Oct 162011

In business, economies of scale means that it is less expensive, per unit of output, to produce goods, if one produces a lot rather than a few. For example, one would not build a factory, buy raw materials, and hire workers to make only one car. Similarly, one would not set up a restaurant to make only one meal.

Once the oven is hot, the freezer cold, and the employees on-site, the additional cost (what economists call the ‘marginal cost’) of producing a second meal is substantially less than the cost of going from zero to one meal. Likewise, the cost of producing the third, fourth, and subsequent meals can fall even further, as the employees get into the rhythm of the job, several items bake in the oven at a time, and the freezer is cooling more than air and empty shelves.

The larger the operation, the greater the output relative to the costto a point.

However, as with plants, animals, and essentially everything else, there is a limit to how much a firm can grow, before costs begin to rise faster than income.

Sticking with the restaurant example, let us assume that a good day’s gross income is $10,000, and that the pre-tax profit is about 15% of that, after paying for groceries, utilities, maintenance, payroll, insurance, etc. [Feel free to substitute an appropriate amount of your local currency, if you reuse this text.]

Now, imagine that the owners have hired a new general manager — we’ll call him Skippy [Feel free to substitute a culturally appropriate derogatory name here.] — who wants to double the gross revenue to $20,000 per day, even on historically slow days.

Skippy holds ‘motivational’ meetings and exhorts the employees to “work smarter” and to be “dedicated” to the “mission” and “vision” of the organization. He wants to run three eight-hour shifts per day, seven days per week including holidays, and to minimize costs.

One young man at a meeting asked, “Um… If we wanted to minimize costs, shouldn’t we just shut down? That way, costs would be reduced to zero.”

Skippy replied, “You have a bad attitude. Ask not what this firm can do for you; ask, rather, what you can do for this firm.”

One problem with selling more meals than is optimal is that one has to provide incentives for potential customers to become actual customers. One option is to offer larger servings, but customers typically eat only so much at each meal. Another option is to reduce prices, either across the board, during times that the restaurant is usually closed or business is slow, for individuals who are members of a favored category — females, a particular ethnicity, a profession, etc. — or some other form of discrimination against those who are not members of the favored category.

By doing so, the restaurant operator reduces the income from each meal sold, even though the costs of producing those meals do not fall. Quite the contrary, by running the equipment without break, one is unable to clean, maintain, or repair it, and by working one’s employees harder, they get tired, make mistakes, and become resentful; beyond the optimal scale, costs per unit of output rise.

It does not matter if it is a restaurant, factory, bank, or whatever, each firm has its optimal size, and anything larger or smaller than that optimal size is less efficient than it would be if it were operating at the optimal scale.

If Goldilocks were a management consultant, one might hear her say, “This firm is tooo small. This firm is tooo big. And, this firm…? This firm is juuust right.”

In general, two things systematically prevent firms from operating at their optimal scales: hubris and regulation.  Things that unsystematically prevent firms from operating at their optimal scales stem from the unknowability of the future: uncertainty, surprise changes in market conditions, natural disaster, and other things that one cannot foresee.

Hubris is the kind of overconfidence that leads one to believe that one knows more than one knows, and thus can do more than one can do. It is one of the qualities of the kind of narcissist that is expert at climbing to the top of an organization, in spite of a lack of actual knowledge, talent, or skill.  Such individuals often conflate speculative hypotheses with proven conclusions, confuse ‘could’ with ‘must’, and are loath to admit when they are in error.  They speak with great bombast, demean those who ask for clarification, and typically refer to their track records when pressed for details.

In positions of power, hubris can lead to doublethink, especially a desire to minimize costs and to maximize gross sales simultaneously, in spite of the fact that there is a cost for every benefit.

Granted, one can try to minimize fraud, abuse, and waste, but any more than this implies fewer raw materials, fewer fixed assets, and less available labor, and thus reduced output; decrease costs, decrease revenue.  Similarly, if one wants to increase output, this implies more raw materials, fixed assets, and available labor, and thus increased cost; increase revenue, increase costs.

Hubris tends to result in firms that operate above their optimal scales, based on the notion that bigger is better.

Regulation leads to inefficiency most commonly through the misapplication of the observation that price tends to approximate the marginal cost of production in a competitive market.  Only in a monopolistic market can one charge a price higher than the marginal cost of production, because in a competitive market – i.e., a market that has a very large number of relatively small suppliers – if one tried to charge a higher price, a competitor would undercut the price.  This process would continue, until no one were willing to charge a lower price.

In monopoly markets with only one supplier or in oligopoly markets with a small number of relatively large suppliers, sellers can charge prices that are substantially above marginal cost, because buyers have nowhere else to go.  The choice is between paying the high price or going without.

This reasoning underlies antitrust statutes.  The idea is that, since perfectly competitive markets have the lowest profit margins, and thus the lowest prices to consumers, a small number of large suppliers is de facto bad.

This ignores economies of scale.

Some productive processes have very high barriers to entry, typically in the form of expensive equipment, as is the case with airlines, cruise ships, railroads, electrical utilities, etc.  If it makes economic sense for suppliers in these industries to be large and highly concentrated, then the tendency will be for the successful to acquire the unsuccessful.

Some suppliers operate in a ‘winner-take-all’ environment, as is the case with search engines, social network websites, operating systems, etc.  If consumers tend to favor a particular supplier to the exclusion of essentially all other competitors, then the optimal supplier will tend to be a monopoly.

Regulations that hinder concentration where it results from economies of scale serve only to force suppliers to be inefficient.

The main thing to bear in mind is that hubris is ultimately its own undoing, and, in an increasingly integrated global community, regulation at the national level is increasingly anachronistic.

BEARING THE DISCLAIMER AT THE BOTTOM OF THIS PAGE IN MIND, a contrarian speculative strategy might be to sell short assets that are darlings in the popular media (i.e., subject to hubris) and buy long assets that are under intense government scrutiny (i.e., likely to migrate from unfriendly jurisdictions to friendly jurisdictions).

Invest accordingly.

Prof. Evans