It pays to take heed to this statement because it describes exactly what had taken place and will takes place. This statement has enormous power. However, it also has some standard malfunctions that often cause it to reach the wrong conclusions. It also makes man extraordinarily susceptible to manipulation by others. For instance, roughly half of the army of Adolf Hitler comprised of Catholics (this has nothing to do with religion). Given enough clever psychological manipulation, what human beings will do is quite interesting.
There are two questions to ask. First, what are the factors that really govern the interest involved taken with rational consideration? Second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things – which by and large are useful but often malfunction.
One approach is rationality – the way you work out any problem – by evaluating the real interest, the real probabilities and so on. And the other is to evaluate the psychological factors that cause subconscious conclusions which are often wrong.
Then we come to another somewhat less reliable form of human wisdom – microeconomics. Here, it is useful to think of a free market economy as kind of equivalent to an ecosystem. Though it is an outdated way of thinking because in the early days after Darwin came along, people like the robbers barons assumed that the doctrine of the survivor of the fittest authenticated them as deserving power – “I’m the richest. Thus, I’m the best.” And that thinking of the robber barons surely does not goes well to the others and it makes it unfashionable to think of an economy as an ecosystem. But in truth, a free market economy is a lot like an ecosystem.
Just like an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. It is the same as how animals flourish in niches. Similarly, people who specialize in the business world frequently find good economics that they wouldn’t get in any other way.
Here, we get into the concept of advantages of scale which brings us much closer to actual investment analysis because in terms of which businesses succeed and which fail, much is dependent on advantages of scale.
An example of advantages of scale taught in all business schools is cost reductions along the so-called experience curve. Well, as human do something more and more in volume, it enables them to do it more efficiently as they try to improve while being motivated by the incentives of capitalism.
If you think of it in simple geometric in building a spherical tank, obviously as you build it bigger, the amount of steel you use for the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel. Like that, simple geometric exercise like this shows simple reality of life which gives one an advantage of scale.
A much more relevant example that shows how advantage of scale is towards business is from TV advertising. When TV advertising first arrived, it was an unbelievably powerful tool. If you were P&G, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn’t. And there was no way you can buy it in part. Thus, the small guy can’t use it. In effect, if you didn’t have a big volume, you couldn’t use network TV advertising which was the most effective technique. So when TV came along, the big companies were given a huge tail wind pushing them forward. Indeed, they prospered and prospered until some of them got really fat and sluggish – which happens with prosperity inevitably most times.
And this sort of advantage of scale through TV advertising gives an informational advantage too. For instance, if I’m to buy chewing gum, between Wrigley Gum and China Gum, Wrigley costs 40 cents and China costs 30 cents, which do I choose? I know Wrigley and how it taste. Am I going to take something else I don’t know and put it in my mouth which is a pretty personal place after all just for a difference of a lousy dime? Surely not! So what can you gain from here? When you have advantage of scale, it goes in many ways that is advantageous to the business. Most important, as in the Wrigley case, they have an advantage in dictating price even if it is 33% more than their competitors.
Another advantage of scale comes from psychology or rather what psychologists term as “social proof.” We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everyone’s buying something, we think and assume it must be better. We don’t like to be the odd one out.
Then again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, “Hey, I don’t know much about this. They know more than I do. So, why shouldn’t I follow them?”
So why does social proof give huge advantages of scale? So for any business that holds an advantage of scale of such kind, for example, coca cola, they have a very wide distribution where it’s available almost everywhere on earth. So when you have an advantage of such kind, it can become very hard for anybody to dislodge you.
Then, there is another form of advantages of scale. In some businesses, the nature of things is kind of cascade toward the overwhelming dominance of one firm – monopoly. One great example is newspapers business. And, that is a scale thing. Once one secures most of the business, one gets most of the advertising. And once one gets most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner-takes-all situation. Similarly, all these huge advantages of scale allow greater specialization within the firm. So, each person can be better at what he does.
