Value Investing

How To Defend The Economies Of Scale

Economies of scale refer to the reduction in the per unit costs of products due to an increase in the total output of the products. It is a competitive advantage that the large companies have over the smaller ones. This is explained by the fact that the cost of producing one unit is more than producing many units at once.

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Defend The Economies Of Scale market share
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The economies of scale can be internal or external. The internal economies of scale result simply from the size of the company, irrespective of the industry and the target market. On the other hand, the external economies of scale result from the preferential treatments that the large companies receive from the government and the external sources.

Building economies of scale is an uphill task, however, the bigger task is to defend them. The markets are not efficient and with the presence of multiple competitors and new entrants, a business needs to ensure that it is able to protect its economies of scale. Detailed work has been done on this concept by Bruce Greenwald and Judd Kahn in their book “Competition Demystified: A Radically Simplified Approach.” With reference to defending the economies of scale, the authors say,

“The best strategy for an incumbent with economies of scale is to match the moves of an aggressive competitor, price cut for price cut, new product for new product, niche by niche. Then, customer captivity or even just customer inertia will secure the incumbent’s greater market share. The entrant’s average costs will be uniformly higher than the incumbent’s at every stage of the struggle. While the incumbent’s profits will be impaired, the entrant’s will be even lower, often so much lower as to disappear altogether. The incumbent’s competitive advantage survives, even under direct assault.

The business with existing economies of scale can afford to reduce costs and match the competitors. The new entrants will not be in the financial position to reduce costs beyond a certain point. This will help the established business to stay ahead of the new entrants at all points in time. In fact, this may also help in eliminating the competition completely.

The combination of economies of scale coupled with better access in the future to existing customers also produces an advantage in the contest for new customers and for new technologies. Consider the competition between Intel and Advanced Micro Devices (AMD)—or any other potential entrant, like IBM or Motorola—to provide the next-generation microprocessor for Windows-compatible personal computers.

Three features of economies of scale have major implications for the strategic decisions that incumbents must make. First, in order to persist, competitive advantages based on economies of scale must be defended. Any market share lost to rivals narrows the leader’s edge in average cost. By contrast, competitive advantages based on customer captivity or cost advantages are not affected by market share losses.

Therefore, in order to the defend the economies of scale, the market share must be defended. Loss in market share reduces units supplied and produced, and thus hampers the economies of scale on the whole.

Second, the company has to understand that pure size is not the same thing as economies of scale, which arise when the dominant firm in a market can spread the fixed costs of being in that market across a greater number of units than its rivals. It is the share of the relevant market, rather than size per se, that creates economies of scale.

Again, when the market share goes down, the business can only distribute its fixed cost to a lower number of units, thereby increasing its per unit cost. so, it is highly critical for a business to protect its market share. How huge a company is, is irrelevant compared to how large market share does the business hold.

Third, growth of a market is generally the enemy of competitive advantages based on economies of scale, not the friend. The strength of this advantage is directly related to the importance of fixed costs. As a market grows, fixed costs, by definition, remain constant. Variable costs, on the other hand, increase at least as fast as the market itself. The inevitable result is that fixed costs decline as a proportion of total cost. This reduces the advantages provided by greater incumbent scale. Moreover, growth in the market lowers the hurdle an entrant must clear in order to become viably competitive.

Another significant way to defend the economies of scale is to remain in a smaller market compared to a bigger one. When the market size grows, the fixed costs remain constant but the variable costs keep increasing, thereby reducing the ratio of fixed costs to total costs. This is detrimental to competitive advantage due to economies of scale.

Although it may seem counterintuitive, most competitive advantages based on economies of scale are found in local and niche markets, where either geographical or product spaces are limited and fixed costs remain proportionately substantial.”

Thus, economies of scale provide excellent competitive advantage to the incumbents. However, the dynamics of economies of scale are fast and the tables get easily turned. It becomes necessary for the established companies to ensure that they protect their economies of scale to remain on top of their game.