so that companies gaining market power through excellence could become large and dominate industries. In the case of some industries, a concentration of economic power had ancillary benefits for society — for example, water, electricity or cable television — with consumer prices and service quality regulated by commissioners with the authority to set rates and profit margins.

However, through an erosion of the vitality of regulation of business concentration, the emergence of winner-take-all industries where business scale can be achieved through the efficiency of the Internet, and the blurring between industries offering benefits for society and those that are merely businesses, our economy is now struggling for a rule book that will allow for innovation to co-exist with business scale.

Some argue we have too much regulation in our economy, while the concentration of a growing number of industries and the effects on innovators suggest the reverse may be true.

The Pepco Exelon merger will most likely occur, with the new utility achieving greater scale, and maybe even providing better service when power lines are down. What is less certain is whether it will be a driver of energy innovation. The odds are not favorable.