Complementary and Contradictory Economies of Scale

The odd thing about economies of scale is that they operate on both the revenue and the cost side, and the two do not have to coincide.
I’ve been digging into some of the literature on network effects, which can drive positive economies of scale – e.g., Facebook is a lot more valuable because all your friends are on it.  This is common in many current-generation software companies based around networks, and the promise pitched to innumerable venture capital investors.  Many competitive spaces based around networks are natural monopolies for this reason, in that the value proposition to the largest player is naturally higher than its competitors.  The rich get richer.
In traditional industries, positive economies of scale are ubiquitous on the cost side. As your brand gets bigger, you can e.g. shift from expensive contract manufacturing to more inflexible but lower-cost in-house manufacturing.  For many traditional industries the economies of scale are highly positive on the cost side but next-to-nothing on the revenue side – the value of Tide is unaffected by whether your neighbor uses Tide.  For consumer brands that are big enough, the revenue economies of scale can turn negative due to reasons of market saturation, fashion, and taste.
A bit of a novelty are businesses with the opposite problem – strongly positive economies of scale on the revenue side and negative economies of scale on the cost side.  For example, a two-sided marketplace where an app mediates physical activities.  As the business gets bigger, issues like liability (legal and PR) become commensurately bigger.  For businesses where the profit model is based on externalizing internal expenses, e.g., shifting insurance and maintenance costs from the service provider to the service operator, that becomes less practical as the firm gets too big.
It strikes me that many of the current-generation sharing-economy companies fall into this category of wrong-way-round economies of scale.  When there are network effects to drive growth but difficult physical realities to work around, it could turn out to be easy for a company to outgrow its economics.  For example, if there are positive cost economies of scale for operating a car-dispatch service, why were there no globe-straddling car-service companies beforehand?  The contradictory economies of scale suggest a natural boom-and-bust cycle where operating cash flow plummets inexorably while revenue (and need for operating cash!) explodes.
Also a fun question – on a conceptual (not accounting) level, is paying to acquire a competitor in a marketplace business a capital or marketing expense?


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: