Economies of scale run out at a certain point: are some of the biggest US firms about to reach it?

I’m often blogging about the idea of economies of scale. The simplest way to understand this concept is to focus on the particular advantages bigger firms have over their smaller rivals. More accurately, economies of scale represent falling average costs as firms grow. I’ve argued that big firms are back, and even bigger – and even that they are dominant innovators.I’m pleased to be able to pick up on an article that argues this is not the end of the story…

According to The Economist, companies are operating at record scale. Greater size still promises greater efficiency, as fixed costs are spread over higher output. Container ships provide a good example of economies of scale in action. Introduced in the late 1950s, the first ships could carry 480 containers. By 2006 the biggest could shift 15,000. This means that the shipping cost per container keeps on falling as ship size rises, so container ships are set to keep growing. A new range of 18,000 container ships is due to launch in 2013. Per container they will be the most efficient yet.

Can this last? The long-run trend seems to be towards bigger companies. All of the top ten American firms have been involved in at least one large merger or acquisition over the past 25 years. Yet several big firms are fighting to keep the disadvantages of size at bay. So are businesses like boats? Are they capturing economies of scale, or are they too big to be efficient? Some studies suggest the limits of scale may have been reached for some very large firms. Merger studies support this. The “winner’s curse” describes the situation where mergers destroy value for the shareholders of an acquiring firm. Research by McKinsey, a consultancy, provides one explanation: close to two-thirds of managers overestimate the economies of scale a merger will deliver, often overestimating the benefits by more than 25%. Size can even drive costs up, if firms get too big to manage efficiently.

If size does not keep driving down costs, why do big firms keep expanding? One possibility is that they are seeking to boost profits not by driving down costs but by raising prices. Buying up rivals softens competition and enables firms to charge more. Another view is that mergers are driven by something other than profit. The “empire-building” theory holds that managers are out to increase the scale of their business whatever the cost in terms of creeping inefficiencies. We’ve also seen that when businesses like huge banks and car firms become “too-big-to-fail” they may be rescued by government too.