Costs and Risk: Knowledge Economy Vs Scale Economy

Often we assume or theorize that large firms using their size and strength can crush relatively smaller competitors. In economics, it has been observed that the firm asset size increases market power. From an antitrust point of view, it is argued that such a high concentration may result in a lack of investment, high prices, less innovation, and reduced business dynamism and it is not good for the economy in general.

Are these still valid arguments, Given that we are now in a knowledge economy? Although too high an industry concentration, in general, is not good for competition or consumers, the economic reality in recent times, however, is that industry-concentration strategies like size and scope through mergers or acquisitions did not translate into profitability for large firms in many mature/traditional industries in the U.S. economy. In fact, many large firms have done damage to themselves with their size and asset concentration,

My contention is based on the following rationale. First, Except for the new-age knowledge economy firms, size, and concentration are not adding any advantage in many industries. Second, in many industries such as Airlines, steel, processed food, banking, electrical and electronics, and beers large-scale mergers or acquisitions were pursued primarily to stop the declining growth or avoid the bankruptcy crisis. Although what ensued was a high asset and revenue concentration across many U.S. industries, these integration efforts did not always translate into high profitability or stock returns. Third, now the scope of the competition is global with dynamic technologies and fleeting investors, and ever-uncertain price-sensitive customer markets. In a sense, the espoused economies of scale, scope, or integration effects did not accrue big financial gains to large companies in traditional industrial sectors. That is what the reported public data points to. While many firms are hoping to sustain their profitability through integration and concentration, the net result is just in contrast to the premise of bigness means profits.

In the scale economy until the early 90s, vertical or horizontal integration was considered a ‘thumb-rule strategy’ across many industries for increased control over costs and market share (Coase, 1960; Williamson, 1975). The paucity of managerial or technical expertise among suppliers, and the trust chasm that prevailed among buyers-suppliers (given concerns of opportunism between transacting parties) had led to a praxis that integration despite the high investment risk offers better strategic control (Coase, 1937, 1960; Williamson, 1975). Until the 1990s, as firm sizes expanded.. increasing returns to speed, volume, or revenues accrued, so productivity and profitability increased. But, not anymore...That is what our recent study on large U.S. public firms point out.

Integration/consolidation is rather turning into a high-risk and economically unattractive strategy, as firms experience demand fluctuations and market fragmentation. In traditional industries, firms had grown too big and had become too slow to respond to the dynamic market and technological changes.

A paradigm shift from a scale economy to a knowledge economy has already occurred. The?knowledge economy with the rise of knowledge-intensive high-tech firms with production and service operations that generate more value from intellectual capabilities than physical resources is changing the size and scope related benefits. In the knowledge economy, traditional approaches to growth and profitability through integration and concentration will not work; in contrast, it may erode the profitability of large firms. On the other hand, small and medium scale firms might be performing better given their agility and flexibility to respond to the dynamic changes.

There are some interesting new phenomena shaping up across many industries. First, the knowledge economy drastically flattens transaction costs by reducing information asymmetry and enhancing power and interdependence among transacting parties. Second, with the advent of miniaturized and modular production systems, firms can now operate in a flexible and market-responsive manner. Third, firms equipped with information technology (IT) and a networked computer infrastructure can easily operate in a decentralized and dispersed manner, thus reducing both bureaucratic costs and transaction costs, and the overall coordination costs. It is now widely accepted that the knowledge economy is gradually moving the cost equilibrium – in relation to firm size – in a reverse direction (Senthil Kumar Muthusamy, 2014, 2015). Nike is a prime example of a beneficiary of globally dispersed organization design coordinated with IT infrastructure. Nike manufactures more than 1000 styles of shoes, operating in 51 countries, working with 700 contract factories, employing 500,000 employees.

We extend this analysis and draw a theory of smart enterprise in light of the paradigm shifts toward the knowledge economy.

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