Using Economies of Scale to Make the Sale

Exploiting economies of scale was a driving strategy during the dot com boom of the 1990s. Internet firms raced to get the right domain name, get to market first, and then capture the most market share regardless of cost. This first-mover strategy worked for some and failed miserably for others. Capturing the most market share as fast as possible would seem unreasonable for small businesses wanting to sell online. So how can they exploit economies of scale?

What Are Economies of Scale?

Economies of scale occur when a firm’s long run average costs per unit fall as its production output grows. For example, if a firm builds a factory to produce bunny slippers, and then only produces two pairs, the average cost of each pair is pretty high! However, if the factory produces hundreds of bunny slippers, the average cost per pair is pretty low. When long run average costs are falling as production increases, the factory is exhibiting increasing returns to scale. This continues until production reaches the level that achieves minimum efficient scale – an output level that generates the lowest average cost per unit. However, in most cases, there are limits to how big the factory can get before its average costs per unit actually begin to rise. This is when the firm encounters diseconomies of scale. For further understanding of the technical aspects of economies of scale, a good reading can be found here (http://tutor2u.net/economics/content/essentials/economies_scale_scope.htm).

What Are Some Examples of Firms that Exploit Economies of Scale?

Firms from the early dot com era used size in an attempt to exploit economies of scale. Two such firms are described here. Webvan was a firm established in 1999 providing the convenience of online grocery shopping. In order to succeed, the firm felt the need to provide a vast delivery service. It raised $1.2 billion dollars from venture capitalists. The original plan was to create automated distribution centers in 26 target markets – with each being 350,000 square feet in size and about $30 million in cost. (http://ecommerce.hostip.info/pages/1080/Webvan-Group-Inc.html) The idea was to grow large, take advantage of economies of scale, have reduced prices and convenience, and out sell the competition. Being big in size would allow them to spread out their high fixed costs over their large market share, obtain volume pricing from wholesalers, and speed delivery to the consumer. Ultimately, 10 distribution centers were built or purchased. But the firm way overestimated demand. Economies of scale could have been exploited if the demand had been there. Since it was not, they perhaps should have started out smaller even if it meant having higher average costs. Hodson and Laseter (2001) contrast Webvan’s failure with the success of Peapod, another online grocery service. They find that Peapod’s relative success was due to the fact that Peapod delivered groceries collected from local retail stores. Since they did not have their own distribution centers, their variable costs were high, yet their fixed costs were low. Peapod is still delivering groceries and increasing the number of markets they serve today.

On the other hand, Amazon.com is another online store with humble basement beginnings that grew rapidly and massively in the early 1990s. Originally selling only books, it now sells music, videos, electronics, toys, and more. Jeff Bezos began Amazon.com in 1994 and began attracting venture capital by 1995. Amazon’s strategy was to “Get Big Fast”. By 1999 the company’s sales had exceeded $1.6 billion, but the company was still generating losses. Not only had the company become large, it had clearly become too large and began facing diseconomies of scale. This led Mr. Bezos to order the firm to “get the crap out” and reduce the scale of business (Frey and Cook, 2004). Over the next few years, Amazon began teaming up with other retailers, such as Toys R Us, and later allowed additional smaller third parties to begin selling via the Amazon.com online store. It was not until 2002 that the firm finally reported a quarterly profit. Amazon.com is a success story that supports the “Get Big Fast” theory; however, even Amazon learned that there is minimum efficient scale and a point beyond which diseconomies kick in.

What can we learn from this for selling online?

As will become evident over the course of this study, reaching and driving traffic to your site will become increasingly important. As the early dot com firms learned, being first to market, having the great domain name, or having the largest production or distribution capabilities does not guarantee success. The familiar phrase “if you build it they will come” does not apply to most online business. I did a quick Google search on digital cameras for sale and turned up over 700,000 results. Without sufficient investment, you very well could be the seller in result 699,999. For an online small business, sources of economies of scale include large fixed costs such as wharehouses or advertising campaigns, set up costs such as a quality website, ownership of specialized resources, division of labor or learning by doing, or purchases of large indivisible containers of inventory or other forms of volume purchasing. Setting up a quality online site and business model that can handle the fluctuations in demand may be quite expensive, but the benefits could be well worth the investment. A small business needs to study their potential market well. The managers need to understand and not overestimate the potential demand for their product. But it is important to not think too small either. Many parents have not forgotten the debacle of Toys R Us in 1999 when many Christmas toys could not be delivered in time for Christmas. “During 1999, Toys R Us did not have adequate inventory and fulfillment capabilities to meet the online demand for its products.” (http://www.internetlibrary.com/cases/lib_case424.cfm)

Bibliography and Further Reading:

http://ecommerce.hostip.info/pages/1080/Webvan-Group-Inc.html, Inc Webvan Group

http://www.strategy-business.com/press/enewsarticle/22494, Sweeping Webvan into the Dustbin of History, Nicholas Hodson and Tim Laseter, 8/13/01

http://seattlepi.nwsource.com/business/158315_amazon28.html, How Amazon.com survived, thrived and turned a profit: E-tailer defied predictions it would do none of those, CHRISTINE FREY AND JOHN COOK, seattlepi.com, January 28, 2004.

http://www.peapod.com/corpinfo/GW_index.jhtml;jsessionid=KQBQI1NDDUQN4CQBD0WCFEQ, Company History, Peapod.com.

http://www.internetlibrary.com/cases/lib_case424.cfm, Toys R Us.com, LLC v. Amazon.com, Docket No. C-96-04 (Superior Ct. N.J., March 1, 2006), Internet Library of Law and Court Decisions.

http://tutor2u.net/economics/content/essentials/economies_scale_scope.htm, Essential Economics: Economies of Scale and Scope

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