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Economies of scale run out at a certain point. The largest firms in America may
be beyond it
Nov 3rd 2012 | from the print edition
SOME things only get bigger. From boats and planes to skyscrapers and shopping
malls, size records are routinely broken. Companies are operating at record
scale, too. But if the trend towards growing ever larger is clear, the
economics of bigness are far murkier. In some cases, like boats, greater size
still promises greater efficiency, as fixed costs are spread over higher
output. In others, like buildings, the gains from scale may be running out.
Where do firms lie on this spectrum?
Container ships provide a good example of economies of scale in action.
Introduced in the late 1950s, the first ships could carry 480 twenty-foot
equivalent (TEU) containers. By 2006 the biggest could shift 15,000 TEUs. Cost
factors explain the rise: transport adds nothing to the final value of a good
so cost minimisation is all-important. Since the shipping cost per container
keeps on falling as ship size rises, container ships are set to keep growing. A
new range of 18,000 TEU ships is due to launch in 2013. Per container they will
be the most efficient yet.
But it is possible to exhaust the savings that come with size. Between 1931 and
2007 the record for the world s tallest building rose from 381 to 828 metres.
At first, as buildings get taller, the fixed cost of land per square metre of
office space falls. But other height-related changes offset this saving. The
wind force on a building rises exponentially with height, meaning design
becomes more complex and costly. A recent study* by Steve Watts and Neal Kalita
of Davis Langdon, a consultancy, shows that construction costs per square metre
rise as a building gets taller. In addition, the useable space per extra floor
starts to fall as the central core of the building gets bigger. Most very
tall buildings are at an inefficient scale, propelled skyward for reasons of
prestige rather than efficiency. If developers were focused on cost alone, they
would opt for clusters of mid-rise buildings.
Businesses have also been getting bigger. A snapshot of the American economy
shows huge dispersion in firm size: around a third of American workers are
employed by one of the 6m small firms with fewer than 100 workers, and another
third are employed by one of the 980 large firms that have over 10,000 workers.
But the long-run trend seems to be towards bigger companies. In a 1978 paper
Robert Lucas of the University of Chicago documented how average firm size in
America had increased over a 70-year period (see left-hand chart).
And at the very top end of the scale, the world s biggest firms keep on getting
bigger. This can happen gradually, as firms outdo their rivals, or suddenly as
firms merge. Indeed, mergers are particularly important in explaining
gigantism. In the past 15 years the assets of the top 50 American companies
have risen from around 70% of American GDP to around 130% (see right-hand
chart). All of the top ten American firms have been involved in at least one
large merger or acquisition over the past 25 years.
So are businesses like boats or buildings: are they seeking out economies of
scale, or are they too big to be efficient? One way to answer this question is
to estimate how output levels influence the costs of production in a
competitive industry. This relationship known as a cost function can be
tricky to establish because firms often have multiple inputs and outputs. Take
farming. Estimating a cost function requires complex information on how each
farm s outputs (milk, meat and crops) and inputs (labour, energy, feed,
capital) interact.
But once the cost function has been pinned down, it can be used to identify
scale economies. If average costs fall as a firm of a given size grows bigger,
this suggests economies of scale exist for firms of that size. Results vary by
industry. American dairy farms, for example, have been getting bigger but a
recent paper shows there are still economies of scale to exploit, especially at
those many farms with fewer than 200 cattle. By contrast, rail-industry studies
show dwindling economies of scale over time as companies have grown. Overall,
estimated cost functions suggest the limits of scale may have been reached for
some very large firms.
Merger studies support this. The winner s curse describes the phenomenon of
mergers destroying value for the shareholders of an acquiring firm. Research by
McKinsey, a consultancy, provides one explanation: close to two-thirds of
managers overestimate the economies of scale a merger will deliver, often
overegging the benefits by more than 25%. Size can even drive costs up, if
firms get too big to manage efficiently.
Top dogs and fat cats
If size does not keep driving down costs, why do big firms keep expanding? One
possibility is that they are seeking to boost profits not by driving down costs
but by raising prices. Buying up rivals softens competition and enables firms
to charge more. American antitrust regulators recently looked back at past
health-care mergers, and found that prices rose significantly after some deals.
Another view is that mergers are driven by something other than profit. The
empire-building theory holds that managers are out to increase the scale of
their business whatever the cost in terms of creeping inefficiencies.
State safety nets can distort incentives, too. America s leading three car
manufacturers have all grown through mergers: each of them employs over 50,000
workers, and the government balked at letting them fail during the crisis. Some
firms may be growing not to lower costs but to receive the comfort of implicit
state support. A 2011 paper by Federal Reserve staff supports this conclusion,
suggesting banks pay a premium to merge if the tie-up gives them
too-big-to-fail status. None of these reasons for operating at a vast size is
benign. All suggest that antitrust authorities should be much more sceptical
about mergers that claim to be justified because of economies of scale.
Sources
Tall Buildings, A Strategic Design Guide Cost Section and The Economics of
High Rise , by Steve Watts and Neal Kalita, Davis Langdon Tall Buildings
Research. Contact details here
On the size distribution of business firms , by R.E. Lucas, Bell Journal of
Economics, 1978
Scale Economies and Inefficiency of US Dairy Farms , by R. Mosheim and C.
Lovell, American Journal of Agricultural Economics 91(3) (August 2009): 777 794
Rail cost functions and scale elasticities: a meta-analysis , by E. Pels and
P. Rietveld, 2003
Anomalies: The Winner's Curse , by Richard H. Thaler, Journal of Economic
Perspectives, Vol. 2, No. 1 (Winter, 1988), pp. 191-202
Where mergers go wrong , McKinsey Quarterly (2004)
Symposium on retrospective merger analysis in healthcare, International Journal
of the Economics of Business, Volume 18, Number 1
How much did banks pay to become too-big-to-fail and to become systemically
important , by E. Brewer and J. Jagtiani, Federal Reserve Bank of Philadelphia
Working Paper No. 09-34, 2011
Economist.com/blogs/freeexchange
from the print edition | Finance and economics