I created a post on Facebook the other day (the contents of which is irrelevant), and one of the comments in response included the following statement:
I assume this is opposed to unfettered capitalism that inevitably evolves into corporatism.
I was heading to bed when this comment came up, so I quickly snapped back:
Issue one with that statement: corporations are Government chartered organisations. Without the state, you cannot have corporatism.
In hindsight, I feel like this response is lazy. Sure, while it is technically true, its really just semantics. I knew what he meant wasnt corporatism as what we see today, what he meant was that in a free market, companies will grow large enough that they will hold a monopoly position.
Prices will dramatically increase, quality of the goods will decrease, working conditions and pay will drop to the ground, because our choice will be between working for one of these few major companies, or starve and go homeless.
Pictured: capitalist
So, that (I assume) was his real argument. And that is the argument Im going to address today.
Diseconomies of Scale and Profitability
This is something that is covered in most economics courses. I think most people are somewhat aware of economies of scale, even if they dont know the name. Everybody knows that you buy in bulk, its cheaper than buying one item at a time. And the reason is fairly apparent: if you build a factory and only produce 1 unit, that was one expensive unit. But if you produce 100 units
you dont need to build 100 factories, you can use the first factory. So the next 99 units are significantly cheaper than the first one.
I believe this is where most of the scares come in. If a company gets better deals by buying in bulk, then the market is clearly going to favour larger businesses. A supermarket that can buy 100,000 gallons of milk at a time is definitely going to outcompete a small local store than can only purchase 500 gallons at any given time.
But, believe it or not, there is a maximum limit to this. There comes a point where growth reduces profitability. And this is all to do with the nature of economies of scale and diseconomies of scale. You see, with the widget example above, building the first widget was extremely expensive, and the second widget was significantly cheaper. The third widget will be cheaper, still
. but by a vastly reduced margin compared to the difference in cost between the first and second widget. The same will be true for buying milk: while a company could save a large sum of money, per gallon, buying 100,000 gallons versus 500 gallons. The per gallon price wont change that much at 100,001 gallons. It gets to a point where the savings from increasing order sizes just arent significant.
So what about diseconomies of scale? What are these. Take another example: you own a shop, and its doing well. So well, in fact, that you decide to expand and open up another shop in the next town over. The issue is: you cant be in two places at once, so while youre managing one shop, you need to hire another manager to look after the other. As you continue to expand, you need regional teams, national teams, corporate staff. You need to build a HQ for your corporate staff, and that building needs equipment, cleaning, maintenance, energy. You need to pay taxes on that building. And that building doesnt generate any new revenues. As you grow further still, you need to start building similar infrastructures around the globe, you will need to deploy computer systems which require IT staff. Those IT staff will need toilets, and seats, and computers, and lighting
and when they build the systems, you need to have a whole host of teams testing them, and then deploying them.
This is what diseconomies of scale are. Every time you expand your business, you will have to incur a slightly larger cost in one area or another. For a while, this doesnt affect profitability, because the economies of scale offset the diseconomies of scale
but as economies of scale diminish, and diseconomies grow, the profitability of expansion reverse. It starts to cost more pennies to earn the next pound than it did to earn the previous one.
The point at where this cross over occurs will vary depending on the business model, and the industry.
At output Q, average costs start to increase again
Why does this matter? If you can boost your total profit, why would the profit margin matter? Would a company prefer $10 of profit on a $1 dollar investment, or $1,000 profit from a $10,000 investment? Heres the thing: if your profit margins decrease, then the firms that did not expand (and thus, have lower diseconomies of scale, and larger profit margins), will be able to lower their prices to outcompete with you. This competition is what would provide the cap on the total size of any given company.
So, why doesnt this happen today? The answer is that Government interventions have distorted the rules of economies and diseconomies of scale, moving the cross over point so high, that vey few firms ever reach it.
Lets go back to our scenario where youre a happy, successful shop keeper, and you want to open up a new shop. For every employee, theres Government paperwork. Once youve bought the land (and paid whatever taxes in the process), youre going to need to get planning permission and zoning approval, there will be licenses and permits required to open a business, and/or sell various products, the new town may have different health and safety laws that youve now got to amend your business model for.
Now, compare this to whatever major supermarket you can think of. First off, they might not even have to buy the land, many major companies will get access to public land for free, or local Governments may use eminent domain or compulsory purchase laws to force the landowner to hand over the property for cheap, rather than having to pay market price. Oftentimes, rather than paying taxes, they will be given tax breaks or even subsidies to enter the town. While they will still have to comply with local regulations, they would have long ago set up a compliance department, and the additional cost of making sure the new outlet is compliant will be minimal.
Tesco
Other diseconomies/economies of scale have also been tampered with: through the socialisation of roads, the cost of having sprawling infrastructure has been minimized. Same goes with energy and water.
Manipulations of the economies of scale arent the only things that result in companies being far larger than what they should be. What about the fact that large, Government contracts almost always go to the big corporations? What about IP laws which allow old companies from blocking new ones from coming in? What about certified legal monopolies where a Government decrees that only ISP X or water company B may operate in a certain geographic region? All of these things result in lower competition, fewer firms, and large, monopolistic, corporations, as the original commenter correctly labeled them.