'Economies of Scale' is a Myth

Author: Ahmad Karnama

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After the industrial revolution in 19th century, there is a common, firm and dominated belief that there is economy in scaling production which is so-called Economies of Scale. In this article, it is described that Economies of Scale is one of the great examples of ‘Halo Effect’ which has biased our societies and minds for decades.

Industrial revolution known as the transition to new manufacturing processes in Europe and the United States, in the period from about 1760 to sometime between 1820 and 1840. This transition included going from hand production methods to machines, new chemical manufacturing and iron production processes, the increasing use of steam power and water power, the development of machine tools and the rise of the mechanized factory system. This was inevitable as cause of an unprecedented rise in the rate of population growth and the need for goods at any price. The price is considerably high, and we need to pay for it for generations to come.

The simple meaning of economies of scale is doing things more efficiently with increasing size. Common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), marketing (spreading the cost of advertising over a greater range of output in media markets), and technological (taking advantage of returns to scale in the production function). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down (lower cost) and to the right (more production). This is simple example of how Halo Effect can bias individuals and even societies for decades.

Halo effect (sometimes called the halo error), one important type of cognitive bias, is the tendency for positive impressions of a person, company, brand or product in one area to positively influence one's opinion or feelings in other areas. The halo effect occurs when a single aspect dazzles us and affects how we see the full picture. The full picture of Economies of Scales is described in the following table. The claimed advantages of economies of scale and its drawbacks are described in the table below:

In purchasing, it is always claimed that bulk buying of materials through long-term contracts can reduce a cost. This is now proven to be wrong. What happens in reality is that few giant corporate are eligible (by their internal rules) to trade with each other and they know how to make it. The per unit cost of buying material is not only lower in many cases but also if the high cost of managing those procurement processes and also the social cost of intra-giant deals and loss of local jobs is considered, the actual cost is considerably higher. On the other hand, the quality is proven to be much worst due to the fact that competition is already killed as the giants have market power.

In the giant corporate as result of economy of scale, the common skill to survive is politics. There is no room to use actual expertise and skills. If one knows how to deal with internal politics, he/she can be pretty successful without having any particular leadership skill or technical expertise.

Exclusive control over financial market and access to capital is one of the dangers of economies of scale. Getting such power, large corporate will have the flexibility to ruin the environment at any cost and kill local businesses and jobs. This is the main cause of climate change when the mass production fed by large finance institutes related local businesses and killed many local jobs.

I believe marketing is by far the largest drawback of economies of scale. Toxic marketing campaigns to promote consumerism is one of the main problems in modern societies. In addition, marketing is the most unregulated business and the giants can literally use any tool (women, kids or etc.) to promote their goods and there is no regulation to stop them.

It is a myth the that technology is developed in large companies. Almost all the new technologies are being invented either at universities and then taken to a startup or originally developed in startups. When the startups start to make revenue and sell their technologies, the giants come to buy them with very tempting prices and in almost all the cases, they are successful. Then these technologies go inside a toxic environment in which the key valuable talents with no political skills leave and the technology serves the giants to be even more giant.

There is no doubt that economy of scale helped societies to grow and it was the single way to cope with the population growth many decades ago. But in modern societies, we need a change! We now know that this model is not functioning anymore, and the cost is much more than its value. The next global political and economic revolution will be centered to ecologism and altruism. This revolution already happened among individuals but corporate need to adapt immediately to this change by evolving to be operated more and more like a Founcorp as described in Organic Growth Theory.