Being a market leader is not always translated into a durable competitive advantage. This post will talk further about economies of scale as a durable competitive advantage. What is a common mistake regarding the economy of scale as an economic moat? How does economies scale create a layer of protection for business? We are here to answer this moat question.
. . .
In This Issue
Market Leader: Misconception About Economies of Scale as Durable Competitive Advantage.
Like a good product doesn’t always imply a durable economic moat, being the market leader also doesn’t give a grant about it.
A little old story, in autumn 2012, The Chinese giant who take over IBM PC, Lenovo, dethroned US-based HP as the largest PC maker. In 2021, Xiaomi – China again – overtake the Korean Giant Samsung as the number one smartphone maker. In some cases, you won’t be the biggest forever.
Under fierce competition, being the biggest does not always give you the upper hand. Even if the largest “size” really gives tremendous advantages, that advantage doesn’t have a guarantee to last long. Nokia in the dinosaur in 2010, dominating market share as the leader. Yet, it struggles right now – forgotten, uncounted.
Economies of Scale as Durable Competitive Advantage Due to Cheaper Production Cost.
Reduce by Number
Buying in bulk often gives you a discount. This shopping adagio also holds true for the corporate level. This is the most primitive form of economies of scale. That is, buying more raw material through a long-term contract with a special supplier gives you a discount.
As a result, by having lower production costs, a company could reduce its product prices. Giving pressure to the competitor.
But the strength of this advantage is questionable, especially when there is a lot of stand-by suppliers. This means that competitors can access the same boost.
Reduce by Efficiency
The better advantage is when the increasing of units produced brings efficiency. It is because production cost and units produced don’t move in a proportional or linear way. Doubling the output may just need an additional 50% cost. Because the power plant unit can operate at max capacity, or because the flow through chemical plant becomes wider, etc., etc. You get the point without getting deeper into engineering things.
Still, it doesn’t mean that competitors can’t replicate. Rival with the same size or market access could exploit the same advantage. This holds up when there are too many players within the industry. The smartphone market and auto is a perfect example. All player has relatively the same size, thus there is no significant difference in the term efficiency.
Mixed Moat: Economies of Scale as Durable Competitive Advantage and Its Relation with Barrier for New Entrant.
Go to the higher level, the better advantage is when certain industries require high costs just to enter the game. Businesses like jet engines, defense, chip manufacturers are good examples. Due to the high cost needed to just manufacture chips, it is difficult to challenge Intel and TSMC leadership in the foundry business. Or, Intel and AMD supply a group of computer vendors.
In this case, economies of scale help the company to jump over the high barrier to enter the industry. The main character of this industry is the high fixed cost that can be R&D, government approval, patent. Another notable point is it doesn’t have to make its product cheaper than the bulk of rivals, because the rivals may nonexistent.
Cost Reduction by Number of Multiple Number of Services and Products
Another way to reduce production or services cost is to distribute it through multiple kinds of goods or services. Economies of scale ease this process. A good example is transportation services with many routes. The profit margin for each road can vary depending on traffic, distance, accessibility. To be detailed, this advantage belongs to companies like Railroad transportation, Airlines, Export-Import companies.
We warn investors not to take further this advantage for the restaurant or food chain industry. A fast-food company could experiment with new menus that are subsidized by its most wanted items, edging the rival. The problem is, this kind of industry has very low switching costs, which means you can buy burgers from any franchise. The complement or alternative product is at an abundant number.
Economies of Scale as Durable Competitive Advantage simply by outnumber the Rivals
The highest level of economies of scale advantage is when there is no rival that could match your capacity. It happens with Intel and its not-so-good x86 architecture that offered for IBM PC. A long time ago. IBM choose intel simply because the rival, Motorola can match the scale.
When your partner needs a large amount of supply if you can fill that gap alone, so the market is yours.
Let’s get to our point:
- Economies of scale could be a source of economic moat, but there is a prerequisite and there is a level. That economies of scale level can be summarized in the first figure of this article.
- The strongest form of economies of scale as the economic moat is when there is no rival that can match your capacity and at the same time, you get contracts supplying quite large companies that produce at scale. Investors should find out this kind of business.
- The weakest form is when the company could cut down its cost due to the volume produced. We don’t recommend you pick this one.
- The company could have several competitive advantages at once, for instance, Microsoft enjoys intangible assets, switching costs, and economies of scale as this lad’s edge.
We recommend readers visit articles about economies of scope here. Also, please visit our article about economies of scale here that specifically analyze ride-hailing and food delivery business. Both will give you a deeper understanding of economies of scale, which company really takes the upper hand.