As previously discussed, I think the most sustainable competitive advantages are, in descending order:
- Economies of scale combined with customer captivity;
- A network effect;
- A government licence;
- Patent protection; and,
- Customer captivity[1].
In this post I will explain when I think a business has an economies of scale competitive advantage.
When does a business have an economies of scale competitive advantage?
A business has an economies of scale competitive advantage when:
- It has a much larger market share with a product or service than its competitors in a:
- Geographic area; or,
- Product or service space (for example Intel with computer CPU’s); and,
- Fixed costs make up a large share of total costs.[2]
If this occurs the dominant business’s average cost per unit will be lower than its competitors. Its smaller competitors will have higher average costs because they cannot reach the same scale of operation. The dominant business’s lower average cost per unit means it can keep competitors at bay by using one or more of the following tactics. It can have:
- A lower price for its product or service than its competitors; [3]
- A more technologically advanced product or service than its competitors (it can spend more on research and development); or,
- Better marketing for its product or service than its competitors (it can spend more on advertising and sales promotion).[4]
However, as Professor Greenwald points out, pure size is not the same as economies of scale.[5] It is the share of the relevant local market rather than size by itself that creates economies of scale. Economies of scale coincides with large businesses in only a relatively few products, for example, in Boeing’s airframes, Microsoft’s operating systems, and Intel’s CPU. Even these global businesses are dominant in only a few product lines, and are, thus ‘local’ in the sense of ‘product space’.[6]
Why a business with an economies of scale competitive advantage also needs some customer captivity
Economies of scale by itself is not enough for a business to keep a competitive advantage. If a business has only an economies of scale advantage, its competitors will be able to take some of its customers and will eventually be able to capture enough market share to remove its scale advantage. The business with the economies of scale advantage needs to be able to keep its larger market share. It does this by keeping its customers. The way to do that is to have at least a mild form of customer captivity.
How a business keeps this economies of scale competitive advantage
The overwhelming priority of a business with an economies of scale advantage is to protect its market share and, thus, keep its large size relative to its competitors. It can do this by matching the moves of an aggressive competitor price cut for price cut, new product for new product, niche by niche. If it does, then its customer captivity will secure its greater market share. Its competitor’s average costs will be higher than its average costs at every stage of the struggle. While this will reduce the profit of the business with the economies of scale advantage, its competitors will usually make very low returns on capital, or a loss, and will eventually stop competing.
Another priority for a business with an economies of scale advantage is to increase this advantage. The best way to do this is to increase the proportion of fixed costs relative to the variable costs that is needed to produce the product or service. For example, the business can spend more on research and development to speed up product development cycles, or it can increase the number of features with the product or service.
[1] Customer captivity refers to how a business has ‘captured’ a customer. This can be because the customer will have high costs in ‘switching’ to an alternative product or service provider, or high costs in ‘searching’ for this alternative, or simply because the customer has developed a strong ‘habit’ in buying the product or service. I will discuss this form of competitive advantage in much greater detail in a later post.
[2] Fixed costs can be capital investments on plant, equipment, or information technology, or it can even be operating expenses like advertising or managerial supervision. See p32, ‘Measuring the Moat, Assessing the Magnitude and Sustainability of Value Creation’, Michael Mauboussin, 16 December 2002.
[3] The dominant business can be highly profitable at a price level that leaves its smaller competitors, with higher average costs, losing money.
[4] Even if its competitors can spend the same proportion of revenue on R& D, or sales promotion, they cannot sustainably spend the same dollar amount as the dominant business.
[5] See, ‘All Strategy Is Local’, Bruce Greenwald and Judd Kahn, Harvard Business Review, 2005.
[6] Also a business selling services is more likely to have an economies of scale competitive advantage than a business selling products, because services are usually provided ‘locally’. See, ‘All Strategy Is Local’, Bruce Greenwald and Judd Kahn, Harvard Business Review, 2005.
