Economies and Diseconomies of Scale – Part 1 Goliath

There is a curious unasked question that serves as a back drop to much of the media’s reporting on the economy.  If big business is so powerful, why is it that most people in the private sector of the United States work in small and medium businesses?  Surely both the power that big businesses yield (lobbying, political, and resources) and the economy of scale they enjoy would allow them to outperform and outlast their competitors in the smaller firms.  Asked differently, why isn’t the world dominated by huge multinational corporations?

This idea of the dominance of big business is certainly common fare in the daily fiction that passes in movies and TV.  Many tales come out every year featuring the evil, predatory practices and near omnipotent power of big business, and yet the small and medium rebellion continues unabated every year.

Now, to be clear, I am neither suggesting that big business is benevolent nor that it exercises its power gently.  Businesses, large or small, have a right and perhaps an obligation to aggressively protect their market share and to continue to grow.  In addition, crony capitalism and political favoritism tends to give the larger firms political concessions that the smaller firms lack.  What I am suggesting, or at least exploring, is the notion that smaller can be better, and that we tend to remember economies of scale and forget about diseconomies of scale.

To better understand the staying power of small and medium business, consider some elementary statistics.

Small businesses make the bulk of the US economy, both in terms of the number of firms and in terms of the number of employees.  According to statistics provided by the Census Bureau, 61% of the firms in the country are sized between 1-4 employees, and 99.6% of the firms have fewer than 500 employees.  Nearly 50% of the employees in the economy work in this segment.

The wages these employees make, in aggregate, are comparable to the wages earned by their big business counterparts. Although a more detailed analysis by labor segment (e.g. secretary to secretary) in addition to size of firm is needed to make clear conclusions, there doesn’t seem to be obvious evidence that being in a big business significantly increases wages.

The table below, adapted from 2007 data from the Census Bureau, shows the details:

Now let’s talk a little about all the advantages enjoyed by big business (say, more than 1000 employees) that are either available to a lesser degree for smaller firms or unavailable entirely.  This discussion will focus only on the legitimate advantages afforded to these firms from economy of scale effects and will ignore additional, unfair, advantages due to lobbying and crony capitalism.

As a reminder, an economy of scale is the term that is used to describe any effect that allows the cost per unit of production to lower as the number of units produced grows. Large firms generally have three areas that provide them with economy of scale advantages.

The first is in the form of non-reoccurring costs or what is sometimes known as sunk costs.  This category covers all the initial investment in the production capital, such as factories and specialized machinery.  A milling machine comes with a fixed price tag whether it is used to produce 1 unit of goods or 100.  In the latter case, the initial outlay for the machine can be recouped over a large customer base and so allows the cost per unit to be reduced.  Similar advantages occur for advertising and marketing, where the price passed onto consumers is smaller per good the larger the number of consumers, and for shipping, where it is cheaper to have a truck that ships 200 goods than to have two smaller trucks that ship 100 goods each.  Finally, a large firm typically has greater financial resources and can bear the risk associated with research and development of new goods and services more easily than smaller ones.

The second advantage of larger firms comes in the form of the workforce.  Employees at larger firms can more easily specialize, leading to production.  The prototypical example of this is given in Adam Smiths ‘The Wealth of Nations’.  Smith examined how straight pins were made, and identified 18 distinct tasks.  A single worker performing each of these 18 tasks might be able to produce 20 pins in a day.  By dividing up the tasks amongst several workers so that one worker performed only 1 or 2 of them, Smith estimated that a group of 10 workers could produce 48,000 pieces in the same time.  Division of labor and specialization enabled each worker to increase his output by over a factor of 200.  Large-firm employees also enjoy a larger community from which to learn, and an environment filled with greater intellectual capital and corporate knowledge.

The third advantage is the leverage that big businesses have in procuring goods and services.  They can bulk-buy from suppliers and vendors and receive a discount that is out of reach for the smaller firms.  They can also command better terms and concessions on loans and related financial instruments that can be used to increase their production.

So, having enumerated all these great advantages, how can small firms ever compete?  And yet, they not only compete; they also dethrone the giants of yesterday.  Not so long ago, IBM was the unassailable provider of computers and business machines.  Within two or three decades, Microsoft had supplanted IBM.  As time progresses there is mounting evidence of Microsoft losing ground to both Apple and Google.  Other examples from every enterprise and industry can be found where yesterday’s giants are today’s has-beens; simply look at Abercrombie & Fitch, or Nokia, or Borders, or… well, you get the picture.

In next week’s column, I’ll discuss how the Davids of the economy can defeat the Goliaths.  Stay tuned.