We all learn in our first-year economics courses about economies of scale – the concept that the larger a firm becomes, the more cost efficient it can be. This cost efficiency comes through the streamlining its processes (#lowermarginalcosts) and can often provide the firm with an upper hand against smaller competitors. But this leaves students asking the age-old question: does size really matter?
Yes. Size matters.
Economies of scale is no elementary concept – there’s not an economics textbook worth its salt that doesn’t mention it. The theory goes that as a firm expands it is able to engage in activities such as bulk-buying, specialisation and raising funds at a lower cost. Activities like these allow them to lower the cost of their product and obtain a competitive edge over other, smaller businesses.
The perks of being big.
Some businesses are just “too big to fail”, whilst only 50% of all small businesses are still competing after five years in the game. A recent example is that of the Hong Kong Shanghai Banking Corporation (HSBC). They were involved in money laundering an amount of $881m for highly organised drug cartels out of Mexico. The bank was involved in assisting some of the largest, most dangerous cartels in the world and turned a blind eye, and what was their punishment? A fine of $1.9 billion. This might seem like a lot, but it’s less than 10% of the profits the corporation makes in a year. So, it’s fair to say that if you’re big enough, you can get away with anything.
It’s more about how you use it.
While there are clear advantages to being big, there may be a misconception about the performance of the big players. If you look at the period from 1955 to now, you would have seven times as much money now if you invested in small and medium sized firms than you would have if you invested in large firms. Small cap indices tend to outperform large cap indices. Yes, they’re a little more volatile, but you might receive a big payoff if you stick it out. In summary, small firms generally outperform large firms, if you’re willing to take the risk that is.
Some companies experience what economists call ‘diseconomies of scale’. Essentially, corporations reach a point where they are so big that they become less efficient. The cost of communication and travel increases as the firm goes global. Firms spend more money on, say, business flights in order to meet with members of another department or money on international calls between offices. All these are examples of extra costs associated with expanding. This gives smaller, local business the upper edge in some cases.
It’s mostly about where you’re looking at it from.
It’s up to you whether you think size really matters or not. It appears that yes, size does matter, but not as much as you might think. However, the correct answer is the same as with just about any other economic problem – it depends.