And really, these advantages of scale are a great thing although it kills out the smaller players. But well, that is how the way the world works – the Darwin way. When Jack Welch first came into control at General Electric, he said, “To hell with it. We’re either going to be number 1 or 3 in every field we’re in or we’re going out of it. I don’t care how many people I have to fire and what I have to sell. We’re going to be number 1 or 2 or out.” Wow, that was a very tough worded statement and thing to make and do. But there was nothing wrong in the idea. In fact, it was a great guiding principle and a correct decision if you’re thinking about maximizing shareholder’s wealth. And it is not a bad thing to do either, even if competition was killed because better products were delivered and GE was stronger with Jack there.
Thus far, only advantages of scale are mentioned. But in truth, there are also disadvantages of scale. An example is in some newspaper of publication business. As you know, when we talk about a business which does newspaper or publishing or both, it is really a specialization of doing something. At Capital Cities/ABC (a USA media company), they had trade publications that got killed and also a few who got ahead of them. And the way those who got ahead of them was by going to a narrower specialization. They have a travel magazine. Then someone would create one which addressed corporate travel. Like an ecosystem, you are getting a narrower and narrower specialization. Well, the one who got narrower got more efficient in what they do. They could tell the guy who ran corporate travel department more. Plus, they didn’t have to waste ink and paper mailing out stuff that corporate travel staff wouldn’t be interested in reading. It was a more efficient system. There are some papers that did not further specialize who got killed, and some who survive were those who further specialize. For example, there’s Motorcross – a magazine which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. These people they don’t care much about the price of the magazine, it is their purpose of life. A magazine of such kind is really a total necessity to these people. And its profit margin would make anyone salivate.
So if you think about it, occasionally scaling down gives you the big advantage. Bigger is not always better.
Then one of the greatest defects of scale is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality which is again sort grounded in the nature of human. This defect really makes the game much more interesting because when you get bigger, it creates some problems and it shows that the big people don’t always win.
For example, let’s say that you work in a very big company with a great deal of bureaucracy, who the hell will really think about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-tray into someone else’s in-tray. But of course, it isn’t. The work is not done until the business delivers what it’s supposed to deliver. So you get the big, fat, dumb and unmotivated bureaucracies. They also tend to be somewhat “corrupt.” In other words, if I’ve got a department and you’ve got a department, and we kind of share power running this thing, there’s a sort of unwritten rule: “If you won’t bother me, I won’t bother you and we’re both happy.” So you get layers of management and associated costs which no one needs. Then, while people are justifying these layers, it takes forever to get any real jobs that count done. They’re too slow to make decisions and nimbler people run circles around them.
The constant curse of scale is that it tends to lead to big and dumb bureaucracy which gets to the highest and worst form in governments where the incentives are really perverse. That doesn’t mean we don’t need government which of course is needed. But it is a terrible problem to solve by getting big bureaucracy to behave. So, people use ploys. They create little decentralized units and fancy motivation and training programs. One of the big companies that fought off bureaucracy with amazing skill was GE. But that’s because they have a genius and a fanatic running it and that’s was Jack. And they put him in young enough to have a long run in it to get things work out.
Then, there is another interesting aspect of psychology which CBS provides an interesting example – namely Pavlovian association. If people tell you what you really don’t want to hear and unpleasant, there’s an almost automatic reaction of antipathy. You’ve to train yourself out of it. It isn’t destined that you have to be in this way. But you will tend to be this way if you don’t think about it.
In the early days, CBS was the dominance TV network. And their founder, Paley was a god. But he didn’t like to hear what he didn’t like to hear. And people soon learned that. So they only told him what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt although it was a great business.
So the stupidity that crept into the system was followed by a huge tide. You can get severe malfunction in the high ranks of business. And if you are investing, it can make a lot of difference. If you take all the acquisitions made under him, his advisors – the investment bankers, management consultants and so forth – were all paid handsomely which was absolutely terrible. You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss. It’s really hard to tell the emperor that he is naked.
So in a business and life is an everlasting battle between those two forces – to get these advantages of scale on one side and a tendency to get very bureaucratic where they just sit around doing nothing much useful.