TCS Daily


In Today`s Economy, Bigger Can Be Beautiful

By W. Michael Cox - March 27, 2000 12:00 AM

March 2, 2000

During the technological revolution that brought us personal computers and the Internet, just about everything about computing keeps getting smaller and smaller.

So it is somewhat ironic that the Information Age brought with it a string of mega-buck mergers long enough to make trustbuster Teddy Roosevelt roll over in his grave.

Several companies have united or announced intentions to merge in the past two years Exxon and Mobil, MCI Worldcom and Sprint, CBS and Viacom, AT&T and MediaOne Group, Citicorp and the Travelers Group, SBC Communications and Ameritech.

This year, deals are still coming fast and furious. If things go as planned, Internet upstart America Online will buy entertainment giant Time Warner for $166 billion. Pfizer and Warner Lambert, two fast-growing drug companies, agreed to a $92.5-billion merger. Glaxo Wellcome and SmithKline Beecham, two other pharmaceutical producers, are joining in a $76-billion deal. Britain`s Vodafone AirTouch is awaiting approval to acquire Germany`s Mannesman for $180 billion, the biggest deal in history.

At least so far.

The billion-dollar mergers get all the headlines, but they are just the leading edge of a record-setting wave of corporate wheeling and dealing. The past year saw nearly 10,000 mergers and acquisitions of $5 million or more, six to seven times the activity of the early 1970s [see chart]. And companies are not just doing more deals, they are also doing bigger ones: The dollar value of merger and acquisitions set a record last year.

What a difference a century makes

In Roosevelt`s time, big was bad. Nearly a century after its breakup, John D. Rockefeller`s Standard Oil remains, at least in the popular vision, a cautionary tale of corporate power gone astray. The company gained control of oil fields and distribution networks, erecting nearly impenetrable barriers to entry. When Standard Oil eliminated competition, it gouged consumers by raising prices.

There is a bit more to the story, however. In the early days of the Industrial Age, higher prices reflected not only raw monopoly power but also the decreasing returns to scale. As enterprises grew, the cost of producing additional output began to rise, slowly at first but then more rapidly. Companies raised prices to cover the higher expenses.

Today`s tidal wave of mergers and acquisitions does not represent a return to the bad old days of Rockefeller and his compatriots. What`s different? First, it is much harder to erect barriers to entry. The Industrial Age relied heavily on physical capital, such as land, natural resources, buildings and transport. One company`s control excluded another`s. In the Information Age, intellectual capital forms the foundation of new enterprises, and there is no monopoly on ideas, at least not in an economy where financial capital flows freely. A novel idea and a little money can create a billion-dollar business almost overnight.

Turning the cost structure upside down

Just as important, the Information Age has transformed the economy`s cost side. The rising-cost sectors of yesterday`s industrial economy are giving way to industries with increasing returns to scale. As a result, the average cost of producing goods and services actually declines as the size of the market increases.

Take prescription drugs. It requires an average of $350 million to bring a new pill to market. At that price, the cost of producing the first dose is exorbitant. If it takes a penny to produce each additional one, though, the average cost of production falls quickly -- to $350 at 1 million pills to $3.51 at 100 million and 4 cents at 10 billion.

Many of the new information technologies show a similar structure. In the software business, for example, companies pay millions of dollars to programmers who write line after line of computer code. Delivering additional copies to customers becomes virtually costless when downloaded via the Internet.

In establishing networks, it is expensive to link the first users but far less costly to add customers once the delivery systems reach critical mass. It was true in the past for telephones, trucking routes, airlines, television and electricity. Now, it applies to the Internet, media, cellular phones and telecommunications.

The proliferation of declining-cost industries requires rethinking of our attitudes on mergers and acquisitions. For a century, the prime justification to fear larger enterprises was protecting consumers from rising prices. Now, many of our fastest-growing industries can reduce prices only by getting large enough to capture the scale economies inherent in Information Age technology and networks.

New rules to live by

Scarcity, the first assumption of the old economy, is not the dominant feature of the Information Age. Many of today`s markets are awash with goods and services. Sellers compete aggressively for buyers. They discount. They cut costs. They expand markets through relentless promotion and advertising. New entrants, actual or potential, are always clamoring at the gates, providing companies with reason to pass cost savings on to consumers.

The surge of mergers will not abate anytime soon. Market pressures to get bigger emerge from the Information Age`s revolution on the cost side, made all the more urgent by modern technology's relentless ability to generate economies of scale.

In today`s business environment, though, mergers and acquisitions are less threatening to consumers. Increasing size may well mean lower prices, not higher ones. America cannot simply abandon anti-trust policy, but a knee-jerk attitude of "big is bad" is no longer in the best interests of consumers.

The wishful economics of the Age of Aquarius proclaimed that small is beautiful. Today, we ought to rethink that maxim and recognize that bigger can be beautiful, too.

W. Michael Cox is Senior Vice President and Chief Economist at the Federal Reserve Bank of Dallas. Richard Alm is a business reporter at The Dallas Morning News. Their new book, Myths of Rich and Poor: Why We`re Better Off Than We Think is available from Amazon.com.

This column originally appeared at www.intellectualcapital.com, part of the VoxCap Network and a great site for policy news and analysis.
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