Benefits of enormity may be questionable. The author explores whether companies realize true economies of scale through increased size or whether they are getting too big to be efficient.
The author investigates whether there is a limit to economies of scale through increased size for companies. For various reasons, an increase in size may not be beneficial or may have a limit.
How Is This Article Useful to Practitioners?
The benefits of enormity are not always a compelling argument. The author provides examples at both ends of the spectrum of economies of scale. Larger boats spread fixed costs over higher output; so, container ships lower shipping costs per container as their size increases. Bigger buildings, however, fail to realize savings because height-related changes (e.g., designs to address wind force) offset savings from declining fixed costs of land per square meter.
The author questions where larger companies lie on the continuum between boats and buildings. One way to answer the question is to determine a company’s cost function, which reflects how output levels affect production costs in a competitive market. To find the cost function, complex information is needed on the interaction between a company’s inputs and outputs. The author notes that some industries may have room for expansion and be able to realize cost savings, such as in dairy farming, and others may not, such as in the railroad industry. As companies grow, economies of scale become harder to realize. Some researchers have even found what is called the “winner’s curse,” in which shareholder value is actually lost in mergers.
There are several reasons why companies may want to expand. For example, they expand to stifle competition and boost profits through price increases, or they may be empire building. State safety nets may also propel firms to expand to receive implicit state backing. This too-big-to-fail syndrome has afflicted automakers and banks.
Investment managers should take a closer look at the “economies” of mergers to determine whether value is actually created.
Bigger is not necessarily better. Not size alone, but also how a company deals with its size determines what benefits are gained by the company and its shareholders. Financial analysts need to understand the economics of the industry a company operates in, how size affects efficiency, and who ultimately benefits from the increase in size.