By Kelvin Tai - Economics and Management Student @ Harris Manchester College, Oxford
Technology companies such as FAANG have dominated the business scene in recent years. Aside from the network effects, a major reason for their success has been the scalability of their offering. As the knowledge economy continues to permeate every aspect of our lives, its pervasiveness can be chalked up to how easily scaled ideas can be.
The concept of scalability is one that involves low marginal cost (the cost of producing one extra unit). While there may be high fixed costs, the subsequent production can be done cheaply. A common example would be the development of pharmaceuticals: while the initial research and development may take decades and consume hundreds of millions of pounds in funding, the production of one extra pill is almost negligible.
Professor Paul Romer developed a model which encapsulates the development and role of ideas in production. A central tenet to his model is that ideas are non-rivalrous, which means that ideas can be used for one purpose without depleting its usefulness for other purposes. Although you may use the knowledge of breadmaking, it does not diminish the ability of others to make bread using that same knowledge. As such, his model frames ideas as a factor in both production of output as well as in the production of new ideas.
The scalability of operations is one factor taken into account for venture capital (VC) firms seeking to invest in promising startups. After all, with a large probability of failure for their portfolio companies, the venture capital firm needs to be able to recoup its investment from those that do succeed in making an exit. This means that VC firms tend to invest heavily in scalable startups that can reap a return of more than 10X. A cakeshop might find it difficult to achieve scalability, since each cake produced requires considerable time and effort to churn out. A social networking platform, on the other hand, would not only find it almost costless to sign up an additional user but also benefit from having a larger network.
A firm with high fixed costs and low marginal cost of production will prefer to expand production as far as possible. With larger output, the average cost ([total marginal costs + fixed costs]/output) will fall since the fixed costs are spread out over a higher quantity. This entails a struggle for market share, which also explains why some scalable startups are so ready to expend millions of dollars in operating cashflow to secure a dominant market position. Governments may also seek to protect the monopolies of firms to spur innovation - the enforcement of patents incentivise pharmaceutical companies to innovate, else they would be unable to sell at a scale and price to recoup their costs. However, firms may abuse their market position to the detriment of consumers by marking up the price of goods excessively from cost. Hence, it is critical that societies grapple with the normative question: How much private benefit should an idea generate and when should ideas return to the public domain?
Further reading:
Sullivan, Tim. "Blitzscaling." Harvard Business Review (2016). Web.
Jones, Charles. "Population and Ideas: A Theory of Endogenous Growth." NBER Working Paper Series (1997): 6285. Web.
Hawkins, Richard. "Marianna Mazzucato The Entrepreneurial State: Debunking Public vs Private Sector Myths." Science and Public Policy 42.1 (2015): 143-45. Web.