Digital is turning the economies of scale paradigm on its head

Those of us who studied economics at school would have learnt that industries have to reach a “minimum efficient scale” of production before they can turn a sustainable profit.  Until such an output level is reached, the fixed costs of running the business will not be covered sufficiently well enough to return a positive cash flow.  Scale economics showed us that a factory needs to be large enough to integrate many production features into one supply chain, and that its market needs to be scaled to justify the investment to put such a factory together in the first place.

Specialists had their place in this world too – to make niche contributions for a fractional share of the value.  The lion’s share was destined for global companies selling to world markets.  British Airways, Singapore Airlines and Emirates ran global operations with billions of dollars in revenue (USD 17Bn, USD 14Bn, USD 22Bn respectively in the most recent financial year), whereas travel agents were localised players making USD 10-20 per ticket sold.  How big business works with specialists across the value chain was governed by the laws of the production function: Industrial Economics 101.  But do these pillars of industrial economics still hold true?

No.

Expedia, the world’s online largest travel agency, reported revenues of just over USD 4bn in 2012.  Cleartrip, one of India’s fastest growing online booking agencies, claims to book 500,000 travel events per month with revenue of some INR 300 Cr monthly.

Expedia’s growth from being a division of Microsoft in 1996 to a global business which has included hotels.com and Trip Advisor in its stable (the latter was divested), is astonishing (see table).  The business has grown through the customer reach and access provided by the internet, powered through two types of acquisitions: businesses with customer reach in various markets, and businesses with technology or functional specialism in the travel business.  In 2010, Expedia acquired a mobile app business, providing the platform needed to engage deeper with individual customers on a daily basis to attend to their travel needs.  As a result, in less than twenty years, a player in one segment of the travel industry value chain has now globalised its niche role to become bigger than most of the world’s airlines.  For Expedia’s loyal customers, it is now more relevant to solving their travel challenges than any global airline or hotel chain.

The real-time and virtual connectedness between people and things that digital enables today is creating new ways for people and assets to create value and reach customers never accessed before.  This is turning the basic tenets of scale economics on its head.  There are two reasons why this is happening.

1. Due to better connectedness, tiny businesses can now reach global markets Thanks to digital, distribution less and less requires global presence as a necessary condition for viability.  Small companies can now reach millions of customers through a mixture of e-commerce portals, social media, channel and solution partners.  Previously restricted to local markets, especially in the services world, geographically small companies can now go anywhere.

A made-to-measure shoe maker in Pune can now sell his merchandise to customers across India via Flipkart.  The portal can provide a link to the shoemaker’s website, where the customer can scan and upload a tracing of their foot size after selecting from samples of leather, soles and shoe designs and lace colours.  This can be done without the need for the shoemaker to spend more money on advertising, sales or distribution, or even for the customer or shoe maker to speak to each other.  So even though the shoe maker only owns the production segment of the shoe market value chain, he can still play national or even global.

Similarly, a highly-rated restaurant in Bandra features high on Trip Advisor’s city guide for Mumbai, meaning that thousands of hungry Mumbaikars will see the reviews and frequent the eatery on the basis of peer customers’ reviews.  In this case, the restaurant gains visibility through social media which simulates word-of-mouth feedback on the destination and replaces the need for the restaurant to spend more on advertising.  So even though the restaurant is a small establishment without the scale to advertise in the city press, the digital world ensures that it becomes visible to thousands of people specifically looking for a place to eat.

2. Digital technologies mean the production function can be more dispersed and collaborative
An international language school based in London providing Hindi classes worldwide discovers through an e-learning portal that there is an expert in Lucknow whose work is relevant to the latest module the school is looking to develop.  Using online collaboration tools, the school works with the translator to source audio, visual and written learning materials which are then edited and digitally integrated into a global publishing portal and resold all over the world.   A bone specialist working at a Bangalore clinic is now retained by a medical tourism company in Delhi to review X-ray images sourced from its customers.  The specialist reviews an image from a pathology lab in Assam, while having a video call to discuss the results with the patient.  Payment for the specialist services are completed through a mobile payments service once the face-to-face consultation call is over.

Even though specialists (whether linguist or osteopath) are remote from the customer, they can be discovered, supply their services and charge remotely.  The emergence of revenue models to sustain the linguist in Lucknow or the osteopath in Bangalore through remote use of their skills creates new businesses which have never existed on this scale before.

The digital phenomenon is having a democratising impact on business because it levels out a playing field once surrendered to big business, but now giving hope to SMEs to play seriously in global markets.

Make in India is looking to the next group of small businesses to scale up and reach the world market: Digital is turning scale economics on its head and has the potential to make that happen.

Sources: Expedia

The thoughts and opinions shared here are of the author.