Over the past century economists have hotly debated whether the dynamic forces of capitalism are taking us to a future dominated by a few Mega-Corps, or will these dinosaurs be eaten by small, entrepreneurial firms.
The debate’s modern terms were set in the 1930’s, as Progressives like Richard Ely and John Commons argued that the Mega-Corp future was inevitable. As it turns out, these predictions were dramatically wrong: the US economy became much more entrepreneurial in the following decades. Over just the past 50 years, for example, Deloitte estimates the average industry has become ne
arly three times less concentrated. The Mega-Corp, so far anyway, was a dinosaur.
But will they stay dinosaurs? A recent study, again from Deloitte, asks how the internet changes things. Hagel and Brown argue, plausibly, that the internet threatens to change long-running trends on firm concentration. And it does this for two reasons:
First, the internet reduces costs. This is important because lower costs can erode the economies of scale that give large firms their advantage in the first place. If these advantages fade, we’d expect large firms to be increasingly displaced by smaller and perhaps more nimble competitors.
At the same time, the internet actually creates new economies of scale, particularly in marketing and customer acquistion. This transforms some industries towards winner-takes-all. Ebay, for example, replaced ten thousand farmer’s market stalls with a centralized platform for reaching millions of customers at once.
The common thread here is that the internet reshuffes economies of scale, even while reducing prices across business functions.
The trick for an entrepreneur or corporate strategist becomes, then, predicting which economies of scale will weaken, and which will strengthen. And in both cases whether those economy of scale changes will outweigh the general price reduction from the internet.
So let’s play a bit with these moving parts.
The key element is cost-reduction, since the internet makes it cheaper to find and reach customers and it makes it cheaper to outsource or contract out production and infrstructure. So essentially every business function is made cheaper by the internet: customer facing (sales, marketing, distribution), production (operations, manufacturing) and infrastructure (finance, HR, IT, admin).
How does this across-the-board cost lowering affect firm size? To unpack that, we want to look at relative economies of scale. In other words, what the “starting” advantages and disadvantages of small vs large firms.
For small businesses, the key challenge is that many functions have irreducible fixed costs. For example, before the internet it was hard to have 1/10 of an HR department. You either had a whole HR department, or you did it yourself. Perhaps after-5 or on the weekend.
Nowadays, of course, you can outsource the HR function in little bits — job adverts at Monster.com, filtering software or outsourced interviewing, employment contracts bought as-needed, and so on.
But the other side of the coin is that large firms often have much more overhead. Organizational deadwood, bureaucratic cultures, poor information flow can make it more expensive for large firms, while agency problems (distance between owner and manager) can make organizations cluttered and slow.
Boiling down, small firms by nature have high fixed costs, while large firms by nature have high variable costs.
So if the cost-reduction is happening more at the fixed-cost “starting” stage of a particular function then its favoring small firms. And if the cost-reduction is happening in the variable costs then its disproportionately helping big firms.
In practice, of course, many internet innovations help both fixed and variable costs. Being able to hire bookkeeping or HR management over the internet can reduce both fixed and variable costs. In which case we’ll want to drill down and compare the size of the effects.
Let’s take a few examples. Uber does so well because it automates the dispatcher function. Dispatching is a high fixed cost for a taxi firm, but once you’ve got a dispatching function it scales pretty effortless from, say, 20 to 50 cabs. So smartphone apps, it turns out, eroded the fixed costs of the taxi industry more than it eroded the variable costs. And so we have Uber (and Lyft, and probably hundreds of clones worldwide).
On the other extreme, we have platforms like eBay or Etsy gobbling up the independents. Here, technology reduces the variable costs more than the fixed costs. So if you hand-craft mugs in your backyard kiln, the internet didn’t affect your production very much — you’ve still got to make the mugs. What the internet does do, though, is makes it much easier to find customers. Instead of loading those mugs into the station wagon to drive 3 towns over for a Saturday farmer’s market, now you just post a picture and description on eBay or Etsy.
So here the fixed costs weren’t reduced much — you still need the kiln, and you still need to make the mugs. Instead, variable costs of customer acquistion is what was reduced. And so the industry became concentrated, with Etsy replacing customer-facing functions of thousands of mom-and-pop outfits.
This framework is useful not only to corporate strategists, but also to entrepreneurs: if you see a function where the underlying price reductions are favoring fixed costs, then that’s likely to be an opportunity for a new entrant. On the other hand, if price reductions are favoring variable costs, then large firms might actually be getting stronger.
For investors, this analysis can guide not just which industries to invest in, but even which firm to buy in a given industry. Whatever competitive “moats” a given firm has today are likely to be “priced in” to the stock price. Meaning that, if new technologies are eroding these “moats” then your investment can lose out.
A key, then, for an investor is to ask whether new technologies are cheapening fixed costs or variable costs. If fixed costs are dropping, then invest in the smaller players in that industry. If variable costs are dropping, then look for the dominant players likely to gain most from the emerging economy of scale.